Hedgecoins — the new way to create stable cryptocurrencies
By Oleg Bakatanov on ALTCOIN MAGAZINE
In the previous article https://medium.com/altcoin-magazine/a-quest-for-a-stable-coin-b14f1710f112 we analyzed the current landscape of stablecoin solutions and why stablecoins are so important and demanded. In this article I want to offer an alternative solution to create a fully crypto-collateralized stablecoin which uses derivative hedging mechanism, which, so far, hasn’t been implemented in any existing stablecoin but, at the same time, has some advantages over existing solutions.
In traditional markets derivatives are, probably, the most effective instrument to manage market risk: they enable to transmit your market risk to many market players, enjoy high market liquidity and use leverage at fair money market price - hence employ less capital.
Current cryptocurrency markets already provide with multiple derivative instruments which enable to effectively hedge positions held in cryptocurrency (mostly Bitcoin) and peg portfolio value to one of stable fiat currencies (e.g. USD). In other words, if somebody holds 1 BTC, he can sell short a derivative contract (BTC/USD futures or swap) and stay neutral to BTC price volatility. For example, if after hedging 1 BTC at current price (say, 4 000 USD) Bitcoin price will fall down 50% (to 2000 USD), derivative contract will pay off another 1 BTC to the derivative short position holder. This means that having 2 BTC its owner can buy initial amount of dollars (4000 USD) at current price.
Some important advantages of shorting BTC via derivative against just selling it are the following:
- This transaction never involves actual fiat currency, a wallet always holds only BTC with all cryptocurrency advantages;
- BTC holder can use derivative leverage. This means that in order to short 1 BTC its holder must provide only small part of it as a collateral to a cryptocurrency exchange and may keep the most of it in a secure wallet. This gives an opportunity to minimize exchange default risk;
- Interest rate difference. When shorting bitcoin via derivative a contract seller provides (in economic terms) a secured USD loan to a contract buyer. If USD lending rate is higher than BTC lending rate at current market conditions (which is true most of the time), short contract seller receives not only hedge but a certain interest on provided volume.
Derivatives are one of the most popular instruments for investing, hedging and speculation worldwide. According to Bank of International Settlements statistics, average daily trading volume in exchange-traded derivatives exceeds $10 trn with derivatives existing on almost every class of assets. For many assets such as crude oil or gold derivative market is the most liquid one and well comparable to spot market in trading volumes.
Not surprisingly, derivatives appeared on the cryptomarkets and have already gained tremendous popularity. For instance, according to CoinMarketCap, overall spot trading volume in the most liquid cryptocurrency — BTC on 20.08.2018 was around $3.5 bln, while trading volume in the most liquid bitcoin derivative, BitMex XBTUSD, was around $2.7 bln.
The reason of derivative market popularity is obvious, derivatives are much more convenient instruments for speculative trading and hedging than spot markets because of lower trading commissions, high and commission-free leverage, better-controlled cryptocurrency exchange risks.
Growth of derivative markets is important for the hedge coin concept as it will provide an opportunity to effectively hedge larger volumes of cryptocurrency and enable issuing more hedge coins in circulation. We expect that cryptocurrency derivative market will grow even faster than cryptocurrency market itself adding new reliable exchanges and instruments with high liquidity. In perspective, this may support creation of hedge coins based not only on Bitcoin and USD but on multiple cryptocurrencies and fiat targets
What is hedgecoin?
We call hedgecoin a cryptocurrency which is designed to be stable in value compared to a target fiat currency (e.g. US dollar) using collateral hedging mechanism. Hedgecoin collateral consists of two parts: base digital asset (e.g. Bitcoin) and short sell derivative contract pegging base asset to the target currency. This means that a hedgecoin is always backed by a changing amount of digital asset so it can be always converted to initial (or very close to initial) fixed amount in target currency at current market price.
Collateral reserve is a digital asset (in our example — bitcoins), which value is hedged by derivatives and which guarantees price stability of the hedgecoin. Hedgecoin can be freely exchanged back to collateral at current market rate. Free exchange of collateral to hedgecoins and backwards guarantees that on every market where hedgecoin is traded, its price will be equal or very close to 1 USD.
