Collateralizing the Tezos Stablecoin
How USDtz tokens are made fully-backed and fully-redeemable
THE SYSTEM AND METHOD FIRST OUTLINED IN THIS ARTICLE HAS BEEN REFINED AND SUPERSEDED BY:
I urge you to read the Collateral² article first, as a primary resource since many of the details in the article you’re currently reading have been updated since then. This article will remain listed on Medium for historical reference.
In this article, I’ll be explaining:
- How USDtz tokens maintain their redeemable $1 value
- USDtez’s collateralization method and pathway
- Other collateralization methods considered and dismissed
- How to earn interest on USDtez (better than a FIAT savings account)
USDtez’s promise is that every USDtz token can be redeemed for the value of 1 US-dollar. There are different schools of thought on how a stablecoin should approach secure collateralization, each with respective reasonings—philosophical, technological, financial, mathematical—and trade-offs pertaining thereto. What we propose is a solution that we believe achieves the best of approaches for users, backers, and most importantly, for the Tezos ecosystem at-large.
The knowledge that the stablecoin is collateral-backed in full provides assurance to users, and it is a key ingredient in maintaining stability for the stablecoin even in the wake of extreme market scenarios.
For example, in case of a bank run, triggered by a black swan event or another event reflective of catastrophic market scenarios, that all USDtez can be for US$1 dollar. Even if that amount were to be paid directly in XTZ, the XTZ must be worth the USDtez equivalent.
What a stablecoin needs to avoid is ending up like George Bailey (see clip).
Or, if you prefer (as I do), the Simpsons parody.
The USDtez Counter — The 1-1 Stability Guarantor
Although USDtez will be available for purchase across many exchanges, the USDtez Foundation will offer a central Counter (as in ‘over-the-counter’ sales) for users to buy and sell USDtez for the corresponding redeemable $1 amount that will ensure the stability of the coin. That way, even if the price slips underneath $1 on one particular exchange or another, that difference will not last very long as someone will notice the arbitrage, buy the USDtez for cheap, and then sell it to the USDtez Counter for a profit, thereby restoring the equilibrium.
The duty of the USDtez Counter is to be capable of redeeming USDtez with full solvency and to do so even in the case of extreme market conditions. Every single USDtz token sold must be redeemable for $1 (USD), even if all USDtez owners suddenly showed up to bring 100% of their tokens to the Counter for redemption. Period.
Methods of Collateralization
I will explain 2 different collateralization options considered, followed by an overview of the USDtez approach.
Method 1 (we rejected) — Pure FIAT collateralization
First, we considered pure FIAT collateralization. This is most closely associated with models such as Tether (USDT), USD Coin (USDC). The easiest and most concrete way full collateralization can be achieved, no matter what happens to the price of XTZ, is by settling all exchanges for the initial USDtz-tokens for FIAT and keeping that money in a secure FIAT account.
With a 100% FIAT account, even if on day 1, USDtz is issued, and then on day 2 the price of XTZ crashes 99%, and even if 100% of initial USDtez holders now suddenly want to buy XTZ, there are full FIAT reserves available to do that. Effectively, keeping 100% of reserves in FIAT is like shorting the crypto-asset being addressed.
However, even if the price of XTZ raises, 100% of USDtz is still covered because the only amount minted has been the amount accepted for USD.
Although this sounds ideal, therein lies the trade-off; if the price of XTZ raises, no matter how much it raises, USDtz will only be 100% collateralized; it would be very difficult to adequately grow to keep up with demand; no further USDtz would be able to be minted.
Pros of Pure FIAT Collateralization
- XTZ-price impervious solvency
- Can collect interest from custody partners
Cons of Pure FIAT Collateralization
- Reserve does not grow with the price of XTZ
- As XTZ gains in price, liquidity potential shrinks
- No XTZ staking; hurts, doesn’t help the Tezos network
Method 2 (we rejected) — Pure Crypto (XTZ) collateralization
We then considered collateralizing in pure XTZ. This is closer to projects like DAI (DAI). To some, there is a purism of pure crypto-asset collateralization. In this method, the stablecoin is pegged to the underlying cryptographic asset (in this case, Tezos XTZ), reformulating value associations as the price of the underlying asset changes.
If the stablecoin project is bullish on the underlying asset, and if those bullish sentiments can be assumed to be realized in the future, then would be the best option. Pure crypto collateralization effectively takes a long position in the underlying asset.
For example, assuming the price of XTZ is $1.00, and 100,000,000 USDtz could be sold for 100,000,000 XTZ, with 100% of USDtz collateralized. If the price of XTZ then moves to $10, then USDtz becomes 1000% collateralized.
