The Icewater team is about to launch our first mainnet token, v1. Given the ironically volatile history of stablecoins, we will not be engaging in any large-scale sale or distribution of tokens. However, we do think continued innovation in stablecoins is important, so let’s start with a brief reminder of why.
It has often been pointed out that money serves as a medium of exchange, a store of value, and a unit of account. The success of cryptocurrencies such as Bitcoin proves that decentralized money can serve at least some of these functions.
But while a rising value makes Bitcoin a great store of value, it also makes the currency an imperfect choice for a unit of account or a medium of exchange. For example, it is hard to set prices or make prices denominated in a currency that is changing in value (even if it is going up).
Stablecoins seek to avoid rapid appreciation or depreciation so that they can serve as a better currency for making contracts, setting prices, and performing everyday transactions.
Most stablecoins depend on a peg to a fiat currency like USD to maintain stability. Pegging to USD is a reasonable choice in the short term, but we believe the long run it will be important for the crypto economy to be based on something other than fiat.
Icewater provides an alternative approach to stability that does not depend on an external peg. Instead, the protocol stabilizes its value by comparing the present value of the currency to the future value.
Icewater includes three tokens: H2O, ICE, and STM.
H2O is a stablecoin that serves as a liquid currency for everyday transactions, like your checking account. H2O is not meant to be held as an asset, because it is subject to a modest rate of inflation, which helps maintain stability.
ICE is a stable, inflation-protected asset, like your savings account. Each ICE pays out 1 H2O per year (in a continuous stream). Store your money in ICE if you want to keep it safe without losing purchasing power due to inflation. The Icewater protocoluses the price of ICE (measured in H2O) to determine stability.
STM is a speculative asset, like the equities on the stock market. Buy STM if you want to bet on the future of the Icewater protocol. Each STM pays out a variable amount of H2O. The Icewater protocol adjusts the price (and yield) of STM to maintain the stability of H2O.
Icewater measures the relative prices of these coins using virtual pools that determine the internal exchange rates between them.
A virtual pool is similar to the liquidity pools used by automated market makers to determine exchange rates. However, the “tokens” in a virtual pool are internal accounting numbers rather than actual tokens. A basic liquidity pool operates by maintaining a pool with an equal amount (in total value) of each token. When someone makes a trade, they simply enforce the constraint:
(where X1 is the absolute number of X tokens in the pool before the trade, X2 is the number of X tokens after the trade, Y1 is the number of Y tokens in the pool before the trade, and Y2 is the number of Y tokens after the trade)
The reason for using a virtual pool rather than an actual liquidity pool is that the protocol is constantly adjusting the size of the virtual pools. The size of the H2O/ICE pool is kept large enough to prevent manipulation of the protocol, and the size of the H2O/STM pool is kept large enough to enable the protocol to achieve the stability of H2O.
The price of ICE in the internal pools is used to anticipate changes in the value of H2O, and the price of STM is adjusted to prevent changes in the value of H2O.
The central insight of the Icewater protocol is that stability can be achieved by measuring market expectations of stability. Thus, unlike other stablecoins, the stability of H2O is independent of any external currency.
Fundamentally, the stability of a currency doesn’t depend on its value compared to other currencies. The stability of a currency depends on its own value over time. So if you can measure the future value of a token, you can measure stability. Since we can’t measure the future value directly, we use the next best thing: market expectations.
Specifically, the stablecoin H2O is paired with ICE, which pays out a fixed amount of H2O over time. Namely, each ICE pays out one H2O every year. The present value (PV) of ICE can be given by the formula:
where PV is the present value, A is the amount paid out each period and r is the discount rate. As an example, if the present value of ICE is 50 and the annual payout is 1, the equation becomes 50 = 1/r, or r = .02 (i.e., 2%).
There are a few components of r, but based on historical trends we believe that for any sufficiently large and reliable currency, factors other than inflation will tend toward zero. So, by stabilizing the price of ICE relative H2O, we can stabilize inflation. The Icewater protocol uses a target discount rate that changes slowly over time to reflect changing economic conditions.
Once the anticipated inflation (or deflation) rate of H2O is measured using the price of ICE, the Icewater protoco lwill then use STM to achieve stability. Like ICE, STM pays out H2O over time at a rate referred to as the condensation rate.
The condensation rate is used to adjust the supply growth of the protocol based on the measured inflation. Specifically, if the measured inflation is higher than the target, the condensation rate will be reduced and if inflation is below target, the condensation rate will be increased.
The Icewater protocol uses a proportional-integral (PI) controller to achieve the appropriate condensation rate given the past and current deviation from the target ICE price.
The price of STM in the virtual pool is also adjusted to adjust supply in the short term. Specifically, if inflation is too high, the price of STM is reduced in the virtual pool. This creates an arbitrage opportunity for H2O holders to grab some discounted STM, which they can sell on an external market. Ultimately, the reduction in the STM price creates an incentive for H2O holders to give up their H2O, which reduces the available supply to counteract the anticipated inflation. Similarly, the price of STM is increased when predicted inflation is too high.