Very important aspect of collateral reserve is its safety. If we use as a collateral the most liquid digital asset — bitcoins, but our hedgecoin is issued in another blockchain enabling smart contracts (EOS, Etherium, etc), collateral protection and exchange cannot be done on-chain, i.e. It cannot be trustlessly locked in hedgecoin’s smart contract.
Though it creates some centralization problem (meaning that certain people or groups of people will have control over collateral), we believe, it can be solved using multisig wallets. This enables to distribute control of the reserve over several (or multiple) independent parties, thus strongly reducing risks of collateral loss.
Hedgecoin collateral volatility issues
Although hedging mechanism eliminates collateral sufficiency problem to a larger extent, it has its own specifics. Results of hedging are driven not only by price fluctuations on spot and derivative markets but also by money market rates. Money market interest rate is paid or received by derivative contract holder which makes value of collateral to increase or decrease. While these fluctuations are far smaller than volatility of cryptocurrencies, it still prevents to back up hedge coin with cryptocurrency at 1 coin always equals to 1 USD ratio.
Opposite side of volatility driven by interest rate is positive expected (in the long term) interest rate received on derivatives and cryptocurrency held in portfolio (given effective capital management). In simple words, a hedge coin is expected to grow in value in the long term compared to target currency (USD) because of received money-market interest rate.
Nevertheless, a hedge coin needs to be tightly pegged to 1 USD in price. This makes it appropriate to any kind of money transactions (such as payments, lending or investing) and solves problems of risk-averse holders who doesn’t want a hedge coin to go up or down compared to USD.
To illustrate collateral volatility problem, let us model a situation when we issued 1m of hypothetical HedgeCoins on July 1st 2017 with a BTC collateral equivalent to 1m USD (Bitcoins hedged with perpetual derivative contract). We can see on the Picture 1, that collateral value measured in USD fluctuates quite a lot and at some periods it goes below HedgeCoin price. At these moments HedgeCoin isn’t fully collateralized and its market price should inevitably fall below 1 USD. At the same time, in the long-term collateral value goes up and in 1-year period it is substantially higher than HedgeCoin price. With such collateral volatility HedgeCoin price cannot be stable.
Insurance fund as stability protection mechanism
The solution to make the hedgecoin price stable regardless some volatility in collateral value would be a mechanism which automatically mints or burns hedgecoins in response to any change in collateral.
For example, if value of our collateral grows from $1m to $1.01, we mint another 0.01 mln of hedgecoins making total hedgecoin supply equal to collateral value in USD, hence, protecting price of hedgecoin as 1 USD.
The same could be done if collateral value goes down. If collateral value drops below $ 1 mln to 0.99 mln, we must burn 0.01 mln hedgecoins. But, obviously, we cannot burn any hedgecoins in circulation owned by ordinary holders in their wallets!
This means that in order to adjust amount of issued hedgecoins to changing amount of collateral we need to create a special fund of hedgecoins which is taken from circulation and locked on a special account in the smart contract.
In this case, we can burn hedgecoins in this special fund or mint new one to it in order to adjust total amount. We call this fund the Insurance fund
Insurance fund is designed to absorb all possible volatility of the collateral reserve and unexpected losses, and, at the same time, it takes all revenues, received in ecosystem: interest income, transfer and exchange fees, other types of commissions and revenues which is enabled by stablecoin ecosystem
If compare this architecture to a traditional bank, Insurance fund can be compared to shareholder capital while Hedgecoins in free circulation is like client’s money on accounts
Picture 2 illustrates how Insurance fund of 30% solves problem of collateral volatility shown in Picture 1
We beleive that described hedging approach enables to create a stablecoin in the most effective manner, which will have all desired features of true stable cryptocurrency:
- Be fully collateralized by crypto-assets;
- Effectively use crypto-collateral to produce investment revenue;
- Be well protected from internal interventions and third-party censorship
If you wish to learn more about hedgecoin approach to create stable cryptocurrency, visit us on depos.io