Overcollateralization of any type is a surplus and opens up great options. With an overcollateralized amount of USDtz in circulation (owning more XTZ than needed to back it) the Foundation could then choose to mint more USDtz, enabling the asset to grow with the market and maintain its service as a liquidity instrument. It could also choose to expand operations by investing in Tezos-based projects, or offering grants to worthy projects. It could move assets to other financial growth vehicles such as an autonomous fund that would diversify the USDtez portfolio and grow the reserves in other ways as well. Finally, it could offer some of the surplus funds as a dividend to early backers.
The problem with this option is, that the price of XTZ is not guaranteed to go up after the point of minting, and if it goes down immediately, then the USDtez ends up undercollateralized. Returning to our example, if the price is cut in half to $0.50, and then every USDtez buyer would rejoice! They did a brilliant thing. They shorted XTZ at the perfect time, and now the price of XTZ has been cut in half. Their next move is to come to their exchange or the USDtez Counter and buy XTZ twice the amount of XTZ that they sold yesterday. If we assume 100% of USDtez buyers returning on day 2 to buy twice the amount of XTZ they sold on day 1, then USDtez would only be 50% collateralized.
The only main way to get around this is to start charging fees and/or restricting liquidation/redemption options on users until the Counter becomes solvent—the mechanisms for which are triggered through some algorithmic process which incorporates price movements and collateral supply. Doing so however chips away at the stability of the price, as the immediate value of USDtez goes down while the cost of owning it may go up. MakerDAO/DAI has been facing this problem. Users become hesitant to use the stablecoin as the option, exchanges are forced to start selling it for less than a dollar, and without the central Counter able to redeem the value, arbitrage traders won’t work to maintain the equilibrium (the whole thing unravels).
Hybridization can be a good reconciler. If the reserve held full FIAT to back all of the USDtez issued and then held an overcollateralizing amount of XTZ, we could have the best of both worlds.
Under the full-crypto collateralization method, hybridization should only be achieved from a (wishful) scenario. For example, if on Day 2 the price of XTZ goes up to $2.00, at which point 50% of the 100,000,000 XTZ (worth $200,000,000) can be liquidated for USD FIAT. That way, XTZ becomes double-collateralized in both $100,000,000 FIAT (most secure) and 50,000,000 XTZ. Then, even if the price of XTZ returns to $1.00, and thus only $25,000,000 (or 25%) of the 100,000,00 issued USDtz can be covered through XTZ collateral, that’s okay because there’s still enough FIAT in the bank to achieve 125% collateralization overall.
If however, the prize of XTZ falls on Day 2, the token would be under collateralization and liquidation, of course, cannot be afforded.
In other words, collateralization of a stablecoin is a zero-sum game. There are no prizes for ‘near’-full collateralization nor for minimizing the blow of under-collateralizing market movements. Thus it’s better to err on the side of caution.
Pros of Pure Crypto Collateralization
- Purist-friendly as all assets are on the blockchain
- The highest growth potential of any method
- Could lead to a quick hybridization of collateral
Cons of Pure Crypto Collateralization
- An extremely risky way to start
- Only works if the price of XTZ grows from the start
Method 3 (WINNER) — Organic Growth Collateralization
Double-backing (hybridization) of collateral methods must be the end goal, to get the best of both worlds without the sacrifices. However, it would be unnecessarily risky and irresponsible, to begin USDtez reserve with pure-XTZ collateralization, no matter how bullish we are when it comes to XTZ (and we are extraordinarily bullish on XTZ).
Assuming 100,000,000 USDtz tokens are minted, USDtez will source a $100,000,000 US dollar backing by creditors, to be used in case of a bank run. Like any loan or mortgage, this line of credit is a calculated risk by the lenders, who would need to see both another form of collateral as well as a means of income to pay interest premiums (if it ever comes to that).
However, we will not convert any of the lent FIAT into XTZ for baking. The intent of the FIAT option is that it remains static and ideally untouched so that even if the price of XTZ drops 99% in 1 second followed by all USDtez owners coming to the Counter to redeem their holdings, should they choose to immediately exercise that right, we’d be guaranteed to meet that demand.
Rather, every USDtz token sold, for whatever medium of exchange used, must settle into a 100% XTZ reserve. All XTZ accumulated and settled from that sale will be baked, and will achieve an annual return of the blockchain minimum; at least—5.51%.
