Elastic money is good money — Malt’s elastic supply
Supply elasticity is at the core of any stablecoin design, and the importance of a good mechanism for supply elasticity is even more obvious with algorithmic stablecoins. Custodial stablecoins like Tether can create supply elasticity purely in the ability to deposit USD to mint tether and to burn tether to receive USD back. Supply will naturally fluctuate as people mint and redeem.
Now, let us consider a coin that is not 1:1 backed by something else and doesn’t have a mint/redemption mechanism. How does such a protocol create supply elasticity?
The problem can be broadly broken into two parts:
- Creating new supply when there is an increase in demand
- Reducing the supply when there is a decrease in demand
Universally (1) is easy to achieve. The protocol simply mints new supply and distributes it in some way. However (2) is a little trickier. There needs to be some incentive for users to burn their tokens or some other process by which tokens can be burned out of circulation without punishing users.
Another point to consider is the accuracy of the elasticity in response to changing market conditions. There have been other stablecoins like ESD which had an arbitrary expansion of their supply purely because the price was above peg. This is a problem as any expansion of supply greater than what is needed to meet demand will create an excess of supply, which in turn will then drop the price below peg again. The same is true with arbitrary contraction below peg.
Accuracy of the elasticity is critically important. If a protocol calculates that badly it can create a positive feedback loop which further destabilizes the price instead of stabilizing it.
So how does Malt do it?
Above peg Malt, like many other protocols, will mint new Malt. This happens on a per pool basis and the amount minted is exactly the amount required to return the price to peg. In this sense, Malt is minting the exact amount required to stabilize that single pool. The aggregate of supply increase across all pools will actually match the overall increase in demand. This demand is what drove the price above peg to begin with, and Malt mints just enough to accurately match that new demand, and no more or less.
When the Malt price goes below peg, there are two key players which help contract supply:
- Malt’s Arbitrage auction
- Malt’s special Liquidity Extension pool
Both of these players burn Malt from the supply in a carefully balanced way, their interaction varying with the conditions required to bring the price back up to peg. Let’s break them down one at a time.
Arbitrage auction
We previously discussed the idea of the Arbitrage auction, where users bid in a Dutch auction style to purchase Arb tokens, which are later redeemable for non-native tokens like DAI. These pledges are used to buy and burn Malt. In return for purchasing Arb tokens, auction participants receive a premium, which aims to make the auctions a profitable venture for users. This is an effective way to incentivize auction participation, and therefore incentivizing burning supply.
However, there is a debt to pay later — the Malt protocol still has to pay that premium promised to auction participants. The only way to pay the premium is to mint new Malt, increasing the supply again. This works against the efforts to burn supply, and it might even result in a supply increase. Not good!
Liquidity Extension pool
This is where the liquidity extension comes in. It is a special reserved pool of coins that is controlled by the protocol, which kicks in to offset the effects of minting Malt in the future to pay for the auction premiums. It can also burn even more on top of this, to realize a real supply contraction. The LE pool is capped to sustain a minimum ratio against the AMM liquidity pool, so it is an important helper system rather than a stand-alone player.
This is how Malt utilizes those two systems to effectively create a proportional controller on the supply under peg, which ensures the resulting supply matches the current demand.
Asymmetry
There is an asymmetry in the mechanisms above and below peg. Above peg the protocol can act very quickly and immediately just mint enough supply to find the balance. However, below peg the protocol cannot respond as quickly due to the time required to execute the auction and the requirement to incentivize with a premium.
This asymmetry in correction may create imbalances that skew the equilibrium price below $1. To counteract this a proportional damping coefficient can be used above peg to slow down how much supply is produced above peg. This can be modified to lift the equilibrium point back to peg.
Overall, we believe that the way Malt reacts to changes in market demand creates a protocol with a much more accurate supply elasticity than any other protocol that exists right now. We are incredibly excited to put it to the test and see how well it performs.
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