Stablecoin Peg Mechanisms
Algorithmic Stablecoins have become the defining creation of the DeFi 2.0 era. They programmatically employ progressive economic principles based upon the concept of Seigniorage shares to offer DeFi participants an innovative solution to the capital efficiency limits of collateral based Stablecoins. The team at Nereus has created NXUSD to develop upon the current Algorithmic Stablecoin model, providing a fully collateralized and highly capital efficient Stablecoin model on the Avalanche Blockchain. This article will cover the price stability mechanics employed by some of the leading Algorithmic Stablecoins and introduces the peg mechanics which will be implemented by Nereus to keep the NXUSD Stablecoin pegged to the US dollar.
Liquity [LUSD]
LUSD is the leading overcollateralized Algorithmic Stablecoin on the Ethereum blockchain and offers 0% interest loans against Ethereum collateral. Liquity issues LUSD Stablecoins and offers direct redeemability of LUSD against the underlying Ethereum collateral reserves. LUSDs are perpetually collateralized by ETHs at a minimum collateral ratio of 110%. Finally, Liquity employs an Algorithmic fee on all redemptions, this fee is used to dampen redemptions when significant capital flight occurs.
Liquity employs a hard peg mechanism that operates on the principle of external participant arbitrage. External participants (in the form of arbitrage bots) watch out for the LUSD market price falling below the $1 peg: when [1LUSD < $1 — Redemption Fee], participants have an economic incentive to buy 1 LUSD in the market and redeem it for 1$ worth of Ethereum collateral. This system additionally works to improve the overall health of the Liquity protocol. Indeed, the most undercollateralized positions are the first positions to be ‘redeemed against’ and closed. The system burns the LUSDs received after redemption, shrinking the LUSD supply, which subsequently pushes the LUSD price back to the $1 peg.
Contrarily, the 110% minimum collateralization ratio provides arbitrageurs with an additional arbitrage opportunity if LUSD’s spot market price reaches above $1.1. Arbitrageurs can make instantaneous profits: they can deposit $1.1 worth of Ethereum collateral, borrow 1 LUSD at the maximum collateral ratio, and then sell 1 LUSD on the open market for an instant gain as the LUSD/USD market rate is above 1.1. In this situation, the market participant does not care if her position is liquidated, as the LUSD value she received is greater than the value of the Ethereum she deposited. The volume of LUSD which is sold on the open market should naturally drive down the LUSD price below $1.1 and closer to the peg.
Next, Liquity employs soft peg mechanisms that operate on the principle that 1 LUSD is fundamentally anchored to $1, which is the equilibrium state for the entire protocol.
Liquity intrinsically values 1 LUSD at $1 when determining the collateralization ratio of all its participants’ positions. As such, open market expectations should operate under the same assumption. In other words, Liquity position holders who subscribe to this assumption will view occurrences where LUSD is above $1 as the optimal time to borrow from the system and occurrences where LUSD is below $1 as the optimal time to repay borrowing positions. This mean-reverting strategy should ensure that the LUSD supply fluctuates organically to meet the peg consensus.
Finally, Liquity employs an Algorithmic fee on all redemptions & issuance activities within the protocol. The fees are designed to prevent large capital flight from the protocol during volatile market conditions. The Fees also ensure that during a ‘black swan event’ the system will not be wiped out as the fees on redemption & issuance would make any capital flight economically unviable short term. This Fee operates via the formula [(Base Rate + 0.5%) * ETH Withdrawn], with the base rate increasing with every system fee event. Subsequently, the base rate decays back to its origin according to the time passed since the last fee event.
