Piece written in collaboration with @thryec.
Terra is going ahead with its “rebirth”. A yes vote is practically the only way that UST/LUNA holders can recover any of their losses. But will Terra 2.0 be worth something? Or is there going to be another looming disaster?
There were lots of lessons learned from the community over the past weeks. And there probably will be more. LUNA and all the other algorithmic stablecoins out there aren’t ready yet, but that’s not a serious concern for now. There’s always going to be a trial and error process to develop something that’s worthwhile.
Here we chart out the different stages that the industry and community must go through to build a truly decentralized stablecoin that actually works. Many of these phases have either taken place or are happening as we speak.
The idea of having a stable digital currency has existed even before Bitcoin, but the first breakthrough always begins with a person obsessing over a crazy idea.
J.R Willett toyed with the possibility of building a second layer on top of the Bitcoin Protocol. Coined the Mastercoin Protocol, this new layer paved the way for the world’s first successful stablecoin - Tether/USDT. Its mechanism is straightforward - for every USDT, there would be a dollar you can redeem from the bank.
The stablecoin has faced controversies along the way but the key points to note are:
Collateral reserve has been restructured, but Tether still insists it’s fully backed
As the third largest cryptocurrency in the market, it’s the most dominant stable
Sentiments have shifted. At first, there was widespread skepticism but Tether is now seen as one of those that are ‘too big to fail’.
To get to the next stage, more reserve-backed stablecoins must emerge.
Stage 2 is where a segment of the industry (i.e. fiat-collateralized stablecoin) is successfully established. Other protocols with similar models have came along after Tether. They are tokens that are collateralized by assets, typically a fiat currency. Some examples include Binance USD (BUSD) and TrueUSD (TUSD). For investors who want more stability than USDT, CENTRE Consortium’s USD coin (USDC) is a popular choice.
Stage 3 is where the industry starts exploring collateral using crypto assets. These are your over-collateralized but more decentralized stablecoins.
MakerDAO’s DAI is seen as the first example of this case. It began as a stablecoin backed by ETH, but this means that DAI needs to be over-collateralized at a minimum 150%. To put simply, when you borrow DAI, you must give at least 150% of the loaned amount as security.
Eventually, as demand grows, there was a need to raise the supply of DAI. So MakerDAO had to figure out how to add more collateral that users want to borrow against while making sure they are safe for the system.
How MakerDAO works now: for each user who wants to borrow DAI, they create their own Maker Collateral Vault. This is a smart contract where collateral in the form of Ethereum-based assets are stored (see here for collateral breakdown). Since collateral is spread among individual smart contracts, it potentially reduces centralization risk. It’s an advantage because there’s no single point of failure and less incentive for attackers to exploit potential smart contract vulnerabilities.
P.S: You can probably can count Liquity’s LUSD and perhaps FEI in this stage as well.
At this stage, DeFi protocols are still struggling when it comes to liquidity. In theory, someone could provide liquidity to a lending or swap pool. The problem is that liquidity providers don’t have enough incentives to do so until there’s massive liquidity to attract traders or investors who will pay fees or interest.
To get to Stage 4, a project must be able to solve the above issue.
Compound was the first to crack the code through on-chain liquidity in 2020. By introducing algorithms, it put forward the concept of farming protocol tokens. These assets have unique properties, rising in value or in quantity based on the deposit’s success. A DAI deposited in Compound would become cDAI, earning the interest on that deposit. Lenders on Compound could also earn COMP token rewards, which give them special voting rights.
The yield farming craze then kicked off. Projects started to look into how to build a DeFi model that can maximize returns. SushiSwap and Curve’s yCRV pool rose to become among the top platforms.
Another protocol that emerged during DeFi summer was Abracadabra Money, with its stablecoin called Magic Internet Money (MIM). This was game-changing as it allowed users to deposit yield-bearing tokens (”receipt” tokens gained when users deposit their tokens in other DeFi protocols to earn yield) as collateral to borrow MIM. As such, users are able to further capitalize on their assets.
The mechanics used to stabilize MIM mainly rely on arbitrage opportunities in the Abracadabra system. If the price of MIM is less than $1, users can purchase MIM for a lower price to repay their loans. This will result in higher demand for MIM and price trending back to $1. Conversely, if the price of MIM is greater than $1, users can open a collateralized debt position (assuming they own valid yield-bearing tokens) to borrow MIM and sell it in the open market for a higher value.
One level up, DeFi projects start playing around with the mix of algorithms and collateral. This is where the partial reserve-backed stablecoin comes in, with FRAX being arguably the most successful so far. It’s the first fractional-algorithmic stablecoin protocol, meaning its supply is partially backed by collateral and algorithms at the same time.
By leveraging the benefits of both designs, FRAX could potentially create scalable and trustless on-chain money. The collateral ratio adjusts according to the market price of FRAX so the stablecoin can always be redeemed and minted at $1 of value. Such mechanism stabilizes the price of FRAX when it deviates from a dollar, while allowing arbitragers to earn profit.
