As we’ve pointed out in a previous post, the most difficult problem to solve in the algorithmic stablecoin space is how to push the price back up to peg.
This problem took down DSD and ESD, and caused some issues for FEI after their initial launch. This article will introduce and describe Malt protocol’s primary below-peg stabilizing mechanism: The arbitrage auction.
Malt’s arbitrage mechanism takes the form of a Dutch Auction for arbitrage tokens (“arb” tokens). A dutch auction is one where the price goes down over time instead of up. The arb auction price will start at $1 and keep falling over a period of 30 minutes.
At the heart of the auction is the opportunity to invest in Malt’s stability for a market-driven premium, instead of an arbitrarily set premium (e.g., 40%):
- The auctions of these “arb” tokens are triggered once Malt TWAP < $0.99.
- Arb tokens are purchased with DAI and redeemed in DAI
- All DAI contributions are immediately used to purchase Malt from the liquidity pool which is then burned to produce supply contraction.
- Arb tokens are similar to bonds / coupons in other stablecoins, except they do not expire and are automatically redeemed as soon as possible.
- Partial redemption of tokens will also be done. Meaning, if the protocol generates enough profit to pay 10% of an auction then every participant will have 10% of their tokens redeemed.
- The protocol decides how much capital the auction needs to raise.
- The amount is decided based on how much buying is required to push the price back to $1.
- Auctions last for 30 minutes, with the arb token price starting at $1 and continuously decreasing across the span of 30 minutes.
- The auction ends after either (1) all tokens are purchased, or (2) 30 minutes has elapsed.
- If the 30 minutes elapse with TWAP still below $1 and there are unpurchased arb tokens, the next auction starts immediately after.
- Every arbitrage purchase is accompanied by a contribution from Malt’s liquidity extension. We call this “LE” similar to FEI’s protocol-controlled value, “PVC”. The LE contribution is variable, depending on the arb token price (lower arb price = higher contribution from LE).
- The additional buy and burn from the LE contribution ensures a meaningful supply contraction even when factoring in the future premium needed to redeem the Arb Tokens.
- If an auction has no bids, the LE contributes a percentage of LE DAI to the arb auction, helping to push the Malt price higher for the next auction.
- The price that participants receive through the Dutch auction is the price reached at the end of the auction. So, if participant “A” purchases 1000 DAI worth of arb tokens in the first minute, but the auction does not end until the 15th minute, then participant A receives the lower 15th minute price for all 1000 DAI.
- Arb tokens are automatically redeemed for DAI for participants to avoid bot wars.
- Redemption occurs once Malt returns to peg, from above-peg rewards
- Arb tokens never expire and will be redeemed pro-rata as soon as the protocol generates any profit.
There are a couple details an astute reader might notice in the above bullet points:
- Dutch auction allows for a market-driven premium. Previous projects used an arbitrary premium (e.g., 40%) for participation below peg. By incorporating a series of Dutch auctions that can sequentially end at a lower price, Malt allows the market to determine the risk for arb tokens even for long periods of decreasing demand.
- Supply contraction is inherent to the protocol’s auction process, as Malt is burned from the LE contribution combined with auction contributions. We believe that the ability for an algo stablecoin to effectively and regularly contract supply is absolutely necessary for mid- and long-term stability. We also believe that is vital that this supply contraction is incentivized by users
- LE auction participation at the end of the auction allows for participants to compete with the protocol for arbitrage opportunities, introducing protocol-inherent competition for arbitraging.
- 30 minute auctions introduces a very quick cycle to Malt’s protocol, which is vital for facilitating true stability around peg
- The Malt protocol controls the buying/selling of Malt tokens by taking arbitrage purchases in DAI and giving arbitrage rewards in DAI, completely bypassing the possibility of reward dumping. Indeed, if one wanted to provide LP from their arbitrage rewards, they would have to buy Malt, pushing the price higher.
There are also a few details not specified in this article due to their technical nature, but which will be elaborated on further in the whitepaper. For example, the algorithm for LE contribution is complex. Additionally, the specific design of liquidity extension will be described both in the whitepaper and in an impending article.
How the protocol decides on the ending price of each auction (assuming it lasts the full 30 minutes) is also not described here. This is due to the required understanding of LE that is necessary to understand the minimum auction price.
It is worth mentioning that as auctions progress, the ratio of LE DAI to Malt in the liquidity pool increases, allowing more control from the liquidity extension (i.e., LE can more easily single-handedly push price back to $1). Indeed, if the LE DAI ever reaches a 100% ratio with LP Malt, all auctions will cease and the protocol will automatically push price back to $1. A separate LE article detailing all of this will follow.
This is Malt’s auction process, and it is designed to incentivize participants to keep the protocol stable when price falls below $1. Given below $1 is the true test of an algo stable, Malt’s auction is the engine of stability.
It is also worth noting that near-future plans for Malt include a Malt-fund where participants can commit money that is automatically contributed to auctions, based on their risk preferences, which allows auction participation without close monitoring. More on this later.