Introducing H2O
H20 is a stablecoin that adds something no previous currency (crypto or otherwise) has been able to solve: long-term stability. Even currencies that maintain a constant rate of inflation (e.g., as measured by consumer prices) don’t address the problem that it is difficult to meaningfully compare prices over time.
As you can see in the chart below, even the all-powerful USD suffers from a decrease in purchasing power. The crypto economy needs a pure stablecoin that is not tied to any fiat currency.
Enter H2O…H2O is not pegged to any fiat currency or any other commodity. We define stability by whether the market predicts that the future value is the same as its current value. Specifically, we measure the price of an H2O-denominated future income stream. Since the price of such an income stream depends on inflation, we can use it to measure inflation. We then maintain stability by adjusting the supply of H2O.
Why stablecoins?
It has often been pointed out that money serves as a medium of exchange, a store of value, and a unit of account. Another function that is sometimes ignored is that of a standard of deferred payment.
The amazing success of Bitcoin proves that decentralized money can serve at least some of these functions. But one of the key indicators of Bitcoin’s success, its rising value, makes it unsuitable as a unit of account or as a a standard of deferred payment.
What does that mean? Well, imagine what would happen if you got a 30 year mortgage in 2013, denominated in Bitcoin? If the payments were 100 BTC per month when the price was around $15, by now your payment would have ballooned to millions of dollars. Because such an unpredictable contract would very likely be broken, it never gets made in the first place. So, to serve all of the functions of a currency, we need something that maintains a stable value .
This is where H2O comes in. H2O is a crypto token that maintains stability with the help of two ancillary tokens: steam and ice. When the value of H2O is too high, more coins are issued and distributed to the community. “Steam” is the “equity” token for the community, so it’s value can fluctuate based on the expected amount of new coins that will be issued (i.e., seigniorage).
“Ice” is a token that guarantees a regular stream of H2O. It’s value depends on the value of those future payments. Because the payments to ice holders are pre-determined, it’s price can be used to determine expected inflation.
Defining Stability
— H2O defines long-term stability by observing the price of ice (which pays out a fixed amount of water over time).
The central innovation of H2O is that, unlike other stablecoins, H2O includes a mechanism for defining stability that is independent of any external currency. We do this by seeing what how the market compares the present value of H2O to its future value (as determined by the price of ice).
Price stability is hard to define in the long term. For example, the US government measures the stability of the dollar (i.e., inflation) using something called the Consumer Price Index (CPI). Basically, they monitor the price of all kinds of consumer goods, and see how they change over time.
However, we can’t always compare the goods that are purchased now to similar goods that were purchased 20 years ago. For example, if you spend $1,000 on a phone today you are going to get a very different phone than if you bought a $1,000 phone 20 years ago (even after “adjusting for inflation”).
So, instead of defining stability based on the price of another currency or even consumer goods, H2O relies on the “market” define stability for us. To explain, consider the following analogy.
Imagine you have an immortal goose that lays a golden egg once a year. Each egg contains an ounce of gold, and represents an amount of gold that will only be available at a future point in time. How much is the goose worth? In the financial world, such a goose is known as a “perpetuity,” and the formula for the value (PV) is very simple:
PV = D/R (present value equals “D”, the dividend, over “R”, the discount rate)
That is, take the value of each egg (i.e., the dividend) and divide it by the “discount rate” (i.e., the rate at which we “discount” the value of future eggs). So, for example, if we assume a discount rate of 5%, we should pay around 20 oz of gold for the goose.
Now, let’s turn the equation around. If we know D (the amount of gold in each egg) and PV (the market price of the goose), we can compute the discount rate, R, using the simple equation:
R = D/PV
Ice is like a goose that lays golden eggs. That is, ice is a perpetuity that pays out a constant amount of H2O over time. So the market price of ice (as measured in H2O) should be determine solely by the “discount rate”.
One of the main components of the discount rate (and eventually, the most significant component) is the risk of inflation. Inflation causes the value of future payouts to be smaller relative to having the same amount of money today.
So, to stabilize the value of H2O, all we need to do is maintain a stable ratio between the price of H2O and the price of ice.
Achieving Stability
— H2O achieves stability by adjusting the available supply: new H2O is issued when the value of water is too high; and when the value is too low, existing H2O is burned using an intermediary token called steam.
In one way or another, all stablecoins achieve stability by adjusting supply to meet demand. When the price gets too low, supply is reduced. When the price gets too high, supply is increased.
One of the simplest ways of reducing supply is called “rebasing,” e.g., as used by the Ampleforth protocol (AMPL). When the price of AMPL goes above $1, token holders get additional tokens to increase supply. When the price goes below $1, all token holders get a haircut (i.e., some of their coins are burned). Rebasing is an elegant way to achieve price stability, but the result is that the overall value of a wallet isn’t stable because the number of coins can go up and down.
Due to these issues with rebasing, H2O achieves stability using a different method of adjusting supply: steam.
Steam is a token whose price depends on the demand for H2O. When demand for H2O is growing, new H2O is minted and used to buy steam from the market (thus increasing the amount of H2O in circulation and also increasing the value of steam). When demand for H2O falls, steam is sold for H2O, and the H2O that is collected is burned to reduce the supply (and, of course, the value of steam on the market).
Lately, a number of high profile stablecoin launches have cast doubt on whether an algorithmic coin can maintain stability in the face of massive swings in speculative demand. In our view, there are several ways to avoid such swings. Most importantly, we believe it is critical to build ‘real’ demand from a community that uses the coin in everyday transactions before issuing large amounts of the currency. Also, speculative demand is channeled into the price of steam, rather than influencing the price of H2O directly.
Recap
To summarize, H2O is a stablecoin that includes:
- a stable coin (H2O)
- and “ice” token that pays out a constant amount of H2O
- a “steam” token that determines how seigniorage is distributed, and is used to stabilize the value of H2O
In other words, the ice market is used solely to measure long-term stability, and the steam market is used to achieve short-term stability.
