Facing near-collapse, Algorithmic stablecoins continue to innovate
Author: Solaire, YBB Capital
Foreword
Stablecoins have always been the most critical link in the crypto world, accounting for 8.6% of the total blockchain market cap (about $124.5 billion). Centralized stablecoins with US dollars and US bonds as collateral have always been dominant, such as USDT and USDC, but centralized stablecoins have always been controlled by a center, such as Tether, which is fully capable of freezing USDT in any address, and their security is guaranteed by a centralized entity. This is obviously not in line with the original intention of the existence of blockchain, and the exploration of decentralized stablecoins has resulted in two main branches, over-collated stablecoins and algorithm-based stablecoins. While over-collateralized stablecoins can remain stable in the highly volatile crypto market due to their high collateralization rates, their minimum collateralization rates of 1.5–2 times result in capital inefficiencies. While the market for algorithm-based stablecoins has always been the cruelest, although they have the highest capital efficiency, due to their near-zero collateral model, death is always with them, and after the LUNA failure, this track has been dormant for a long time. However, I have always believed that there should be a decentralized stablecoin in the crypto world that is not over-collated, and this article will explore the history of algorithmic stablecoin and some new ideas.
What is an algorithmic stablecoin?
Generally speaking, an algorithmic stablecoin is a stablecoin that does not require any reserves or collateral, and its supply and circulation are completely regulated by algorithms. The algorithm controls the supply and demand of the currency and aims to peg the price of the stablecoin to a reference currency (usually the US dollar). In general, the algorithm issues more coins when the price goes up, and buys back more coins in the market when the price goes down. The mechanism is similar to seigniorage, or the way central banks regulate the supply and value of money by issuing or destroying it. For some algorithmic stablecoins, the function is subject to modification based on suggestions from the community, and this modification is achieved through decentralized governance, so that the power of seigniorage is given to the users of the currency, not the central bank.
All in all, algorithmic stablecoins differ in terms of decentralization as opposed to common stablecoins such as USDT and USDC, which do not require reserves and are independent. Since algorithmic stablecoins are currencies based on the intrinsic relationship between mathematics, monetary economics, and technology, they lead to a model of stablecoins that may be more advanced than centralized stablecoins.
A brief history of algorithmic stablecoins
An early attempt to influence later algorithmic stablecoins dates back to 2014, when economist Robert Sams proposed a model called “Seigniorage Shares, “which maintained price stability by automatically adjusting the money supply. The idea was partly inspired by the monetary policy of modern central banks. Next, BitShares experimented with a hybrid model that, while largely based on asset collateral, also included some elements of algorithmic tweaks. This can be seen as an important step in the evolution of algorithmic stablecoins, although it is not a pure algorithmic stablecoin in itself.
By 2017, a project called Basis (formerly Basecoin) was getting a lot of attention. The project sought to maintain the value of stablecoins through a complex system of Kyngen. However, the project was eventually forced to shut down at the end of 2018 due to incompatibility with US securities laws.
In 2019, Ampleforth proposed a new model called “elastic supply,” which adjusts not only the issuance of new tokens, but also the number of existing tokens in a user’s wallet, thus achieving a stable price. Around the same time period, Terra also released its stablecoin, which uses a composite model that includes taxation, algorithmic adjustments, and asset collateralization, minted through its native token. Of course, this token is also known by its name, which later became LUNA.
Terra Luna
LUNA, the most iconic project in algorithmic stablecoins, is also one of the most notorious projects in the crypto world. The history of Luna is like a flash bomb, which is very bright for a moment and then disappears for a moment. Today’s rediscussion of LUNA is just to learn from the past and discover some implications for the future.
Terra is a blockchain built on Cosmos SDK and Tendermint consensus, originally designed to solve e-commerce payment problems through cryptocurrency, but traditional cryptocurrencies are too volatile, it is not easy to use like fiat currency, and centralized stablecoins such as USDT have regional and centralized problems. So Terra wants to create a rich and decentralized portfolio of stablecoins such as South Korean won, Thai baht and US dollar.
Terra co-founders Do Kwon and Daniel Shin needed to consider a universal minting mechanism, which was later proposed in Terra Money’s white paper in April 2019, through LUNA (Terra’s native token) to mint stablecoins in various countries. Let’s take UST (Terra’s US dollar stablecoin) as an example to briefly explain this method.
· First, the UST is pegged 1:1 to the US dollar;
· If UST exceeds the pegged price, you can convert $1 of LUNA into 1 UST, at which time UST is worth more than $1, and you can earn the difference by selling it;
· Vice versa, if the UST is below the peg price, you can always convert 1 UST into 1 dollar of LUNA.
The model was met with skepticism from the very beginning, and from the birth of LUNA to the eve of its demise, various prominent figures in the crypto community warned that LUNA was nothing more than a Ponzi scheme. But even so, there are still many people who continue to pour into this dangerous place, so why?
Seigniorage
To understand a Ponzi scheme, it is important to understand the motivation behind its design. In addition to raising the price of LUNA, the mass adoption of UST has a key benefit — seigniorage.
Seigniorage is an economic concept that describes the revenue that governments in the past generated by issuing money. Specifically, the term is often used to refer to the difference between the face value of a currency and its cost of production. For example, if the cost of producing a $1 coin is 50 cents, then seigniorage is 50 cents.
In the crypto world, there is seigniorage for all three types of stablecoins. Stablecoins, which have fiat money as collateral, generally charge a seigniorage of about 0.1% during the minting and destruction process. An over-pledged stablecoin, on the other hand, earns money from fees and interest rates paid by the holder. As for algorithmic stablecoins, they have the highest seigniorage rate. By introducing a mechanism pegged to volatility tokens, stablecoins are able to convert all funds entering the system into seigniorage, a creation out of thin air. This mechanism greatly reduces start-up costs and somewhat increases the anchoring rate, but it also comes with inherent vulnerabilities.
Anchor Protocol
LUNA is a miracle in the history of algorithmic stablecoins, as previous algorithmic stablecoin projects have failed in a very short time or have never been able to make it big. LUNA not only achieved the third position in the stablecoin sector, but also one of the few companies to open up the payment business.
Terra actually had a very good financial ecosystem before it died, and there were two payment systems built on Terra protocols, CHAI and Memapay. CHAI has even been a one-stop shop for local payment channels in Korea, and has worked with a number of companies, NIKE Korea and Philips are among the users of CHAI. Terra has been very successful in bringing the benefits of blockchain to the real world by already having protocols for stocks, insurance, and asset splits within its financial ecosystem.
It is a pity that this prosperity has been built on the deception of Do Kwon, rather than on the steady progress of UST’s various application scenarios. By pressing the Anchor Protocol, Do Kwon hastened Terra’s success and death.
Anchor Protocol, the decentralized bank within the Terra ecosystem, offered a very attractive savings product, a 20%APY lossless UST deposit business (the early design was 3% APY, but Do Kwon stuck with 20%). UST has 20% APY when the real world Bank can’t even offer a 1% interest rate. So Do Kwon found the mysterious button of large-scale casting and stable casting pressure in UST.
In order to maintain this deception, Do Kwon was also close to madness in the later years of Terra, by refinancing and purchasing BTC to maintain the annualization of the UST (at the time it was proposed to reduce the annualization to 4%, but Do Kwon knew that a massive dump pressure was a much scarier thing) and the stability of the UST. However, the paper could not hold the fire. On the night of the migration of UST from Curve 3Pool to DAI killing 4Pool, when the liquidity of UST was at its lowest, a well-planned short selling attack directly knocked the UST off the peg, and BTC, as the second shield, also failed to maintain the fixed exchange rate of UST. Instead, it fed the short sellers. At this point, the giant empire of Terra collapsed in an instant.
Parallel Worlds
If there were other parallel worlds, Do Kwon had no interest in pushing that button, or was not attacked that night at the UST migration pool. Could Terra have avoided death in the end? The answer is no, in a parallel world where UST is not attacked, UST will eventually die because of Pond’s death, and even without Pond’s death, UST will die because of a forced hook. It is extremely difficult to peg another currency, and even if there is no short attack, there are many uncontrollable events that could overwhelm this vulnerability.
The Schwarzschild radius
The Schwarzschild radius is a physical parameter of an object that means that any object below its Schwarzschild radius will inevitably collapse into a black hole.
In fact, this applies not only to celestial bodies, but also to algorithmic stablecoins like LUNA, and even to these centralized “gold standard” stablecoins. Since LUNA and UST are twins, either of them is the Schwarzschild radius of the other, UST decoupling or LUNA experiencing liquidity issues. At this point, the casting mechanism is still operating as usual, so eventually they will collapse into a “black hole” at extreme speed.
The Schwarzschild radius of centralized stablecoins, which use dollars or US Treasuries as collateral, can be said to be the security of centralized entities. This centralization problem includes not only themselves, but also banks and custodians. While we all know that both USDT and USDC have been around for years and survived numerous FUDs, their history is only relatively long compared to that of the crypto world. There is no guarantee that any centralized institution in the world is too big to fail. After all, Lehman Brothers could fail, and they could be run into black holes if they lose their collateral or become unconvertible into dollars (as USDC nearly did in March).