Essentially, the goal is to move from the initial 100% collateral ratio to an increasingly algorithmic makeup. This will largely depend on confidence in the utility of the FRAX token over time. Still, such model is agnostic and flexible, relying on the market demand for the stablecoin.
Through all the various experiments taking place, Stage 6 marks the rise of an iconic token representative for algorithmic stablecoin.
In the version of the world we live in, it would be Terra’s UST. It’s a purely algorithmic product that tracks the US dollar price, but we’ll skip the history since there are probably enough details circulating around nowadays.
Another lesser-known algorithmic protocol is Ampleforth. Its token AMPL is simpler than UST. AMPL increases and decreases the supply of all investors’ holdings as needed to meet its peg. This means it has more supply volatility than price volatility.
Stage 7 somewhat threads in and out through all the other stages. In between projects testing different mechanisms and incentive structures, there are those made simply to drive hype. They create winners and losers all the while making sure the projects profit from the game.
In the late 2020, there were Basis Cash (whose primary founders include Terra’s Do Kwon, we might add) and Empty Set Dollar. Both quickly flamed out, falling far off their $1 peg.
Another failed project was Iron Finance. It was a classic case of rug pull. Due to a lack of proper stabilizing mechanism, the protocol crashed after a massive selloff by crypto whales.
There are some smart contract considerations when dealing with stablecoin design. A typical protocol hard-codes UST value to $1 USD in the contract. This allows malicious actors to buy UST at a discounted price, deposit it into the protocol, and borrow more than they should have been able to with the same starting amount of USD. The collateral was then forfeited for a profit of borrowed asset - UST value.
While failures are necessary to get to more enhanced products, it’s no doubt scams, rug pulls, and exploits are hurting the industry’s reputation.
Just when you thought it can’t get any worse, we arrive at Stage 8. This is where the most trusted representative algorithmic stablecoin hits a major crash. It can be due to various factors, like design flaws and market conditions.
Obviously, the best case in point is Terra’s latest collapse. The golden child of algorithmic stablecoins exposed the dangers of being pegged to currencies that are constantly inflating. In the case of UST/LUNA, it was the US dollar.
Stage 8 easily transitions to Stage 9 where calls to regulate the industry grow louder. A global catastrophe is all it takes to get the attention of governments and regulators.
Soon after Terra’s fall from grace, regulation became a hot topic among political circles (more on this here). The key takeaways for regulatory frameworks surrounding the industry are:
Like the US dollar, UST is also backed by nothing but belief and common acceptance.
Societal collaboration is crucial, but it’s hard to strictly enforce through protocols.
The stablecoin industry and community must be involved in the regulatory process through informal forums of participation.
Stage 10 comes as a reaction to moves by authorities. We are probably at this stage now, if not already.
This is where the industry begins to find its own ways to prevent overregulation. Projects start to think about removing power from existing dominant currencies. While the UST is an algorithmic stablecoin that has managed to rise to global relevance, it’s still linked to some state-backed currency.
To carry out Stage 10 well, the industry needs to redefine how the community thinks about value. Outside of the blockchain space, value is most often measured by the consumer price index (CPI). It identifies the real value of an economy’s currency based on the things that its people buy. This helps governments to monitor for any signs of inflation.
The stablecoin industry most likely needs a crypto version of CPI, but it will have to go beyond the traditional tracking systems. A viable crypto CPI must measure global real product prices and find the right package of goods that consistently represents the real value of most people’s livelihoods. This elusive package is what that one ultimate algorithmic stablecoin will set as its peg - not a fiat currency. In other words, a truly decentralized stablecoin would be pegged to something not centralized.
One level up from a crypto CPI involves creating an industry-native measurement for what a stablecoin is worth. Some projects are already at this stage.
FRAX has launched its approach to a CPI that’s designed to fluctuate over time. The Frax Price Index (FPI) is a so-called “inflation resistant” algorithmic stablecoin. It tracks the CPI statistics published by the US government, using Chainlink’s oracle data.
The protocol is still quite new so its success remains to be seen. While it’s a step in the right direction, there are still some kinks to be sorted out. Governments calculate CPI based on a basket of goods that can be changed to reflect actual inflation figure. So a stablecoin that tracks a government’s CPI data may not be able to keep up with inconsistent fluctuations in purchasing power.
Ampleforth appears to avoid such issue by taking a different approach. AMPL is pegged to the value of the 2019 US dollar. This means that the stablecoin will increasingly deviate away from the present value of the dollar over time. Yet, the wealth of the token’s holder should remain the same as it was. AMPL’s mechanism serves as a hedge against inflation, while aiming to be a crypto-native unit of account.
The industry is probably dancing between Stages 10 and 11 right now. While there are promising projects happening in Stage 11, they will most likely be used by very crypto-native people for now - in short, only those in this game simply for the tech. To get to the next stage, projects that prioritize use cases over hype and profit must become successful.
Stage 12 is more like a nice-to-have. Here, we go beyond just the tech itself and into dealing with the collective mindset. This is where the industry introduces a crypto-native way for people to think about how much a thing is worth.