Conservatively estimating, if the ꜩ100,000,000 XTZ reserve baking activities return 5.51% growth annually, and assuming that the price of XTZ remains the same, a lender could assume that the USDtez Foundation can pay interest at the rate of $5,510,000/year. Of course, if the FIAT credited to the USDtez Foundation isn’t touched, then any account fees are relatively negligible then the $5,510,000 can be used to initiate the internal USDtez FIAT reserve, which would reduce the amount of credit needed to be made available from the would-be lender. Over years of compounded interest, and accrued rewards liquidations, the internal FIAT reserve can replace the credit account entirely by around 10 years.
Though, this is a highly conservative estimate. More likely the rewards rate of XTZ will hover around 7%, which will expedite the process (though there will be other divisions of returns such as labor expenses and backer rewards). Furthermore, if the price of XTZ reaches $3.00 at any point (which is not a terribly speculative assumption when it comes to how cryptomarkets behave), a full FIAT collateralization could be achieved and the baking rewards can be used for other activities that will benefit the overall ecosystem.
Some may ask, “why $3.00?” “Why not liquidate when XTZ reaches $2.00?” Although immediately selling off half of the XTZ reserve after the price doubles, would achieve double-collateralization immediately, doing so would not be a very insulated action. Once again, it’s better to err on the side of caution. So, we will set a threshold for FIAT liquidation at the point to the time in which the XTZ reserve has achieved 300% over-collateralization of the USDtz minted (or $300,000,000 value, independent of the FIAT on credit).
In the case of our example, at this trigger point, XTZ will have reached a $3.00 price, and 1/3rd of it will be liquidated to amount to $100,000,000 in USD FIAT. the remaining XTZ will continue to bake with the intent of achieving ever-growing collateralization. The FIAT account lent by the creditor will then be redundant and unnecessary. Instead, banking operations will begin for the FIAT on hand.
Pros of Organic Growth Collateralization
- We safely start with 100% shock-immune collateralization from Day 0
- 200% backed ‘dual-collateralization’ on Day 1 point-of-sale
- Future minting potential grows with market price and volume
- Credited FIAT is replaced by internally earned FIAT
Cons of Organic Growth Collateralization
- Secondary collateralization layer is not on-chain (but that’s okay)
FIAT reserve lending and other banking activities, however, can only be presumed if it can be determined that the FIAT needed to collateralize the issued USDtz won’t be redeemed for a given period of time (the time needed to lend the FIAT and collect a reward). To accomplish this, rather than buy-back and slash (destroy) the USDtz tokens to reduce the supply needed for collateralization, a better way (and a more rewarding option for users) will be the offer of a savings-like account for USDtez holders.
USDtez Savings — Earn interest by holding USDtz
We’re also introducing a new feature for USDtz holders. Obviously, USDtez will be used frequently by investors who want to move to a short position with their XTZ. Though, if a USDtez holder is a truly bearish investor (one that sees a long-term decline in XTZ of months or years) instead of simply holding USDtz until one chooses to move to a long position again), the USDtez holder can open a savings-like account with their USDtz and collect 3% annual interest yield. Given in the form of a smart-contract, the USDtez Savings offering performs is far better than the typical bank CD rate (as can be seen in the chart below).
USDtez’s Savings program offering will be paid by revenue collected. Part of this revenue will come from in part by lending FIAT, and in part through XTZ baking rewards. The high rate of return with no minimum is another way in which USDtez holds an advantage over FIAT. The USDtez Savings holder can opt for various term-periods that accrue different reward rates. As you may have guessed, a better return rate is awarded for a longer period of lock-in.
Once the USDtez Savings smart-contract matures, and after all pertaining transactions are triggered and completed, the smart-contract recognizes this, and it ends the term of duration. Everyone goes along their merry way.
The benefit to USDtez Foundation for issuing this financial instrument is that in aggregate, USDtez Foundation will know with certainty for some period of time, just how much USDtz will not need to be redeemed. Knowing with guaranteed certainty how much USDtz will not need to be redeemed for a given period of time, frees up the corresponding collateral funds for financial activities that would bring growth to the reserve.
The USDtez Foundation may also issue bonds or other asset-backed derivatives in the future. The choice to do so would be a tradeoff between simplicity vs. faster growth plus more growth options. Eventually, these decisions will be resolved democratically by a distributed network; they will be proposed and vetted by the presiding participants of the DAO. Details on the DAO and participation will be forthcoming.
More details will be added soon. We plan to publish at least one article a week in the lead-up to the release of the white-paper, followed by the release of the [more technical] green-paper.
Stay tuned.
How can I continue to follow the project?
Go to USDtz.com to sign up for the USDtez mailing list. You can also follow us on various social media channels, including:
