I am going to assume 2 things in this post: First, you understand the potential value of cryptocurrency. Second, you understand the need for a stable cryptocurrency.
So let’s move straight to H2O. H2O is a self-stabilizing cryptocurrency that seeks to solve the problem of maintaining stability without reference to fiat currency. In fact, H20 goes further than this: H2O maintains stability without reference to any external currency, commodity, or oracle. Here are some of the innovations that make it work. **This project is in active development and some of the details are subject to change.
Innovation #1: ICE — The Measure of Future Value
The fundamental insight underlying H2O is that, fundamentally, “stability” isn’t a comparison of one thing to another. It is a comparison of something to itself, namely, its future self. So H2O doesn’t measure stability by measuring it’s price relative to the dollar. It measures stability by directly measuring it’s value relative to it’s future value.
To do this, H2O is paired with a second token, ICE, that pays out H2O in the future. If the price of future H2O is stable, then H2O is stable.
Specifically, each ICE pays out one H2O every year. The present value (PV) of ICE can be given by the simple formula:
PV = A/r
where A is the amount paid out each period (namely, 1) and r is the interest rate. There are a few components of r, but based on historical trends we believe that once H2O is big enough, the primary component of r will be expected inflation (i.e., inflation will outweigh the real interest rate and default risk). Thus, by stabilizing the price of ICE relative H2O, we can stabilize the value of H2O relative to everything else.
For example, if we are targeting 2% inflation, the target price of ICE will be 50 H2O. If the actual price is 40, we know the market expects too much inflation, so we need to burn H2O. If the price is 60, the price shows that we are below our target inflation rate and we need to mint more H2O.
Innovation #2: Icewater — The Virtual Liquidity Pool
But first we need to measure the relative price of H2O and ICE. How do we do that? One way would be to ask an external oracle, but this would undermine the autonomy of the protocol. So H2O uses an internal oracle.
Luckily, the challenge of measuring the relative price of tokens has already been solved in an elegant way by decentralized exchanges such as Uniswap. The primary innovation of these exchanges is to settle trades between two tokens without the need to keep an order book. This is done by maintaining a pool with an equal amount (in total value) of each token. When someone makes a trade, they simply enforce the constraint:
X1*Y1 = X2*Y2
(X1 is the absolute number of X tokens in the pool before the trade, and X2 is the number of X tokens after the trade. Y1 is the number number of Y tokens in the pool before the trade, and Y2 is the number of Y tokens after the trade)
However, since the H2O central contract controls both H2O and ICE, there is no need to maintain an actual pool of tokens. They can be minted and burned as needed. Instead of holding actual tokens we use what we call a virtual liquidity pool. A virtual liquidity pool uses the same math as a traditional liquidity pool, except it doesn’t actually hold tokens. It tracks the virtual pool size internally, so there is no staking, and no staking incentives. This enables the contract to remain simple and robust, while providing a reliable measure of the relative price of the H2O and ICE.
Innovation #3: Steam — The Stabilizing Mechanism
In addition to H2O and ICE, the Icewater model has another token called Steam (STM). There is an H2O/STM liquidity pool just like the H2O/ICE pool. However, the H2O/STM pool isn’t used to measure the value of H2O, it is used to adjust the supply of H2O (i.e., to control inflation).
Specifically, if the H2O/ICE price indicates too much inflation, H2O is added to the virtual H2O/STM pool (as opposed to minting tokens directly). This creates an arbitrage opportunity for STM holders to grab some discounted H2O. Since the ratio of STM and H2O in the pool determines the “price” of each token relative to the other in the pool, if this price is different from the prevailing price in external markets, smart observers will swoop in to make a profit. These arbitragers serve to distribute newly minted H2O and to gather H2O for burning (in exchange for STM).