If you look at real-world monetary history, these mechanisms have collapsed into black holes before. For example, the collapse of the gold standard was due to the imbalance of gold reserves during the war and the massive issuance of money by the central banks. Their gold reserves simply did not match the total amount of money that was generated. Citizens had no idea how much gold the banks actually held. Only when a bank run occurred did it become clear that the money was worthless, and eventually it became legal for the central bank to print too much money (the modern paper money system). In the case of a currency peg to another currency, such as the pound’s indirect peg to the Deutsche Mark, Britain briefly participated in the European Exchange Rate Mechanism (ERM), a semi-fixed exchange rate system between a number of currencies. In the ERM, the currencies of participating countries fluctuate within a relatively narrow band, with the Deutschmark often acting as an “anchor” currency. This can be seen as an indirect peg. However, the fixed exchange rate that the UK maintained in the ERM became increasingly unsustainable due to a number of factors, including rising interest rates as a result of German reunification and domestic economic pressures in the UK requiring lower interest rates to stimulate exports.
On the occasion of the famous Black Wednesday incident, Soros identified the fragility of the system by working with a group of mutual funds and multinational corporations that had long been engaged in arbitrage operations to sell weak European currencies in the market and short them, forcing these countries to invest heavily in maintaining the value of their currencies.
On September 15, 1992, Soros decided to bet heavily against the British pound, which fell all the way to 2.8 against the mark. The pound was on the verge of exiting the EMR system. On the 16th, even though Britain’s chancellor of the exchequer raised interest rates to 15% in one day, it had little effect. In the battle to defend the pound, the British government spent $26.9 billion of its foreign exchange reserves, and the central bank bought back $2 billion of sterling every hour, but still couldn’t keep the exchange rate above the 2.778 floor. In the end, the British government was defeated and forced to withdraw from the EMR system. Soros earned nearly $1 billion in this campaign and became famous in the First World War.
Credit Money
The modern monetary system is based on the credit of a centralized government. The money in each of our hands is the debt of the bank or the government, and the national debt is the debt of the debt. In essence modern money is essentially “credit money”. The government’s continuous issuance of debt will only devalue the currency and accelerate the cycle of inflation. This monetary system may be the biggest Ponzi scheme in human history, but when it comes to “money,” most people don’t think of anything other than fiat money. That’s because people have accepted the Schelling point that a scam lasts long enough to be “real.” Perhaps in order to build a stablecoin on a blockchain, we need to accept a certain amount of Ponzi.
REFLECTIONS
So here are my personal views on how to build a currency on the blockchain:
· Low volatility but allow for volatility and ample liquidity;
· No forced peg to any fiat currency;
· Tracking supply and demand indicators for allocation;
· Accept a certain Pond presence and make the coin a Schelling point;
· Enough application scenarios to enable real-world payments;
And floating stablecoins, f(x) Protocol
f(x) is an ETH tiered leverage protocol designed to meet the need for stable assets in the cryptocurrency space while mitigating centralization risks and capital efficiency issues. The f(x) protocol introduces a new concept called a “floating stablecoin” or fETH. fETH is not tied to a fixed value, but rather gains or loses a small fraction of the price movement of native Ethereum (ETH). A supplemental asset called xETH is also created, which acts as a zero-cost leveraged long ETH position. xETH absorbs most of the volatility of ETH price movements, thus stabilizing the value of fETH.
· fETH: A low-volatility ETH asset whose price is 1/10 of the original ETH price movement (beta coefficient is 0.1). Let’s say the price of ETH today is $1,650, and the minted fETH is 1,650 and the price is also $1,650. Tomorrow the price of ETH falls to $1,485, while the price of fETH can still be maintained at $1,633.5, and vice versa. You can also think of this simply as 90% stablecoins +10% ETH;
· xETH: zero-cost barre long ETH positions to absorb ETH fluctuations in order to maintain the price of fETH (i.e. β> 1), these xETH can be traded in Defi (via ETH’s long position demand support system).
The beta coefficient can be adjusted under this mechanism.
Beta.
In finance, Beta is a measure used to quantify the volatility of an asset or portfolio relative to the market as a whole. It is a key parameter in the Capital Asset Pricing Model (CAPM) and is used to estimate the expected return and risk of an asset.
Method of calculation
Beta is calculated by regression analysis, usually by comparing the returns of individual assets to the returns of the market as a whole (usually represented by a market index such as the S&P 500). Mathematically, beta is the slope in a regression equation like this:
Return on assets =α+β x market return
Where alpha is the intercept term, which represents the expected return of the asset without risk, while beta is the slope, which represents the sensitivity of the asset to the market return.
Explanation
· Beta = 1: The volatility of the asset is consistent with the volatility of the market as a whole;
· Beta > 1: the asset is more volatile relative to the market, that is, the asset is likely to move more sharply when the market rises or falls;
· Beta < 1: the asset is more stable and less volatile relative to the market;
· Beta = 0: the asset has no correlation with market returns, usually a risk-free asset such as Treasury bonds;
· Beta < 0: the asset has a negative correlation with the market return, such an asset may have a positive return when the market falls, and therefore has a hedging effect.
