Sinking Like a Stone? Non-Pegged Stablecoins
Lesson 13: What on Earth Are Non-Pegged Stablecoins?!
This article’s title was intended to allude explicitly to that Bob Dylan song we all know, “The Times They Are A-Changin’”. However, SEO limitations on title searches prevented me from making the allusion clearer. SEO limits be damned when determining content!
My intention was to assure the reader that even though the idea of a non-pegged stablecoin sounds a bit bonkers — since the general idea of a stablecoin is that it has stability by virtue of being pegged to another asset of stable value (e.g. the US dollar) — we “shouldn’t criticize what we don’t understand”. Ok, just to provide the full reference to the song lyrics for those in the dark about Dylan:
If your time to you is worth savin’
And you better start swimmin’
Or you’ll sink like a stone
For the times they are a-changin’
It’s actually difficult to find articles explaining the general design of non-pegged stablecoins that make sense to the layperson. (It’s easy to find technical articles.) So in the spirit of a general education (in which I include myself), let’s take a dive into the nuts and bolts of these interesting species of coins.
Before we start, I’m assuming that you’re up-to-speed on the basics of stablecoins. If not, you can go here to get a primer or refesher.
What Is the Principle Behind a Non-Pegged Stablecoin?
A non-pegged stablecoin (NPS) is designed to maintain stability by adjusting its value in relation to the wider cryptocurrency market. In other words, NPSs are all about relative stability, not stability pegged to a static value. This is often referred to as using a reflex index (as opposed to a fixed index).
Instead of a static peg to the US dollar, a NPS sets a “floating” peg to a more volatile currency (compared to the US dollar) within its immediate market ecosystem. (And as my favorite windsurfing guru, Sam Ross, would say, “And this is the key.”)
Here’s an (another) analogy that might help:
Conventional stablecoins are made to withstand the punches of the ups and downs of a market by remaining pegged to the US dollar.
Non-pegged stablecoins are made to roll with the punches of the market, and so move with the market.
This will become clearer by the end of the article (I hope!).
In the meanwhile, think of a NPS as trying to maintain stability with like-for-like. It does not seek stability in the wider, external and traditional financial markets (centralized finance, or CeFi), but within its native, decentralized cryptocurrency market (or DeFi). A NPS will choose a cryptocurrency for collateral that tends to have more stability — such as ETH or BTC.
To my knowledge, there are currently two major non-pegged stableccoins: RAI and FLOAT. Each works differently, so let’s take them separately.
RAI
RAI is backed by ETH and was designed by Reflexer Labs. It’s important to note that of all the stablecoins out there, RAI takes seriously the idea of independence from TradFi and CeFi. In other words, it does not rely on a centralized financial institution to control its value (like Tether), and it is not backed in any way by fiat currency (like USDC). As one enthusiastic arbitrage trader put it:
The thesis behind RAI is that by minimizing governance and human intervention, we can actually create a more stable and socially scalable system. As a technology, crypto is all about removing the need for trusted 3rd parties.
Of course, you can say as long as the crypto market is correlated with traditional markets, then there really is no independence. Maybe, but that’s another story.
Back to RAI. RAI uses algorithms to maintain its price stability (surprise!). Something called a PID controller (proportional–integral–derivative controller) uses algorithms to adjust interest rates to encourage the buying or selling of RAI. So how does RAI maintain stability?
There is a corridor of stability that is defined by the market price and the redemption price.
- The market price is the price at which RAI is trading on exchanges (the secondary market); it’s good for holders when it’s high.
- The redemption price is the price which Reflexer Labs wants RAI to have on the secondary market. It tends to be lower than the market price because it is also the price at which RAI is minted by SAFE users.
You can think of this loosely by analogy: the US government mints dollar coins with a value of $1 each while, for some odd reason, the US dollar is trading at $1.20 on the secondary market. The redemption price is $1; the market price is $1.20.
When the market price and redemption price are the same, they are at equilibrium, or what is the target price.
What happens, as in the US government analogy, when the spread between the market and redemption prices grows?
To keep the price of RAI stable, its redemption value is adjusted since it’s the one price that the algorithm can control. The rate-changing process that does this work is called the redemption rate. That which controls the rate is the PID.
Let’s consider a situation where the market price of RAI is higher than the redemption price. The PID can adjust the redemption rate by increasing the value of the redemption price. That is to say, it sets a positive rate at which the redemption value (or price) of RAI is increasing at each subsequent moment in order to move towards equilibrium, or the target price.