Ampleforth [AMPL]
AMPL was the most successful Rebasing Algorithmic Stablecoin from 2020 DeFi Summer, hosted upon the Ethereum Blockchain. Ampleforth operated upon the traditional Monetary policy model employed by central banks via its ‘Policy Smart Contract’. The Ampleforth protocol adjusts the supply of the internally generated AMPL Stablecoin every 24 hours to ensure the system maintains a 1:1 parity with the CPI-adjusted 2019 US Dollar. If demand is high, AMPL will be above $1, and the system will rebase its supply by minting more AMPL tokens (Expansionary monetary policy). If demand is low, AMPL will be below $1, and the system will rebase by burning some of the internally generated AMPL (Contractionary monetary policy). AMPL position holders maintain a proportional share of the AMPL total supply through expansionary and contractionary rebasing phases. Only the quantity of AMPL tokens they hold in their account will fluctuate.
Terra Stablecoins [UST]
UST is the largest and fastest-growing Seigniorage shares based Algorithmic Stablecoin of the DeFi 2.0 era, hosted upon the Terra Blockchain. UST maintains its peg to the US dollar via the use of 2 tokens:
UST — A Stablecoin pegged to the US Dollar.
LUNA — The native token of the Terra ecosystem with the primary utility of being the method of payment for transactions on the Terra network.
The Terra protocol frequently rebalances the system assets (LUNA) and liabilities (UST) to ensure UST maintains its parity to the US Dollar, via acting as a Market Maker enabling on-chain swaps of 1 UST for 1 USD. This system provides arbitrageurs with an organic economic incentive to ensure that UST maintains its peg to $1. Akin to the ‘hard peg mechanism’ employed by Liquity, arbitrageurs can sell LUNA for UST when UST is below $1 and conversely, Buy LUNA when UST is above $1. The volatility of UST is traded for the supply-elasticity of LUNA, which acts as a volatility absorber. UST maintains its peg by ensuring an equilibrium between the circulating UST & LUNA Supply. UST can only be minted via burning LUNA and conversely, LUNA can only be created by redeeming UST (which is Burnt).
More recently, Terra has introduced a Bitcoin Reserve which will be deployed during major market volatility to ensure UST maintains its peg to the US dollar. This mechanism will work in tandem with the LUNA <> UST mechanism, by allowing Traders to exchange $1 of UST for $0.98 of BTC during a crisis, providing market participants with an efficient exit from the UST ecosystem without having to dump their tokens on the open market. The reserve is currently holding around $2.5 Billion and is designed to replenish BTC reserves during normal market conditions.
Fei Protocol
FEI is the leading Direct Incentive-based Algorithmic Stablecoin hosted upon the Ethereum blockchain and operates upon the DeFi 2.0 concept of Protocol controlled Value (PCV). The FEI protocol issues the FEI Stablecoin, which is an undercollateralized Stablecoin that employs the innovative mechanism of ‘direct incentives’ to maintain its Peg to the US dollar.
Fei employs a stability mechanism that uses dynamic mint rewards (for Buyers) and burn penalties (on Sellers) upon DEX trading volume to ensure FEI maintains its Peg. FEI can only be produced and circulated when purchased via a Bonding Curve which is denominated in Ethereum. This Ethereum is accrued by the protocol and remains in control of the protocol (PCV). The PCV of the FEI protocol removes the need for overcollateralized debt positions, as the protocol exclusively owns its liquidity.
Additionally, PCV allows the FEI protocol to fully own & control all the liquidity in its LP’s, effectively enabling the protocol to control the exchange rate of the FEI pairs in its Uniswap LP’s. This is done via rebalancing the AMM Uniswap mechanism, which entails removing all owned liquidity from the LP, then transacting against the market to neutralize any pricing dislocation, and then resupplying the LP at a 1:1 Rate. This consumes the PCV but ensures that the FEI US Dollar Peg is maintained. Additionally, this ensures when the FEI/ETH price from the Bonding curve dislocates from the FEI spot market price, arbitrageurs are not required to trade [(Sell Eth & Buy FEI) from the Bonding Curve, Sell FEI In LP] as they can interact directly with the Bonding curve mechanism.
For example, let’s say there is a Uniswap market denominated in FEI/USDC. The current liquidity depth is 1100 FEI and 1000 USDC (assuming Fei owns 90% of the LP’s Liquidity).