How IT Works
The f(x) protocol accepts only ETH as collateral and is backed by low and/or high volatility (beta) tokens. Offering ETH allows users to mint fETH and/or xETH in quantities based on the price of ETH and the current net asset value (NAV) of each token. Instead, users can redeem the NAV ETH of fETH or xETH from their reserves at any time.
The NAV of fETH and xETH varies with the price of ETH, so the total value of all fETH plus the total value of all xETH equals the total value of ETH reserves at any given time. In this way, each fETH and xETH token is backed by its NAV and is redeemable at any time. Mathematically, invariants hold true at all times:
Where neth is the amount of ETH collateral, peth is the price of ETH USD, nf is the total supply of ETH, pf is the ETH NAV, nx is the total supply of xETH, and px is xETH NAV.
This protocol limits the volatility of fETH by adjusting its NAV in response to changes in the price of ETH so that 10% of the return of ETH (for βf=0.1) is reflected in the price of fETH. The protocol simultaneously adjusts the xETH NAV to exceed the magnitude of the ETH return to satisfy the f(x) invariant (equation 1). In this way, xETH provides leveraged ETH returns (tokenized with zero funding costs) while fETH exhibits low volatility, and both remain trusted decentralized.
Risk patterns
In fact, under this concept, fETH needs to rely on xETH to exist, and the demand for xETH is not large enough to maintain the 0.1β coefficient of fETH, or the fluctuation is too high to maintain, so the protocol introduces a CR formula to calculate the health level of the entire system.
CR divides the total collateral value by the total NAV of fETH and sets four risk levels based on percentage.
If the system’s CR falls to a level where the ability to maintain βf= 0.1 is at risk, the system’s risk management system will initiate four progressively robust modes that steer the system back in the direction of over-collateral. Each mode sets a CR threshold below which additional measures are initiated to help maintain the stability of the system as a whole. The incentives, fees, and controls described by each mode will remain in effect as long as the CR is below its designated level, so, for example, if level 3 is effective, it means that levels 1 and 2 are also effective. They are automatically reinstated when the CR rises back above the relevant level.
· Level 1 — Stability Mode: When the CR value is lower than 130%, the system enters the stable mode. Starting in this mode, fETH casting is disabled and the redemption fee is set to zero. xETH’s redemption fee increases, and xETH miners receive additional rewards from fETH holders in the form of a small stabilization fee;
· Level 2 — User Rebalance Mode: The system enters user balance mode when the CR value falls below 120%. In this mode, users can earn rewards by exchanging fETH for ETH, and the remaining fETH holders pay a stabilization fee in a similar manner to stable mode. In this way, the user can earn slightly more than the NAV of the fETH upon redemption. In this mode, fETH’s redemption fee is set to zero;
· Level 3 — agreement balance mode again: When the CR value is below 114%, the system enters agreement rebalancing mode. This mode is equivalent to Level 2, except that the Agreement balance mode itself can be rebalanced using reserves. This pattern is less likely to be triggered because Level 2 rebalancing actions are profitable and the user is more responsive than the protocol, but it creates an additional layer of protection. In this mode, the protocol uses ETH from the fETH reserve to buy on the market and then burns fETH from the AMM. Using this mechanism, the NAV of fETH will only reduce the rebalancing stabilization fee that the protocol receives in this case;
· Level 4 — Recapitalization: In the most extreme case, the protocol has the ability to issue governance tokens to raise ETH for recapitalization by minting xETH or buying and redeeming fETH.
EPILOGUE
The f(x) Protocol proposes a way to create stablecoins by controlling volatility. The idea is interesting, but it still has some obvious disadvantages, because fETH needs to be relatively stable in the market and xETH adoption is high enough to exist. However, this is a very interesting idea. It is not possible for blockchain to create a situation similar to the modern credit monetary system (it must be centralized), and we need to focus on enough application scenarios and low volatility and liquidity. I personally think that some Meme tokens (such as Dogecoin) have the potential to develop application scenarios, and some new attempts at computing stability are not only f(x) doing, for an embryonic stage of things, we should give a certain amount of patience and tolerance.
About YBB
YBB is a web3 fund dedicating itself to identify Web3-defining projects with a vision to create a better online habitat for all internet residents. Founded by a group of blockchain believers who have been actively participated in this industry since 2013, YBB is always willing to help early-stage projects to evolve from 0 to 1.We value innovation, self-driven passion, and user-oriented products while recognizing the potential of cryptos and blockchain applications.
References
1:f(x) White paper
2:Terra Money: Stability and Adoption
3: 【Denationalization of money】
4: The Lord of the Rings Dream of algorithmic stablecoins: After LUNA, there will be no next UST
5: Expanded by LUNA Coin: Why do I think the attempt at an algorithmic stablecoin is doomed to fail