Like other stablecoins, RAI attracts arbitrage trading. (Arbitrage trading is “the simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the asset’s listed price.” Thanks, Investopedia!) But it does not necessarily rely on abritrage trading. This is because the redemption rate is what moves RAI’s value to maintain stability; it does not solely rely on the process of traders buy and selling to balance the supply of the coin. Of course, abritragers like to take advantage of RAI.
FLOAT
FLOAT is also collateralized by cryptocurrency; however, the protocol does not allow users to draw on the collateral fund (treasury or bank). They can only trade FLOAT for other tokens on the market. To encourage this, the FLOAT protocol adjusts the price of FLOAT to incentivize buying or selling. Its decision to lower the price (incentivize buying) or increase the price (incentivize selling) is based on what the larger crypto market is doing — especially in relation to ETH, since ETH comprises the majority of its bank.
Like other stablecoins, FLOAT relies on arbitrage trading. FLOAT uses a Dutch style auction where prices are set below or above market price to incentivize trading:
In these auctions, arbitragers will be given the opportunity to buy new FLOAT below market price (in an expansion) or sell FLOAT above market price (in a contraction) to make a profit. In doing so, arbitragers will very quickly change the supply of FLOAT on the market. The reason we chose the auction model is a) it allows us to intervene in the market without having to trade FLOAT ourselves and b) it also allows the system to be very efficient.
FLOAT is backed by the initial injection of liquidity into its treasury (or bank). The start of FLOAT’s collateral pool began at 100% valuation in relation to ETH. During the arbitrage auctions the reserves in the treasury will fluctuate. Money received by traders who buy FLOAT is put into the treasury; money used to buy back FLOAT during a contraction is taken from the treasury. So, in effect, FLOAT is collateralized by a basket of cryptocurrencies that they will accept.
So let’s take a fictitious example. Imagine that FLOAT started with a supply of 1 million FLOAT coins at the price of ETH on the opening date of FLOAT (i.e. $3282.40). The total FLOAT value of coins in circulation, or Market Cap, would be 1 million x 3282.40 = $3,282,400,000. So, in effect, the amount of ETH is providing the collateral — you just can’t exchange the NPS for the collateral token.
This would suggest that although the initial collateral of ETH cannot be touched, FLOAT relies on the trading of other cryptocurrencies to collateralize new coins being minted. Let’s call the original ETH collateral “Layer 1 collateral” and the subsequent collateral of other coins “Layer 2 collateral”.
Holders can cash in their FLOAT to access Layer 2, but not Layer 1. In esssence, Layer 1 is a permanent backstop and is theoretically viable as long as the auction process keeps supply and demand honest. If the price of ETH dropped by 10%, then FLOAT coins would be burned as part of a contraction mechanism. If the price of ETH went up, then FLOAT would be minted as part of an expansion mechanism.
What is interesting about relative or reflex systems for stabilization is that they move according to its immediate market — that is, in relation to value already “intrinsically” in the system. With conventional stablecoins, their value relies on an extrinsic market. This has the advantage of marking a clear point of reference for value, but it has a disadvantage of not being flexible when and where the crypto market is fluctuating.
Yet to make this intrinsic relation work, the design of each stablecoin’s stabilizing mechanism must not only be sufficient; the immedate pool of value must also be liquid. This raises an interesting question about value and backing within the crypto market, which I hope to address in a later post. Here’s a hint as to what I am thinking:
How can we trust anything backed by such a volatile asset? The mere ability to float a stablecoin’s price relative to other coins is not enough. It presumes the underlying market is healthy. And convesely, the underlying market often relies on stablecoins to keep things moving, to achieve a sense of health.
How To Apply This
My quasi-philosophical ruminations aside, let’s explore the practical upshot.
While both RAI and FLOAT operate dynamically via their non-pegged system, whether you choose to invest or use either coin comes down to how well their respective algorithmic mechanisms function. Both have treasury mechanisms to ensure value backing remains robust (i.e. RAI’s redemption rate and FLOAT’s prohibition on withdrawing Layer 1 collateral), but because each is dynamically pegged, it means both will fluctuate with the market as opposed to truly remain flat.
Just have a look at RAI and FLOAT respectively:
Compare them to Tether:
You’d expect stablecoins like Tether to remain stable except when there are stress tests, like the one it experience in May 2022 . . . and passed due to having sufficient collateral.
So in sum and to reiterate: Non-pegged stablecoins are designed to roll with the punches; the other stablecoins are designed to withstand them.
For more on the risks involved in stablecoins, you can see my two-part article on counterparty risk and conceptual design risk.
I’m a researcher and writer for The Art of the Bubble.
This article is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.
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