Fei Protocol can atomically execute the following trade:
1. Withdraw all liquidity (990 FEI and 900 USDC)
2. Swap ~5 USDC for ~5 FEI (remaining liquidity is ~105/105 FEI/USDC)
3. Resupply 895 FEI and 895 USDC at the 1:1 exchange rate
The net effect of the above trade is the protocol spent ~5 of its USDC PCV to restore the peg
*Example is from the Fei Protocol Whitepaper
Nereus [NXUSD] — The Fully Collateralised & Capital Efficient Stablecoin
NXUSD is the new US Dollar pegged fully collateralised Stablecoin which will be coming to the Avalanche Blockchain. The team at Nereus wants to sustain its momentum and continue working to create a market-leading & customer orientated Decentralised Finance Protocol and will deliver a Fully Collateralised & Capital Efficient Stablecoin on the Avalanche Blockchain.
NXUSD will innovate upon the battle-tested arbitrage-based algorithmic peg mechanisms to build a robust peg-maintenance foundation, without initially offering redeemability against the underlying collateral of the NXUSD Stablecoin. NXUSD — USD’s 1:1 parity will be maintained by 3 main mechanisms:
- Natural Ceiling Peg
The Natural Ceiling Peg will be an adaptation to the ‘hard peg mechanism’ implemented by Liquity, correcting for the fact that NXUSD will not be redeemable. In the initial phase of NXUSD, the only Token which will be accepted as collateral will be the DAI Stablecoin and as such, NXUSD will operate on a lower Minimum collateral ratio due to the low volatility of the DAI Stablecoin. DAI positions will operate on a Minimum Collateral ratio of 105.26 % (a maximum LTV at 95%), meaning that a natural price ceiling will initially be implied at $1.0526. As such, if the NXUSD price rises above $1.0526, Arbitrageurs will be able to gain a low-risk profit from opening borrowing positions from Nereus via depositing 100 DAI and borrowing the maximum 95 NXUSD. The Arbitrageur can then sell this NXUSD on the open market, gaining an instant profit. Analogous to the Liquity arbitrage trade, the arbitrageur does not care if her position is liquidated as the NXUSD received & sold is greater than the DAI she deposited. This arbitrage trade is naturally enhanced by the frictionless markets of NXUSD, which are only constrained by the 0.5% fee charged on loan origination.
For example, let’s say that NXUSD is trading at $1.15 in the 3CRV/NXUSD LP
Arbitrageurs can atomically execute the following trade:
1. Open a borrowing position by depositing 100 DAI & borrowing 89.55 NXUSD (after fees)
2. Sell the 89.55 NXUSD into the 3CRV/NXUSD LP, gaining $102.9825
The Arbitrageur has gained $2.9825 from the risk-neutral trade
2. Risk-Off Liquidations
Nereus is proposing to employ an innovative Risk-off liquidation mechanism when NXUSD begins to accept ‘Risker’ collateral types such as WAVAX. The Risk-off Liquidation mechanism will ensure that NXUSD can retain parity to the US dollar during substantial market volatility. Traditionally within DeFi lending products, liquidations occur when a position falls below its minimum collateral ratio. During a liquidation, liquidators pay a portion of the position debt and in return receive the collateral assets/tokens with a liquidation bonus, this bonus is also a penalty on the position holder and decreases her collateral. Although, in the case of the Algorithmic peg mechanisms of a Stablecoin, this liquidation process can exacerbate any dislocation of the underlying Stablecoin to its peg currency, as excessive demand for the Stablecoin from liquidators can artificially push the stablecoins price above equilibrium, causing liquidators to incur significant losses.
To combat this, Nereus will implement the innovative Risk-off liquidation mechanism, which will liquidate bad debt risky asset positions into DAI, which will be posted as collateral to mint & borrow NXUSD. This will allow the liquidator to exit the trade with NXUSD, which will replenish the liquidators inventory without having to interact with the open market. This mechanism will only be utilised in the case of significant liquidation volume (during a large market sell-off) and will additionally allow the entire protocol to de-risk its positions, without losing a significant proportion of its TVL.
