Recently, here and here, I have talked about the role of Guardians in a stablecoin system.
Specifically, the main role of guardians is to take on the volatility of the system so that the stablecoin can remain stable. And we must provide them an incentive to do so.
There are two sources of volatility in a collateral backed stablecoin system: volatility of the stablecoin (i.e., demand volatility) and volatility in the underlying collateral. Although it is not logically necessary, for now we will assume that the same group of people (i.e., holders of a single token) will mitigate both forms of volatility.
When the value (i.e., as measured in hypothetical UTILs) of either the stablecoin or the collateral coin goes up, the benefits accrue to the guardians. But when the value of either goes down (more than planned) we need some way to respond so that they system remains stable and sufficiently collateralized. So let’s talk more about both two difficult scenarios.
What happens when the value of the collateral falls
To set up the scenario, let’s assume we have three tokens: a stablecoin, a collateral coin, and a volatility coin: STB, COL, VOL. To start, let’s assume that each is worth 1 UTIL.
A guardian provides 2 COL (e.g., 2 ETH) to the protocol and mints 1 STB and 1 VOL. We can say that the STB is “backed” by 2 COL. Then let’s say the value of COL falls from 1 UTIL to 0.4 UTIL. To maintain stability, we want each STB to be backed by at least 1 UTIL of COL, so this event puts us in the danger zone.
However, the STB is also backed by 1 VOL, and let’s assume for a moment that VOL is still worth 1 UTIL. To regain collateralization, the guardian must put in an additional 0.2 UTIL worth of COL or risk losing their VOL. Since the VOL is worth more than the amount of COL they must put in, it is in their interest to pony up.
If not we can, for example, initiate an auction whereby anyone can put up the 0.2 UTIL of collateral (namely, 0.5 COL) and take a portion of the VOL.
What happens when demand for the stablecoin falls
In this case, the objective is not to increase the collateral but to decrease the supply of STB. To do this we must do one of two things: sell some COL or mint (and then sell) some VOL. These two things are pretty similar in effect, but the more straightforward choice is to sell some COL.
Let’s roll back the clock and reset the value of STB, COL, and VOL to 1 UTIL. Then let’s say we find that demand for STB falls and its value falls to 0.9 UTIL. In this scenario, the STB is still backed by 2 UTIL of COL so this is no big deal. We simply start buying back STB with COL until the price of STB stabilizes. This reduces the supply of STB to match the reduction in demand.
What happens when the value of STB and COL both fall
Let’s say the COL falls to 0.4 UTIL and STB falls to 0.9 UTIL at the same time. In this case we can simply do both things described above: force the VOL owner to put up some additional COL, and also sell COL to reduce the supply of STB.
The system can remain stable as long as 2 COL + 1 VOL > 1 UTIL. This is one advantage of combining the collateralization model with a seigniorage shares model where new STB is issued to owners of VOL (i.e., the currency-as-a-service model). It gives VOL more intrinsic value, which increase the likelihood that we stay in the realm of stability.