For example, let’s say a large market correction has occurred with WAVAX dropping 25%. This has elevated liquidation volume within the Nereus protocol and increased the NXUSD price to $1.15 in the 3CRV/NXUSD LP.
Liquidators operating via the traditional liquidation model would experience significant losses & continue to drive the NXUSD price up when replenishing NXUSD inventory:
1. Liquidators are holding 1 NXUSD
2. The liquidator unwinds a bad debt position, receiving $1.125 of WAVAX
3. The liquidator Sells $1.125 of WAVAX for $0.9782 NXUSD
The liquidator has made a net loss from the transaction as NXUSD > $1.125 (-2.18%)
Liquidators employing the Risk-off liquidation mechanism will continue to profit and increase the supply of NXUSD in the market via minting NXUSD from Nereus
1. Liquidators are holding 1 NXUSD
2. The liquidator unwinds a bad debt position, receiving $1.125 of WAVAX
3. The liquidator Sells the $1.125 of WAVAX for 1.125 DAI (assuming 1 DAI = $1)
4. The liquidator deposits this 1.125 DAI into Nereus, borrowing 1.007438 NXUSD (after fees)
The liquidator has gained $0.00743 (~+0.743%) from liquidating the bad debt position and has not purchased any NXUSD from the open market.
3. Protocol Equilibrium Peg
Finally, NXUSD will employ a Protocol equilibrium peg to ensure that NXUSD can return to parity with the US dollar during regular expansionary and contractionary NXUSD supply phases. The Protocol equilibrium peg is analogous to the market consensus mechanisms which are employed by the majority of Seigniorage shares algorithmic stablecoins. This mechanism is established upon the premise that the Nereus protocol will permanently value its native Stablecoin NXUSD as equal to the US Dollar. This fact will dictate that the equilibrium state of NXUSD & Nereus Protocol will be when 1 NXUSD = 1 USD.
NXUSD position holders will operate informed on this equilibrium assumption, meaning they will view periods where NXUSD is > $1 as the optimal time to borrow from the system and occurrences where NXUSD is < $1 as the optimal time to repay borrowing positions. Fundamentally, the 1:1 equilibrium assumption economically incentivises Nereus community members & participants to manually interact with NXUSD to take advantage of small-scale dislocations between the NXUSD open market price & that within the Nereus protocol.
For example, let’s say that NXUSD is trading at $1.04 in the open market
Nereus participants can execute the following trade:
1. Open a borrowing position by depositing 100 DAI & borrowing 89.55 NXUSD (after fees)
2. Sell the 89.55 NXUSD into the open market, gaining $93.132
3. The Position holder now can wait for the NXUSD price to revert to its equilibrium of $1, where he can unwind her borrowing position for 89.55 NXUSD, profiting $3.582
The Nereus participant has gained $3.582 from this trade
Contrarily, let’s say that NXUSD is trading at $0.94 in the open market
Nereus participants can execute the following trade:
1. Purchase NXUSD off the open market to cover their position, 90 NXUSD at $84.6
2. Pay off borrowing positions they own within Nereus, $90 debt repaid for $84.6
3. The Position holder has arbitraged the Open market vs the protocol equilibrium peg. This action will result in an economic benefit for the trader and a reduced supply of NXUSD in the market.
The Nereus participant has gained $5.4 from this trade
In conclusion, the team at Nereus is excited to continue sharing the innovative features that will be employed within the NXUSD fully collateralized Stablecoin. NXUSD will be built with the aforementioned robust peg maintenance mechanics to ensure that the Nereus protocol & NXUSD can withstand the high-volatility inherent to the Cryptocurrency Markets. Over our next medium articles, we will delve into the final details of the NXUSD Stablecoin, including information about the NXUSD Genesis event and the market-leading utility originating from the NXUSD-Wirex partnership, so please stay tuned!