This requires foremost more successful decentralized stablecoin projects, units of measure, and use cases to emerge. Eventually, trust and understanding of the tech grow and lead to greater adoption.
With more users joining the community, more people can now think intuitively in two different currencies at once. You can easily compare two different stablecoins in your head or even measure the price of a real-world good to a stablecoin. At this point, a reliable, decentralized mode of payment is probably essential to catch up with the growing number of users.
As time evolves and more people come to trust and use the system, successful stablecoin projects will learn that it’s not so much about coming up with the most complex design. It’s far more useful to focus on building up a strong ecosystem.
Without stablecoins, there would also have been no progress in DeFi. Still, many current projects are trying to achieve too much too soon. They are looking for the game that removes all risks entirely. If there were to be a truly decentralized token with a stable value in the future, it would take quite a lot of discussions on whether it works.
The crypto economy will eventually expand so much that it no longer needs a collateral peg. Still, it’s not going to be a fast track. It will be more like a slow consensus-building journey to a truly decentralized stablecoin.
Introspections on all things Web3.
Piece written in collaboration with @thryec.
Terra is going ahead with its “rebirth”. A yes vote is practically the only way that UST/LUNA holders can recover any of their losses. But will Terra 2.0 be worth something? Or is there going to be another looming disaster?
There were lots of lessons learned from the community over the past weeks. And there probably will be more. LUNA and all the other algorithmic stablecoins out there aren’t ready yet, but that’s not a serious concern for now. There’s always going to be a trial and error process to develop something that’s worthwhile.
Here we chart out the different stages that the industry and community must go through to build a truly decentralized stablecoin that actually works. Many of these phases have either taken place or are happening as we speak.
The idea of having a stable digital currency has existed even before Bitcoin, but the first breakthrough always begins with a person obsessing over a crazy idea.
J.R Willett toyed with the possibility of building a second layer on top of the Bitcoin Protocol. Coined the Mastercoin Protocol, this new layer paved the way for the world’s first successful stablecoin - Tether/USDT. Its mechanism is straightforward - for every USDT, there would be a dollar you can redeem from the bank.
The stablecoin has faced controversies along the way but the key points to note are:
Collateral reserve has been restructured, but Tether still insists it’s fully backed
As the third largest cryptocurrency in the market, it’s the most dominant stable
Sentiments have shifted. At first, there was widespread skepticism but Tether is now seen as one of those that are ‘too big to fail’.
To get to the next stage, more reserve-backed stablecoins must emerge.
Stage 2 is where a segment of the industry (i.e. fiat-collateralized stablecoin) is successfully established. Other protocols with similar models have came along after Tether. They are tokens that are collateralized by assets, typically a fiat currency. Some examples include Binance USD (BUSD) and TrueUSD (TUSD). For investors who want more stability than USDT, CENTRE Consortium’s USD coin (USDC) is a popular choice.
Stage 3 is where the industry starts exploring collateral using crypto assets. These are your over-collateralized but more decentralized stablecoins.
MakerDAO’s DAI is seen as the first example of this case. It began as a stablecoin backed by ETH, but this means that DAI needs to be over-collateralized at a minimum 150%. To put simply, when you borrow DAI, you must give at least 150% of the loaned amount as security.
Eventually, as demand grows, there was a need to raise the supply of DAI. So MakerDAO had to figure out how to add more collateral that users want to borrow against while making sure they are safe for the system.
How MakerDAO works now: for each user who wants to borrow DAI, they create their own Maker Collateral Vault. This is a smart contract where collateral in the form of Ethereum-based assets are stored (see here for collateral breakdown). Since collateral is spread among individual smart contracts, it potentially reduces centralization risk. It’s an advantage because there’s no single point of failure and less incentive for attackers to exploit potential smart contract vulnerabilities.
P.S: You can probably can count Liquity’s LUSD and perhaps FEI in this stage as well.
At this stage, DeFi protocols are still struggling when it comes to liquidity. In theory, someone could provide liquidity to a lending or swap pool. The problem is that liquidity providers don’t have enough incentives to do so until there’s massive liquidity to attract traders or investors who will pay fees or interest.
To get to Stage 4, a project must be able to solve the above issue.
Compound was the first to crack the code through on-chain liquidity in 2020. By introducing algorithms, it put forward the concept of farming protocol tokens. These assets have unique properties, rising in value or in quantity based on the deposit’s success. A DAI deposited in Compound would become cDAI, earning the interest on that deposit. Lenders on Compound could also earn COMP token rewards, which give them special voting rights.
The yield farming craze then kicked off. Projects started to look into how to build a DeFi model that can maximize returns. SushiSwap and Curve’s yCRV pool rose to become among the top platforms.
Another protocol that emerged during DeFi summer was Abracadabra Money, with its stablecoin called Magic Internet Money (MIM). This was game-changing as it allowed users to deposit yield-bearing tokens (”receipt” tokens gained when users deposit their tokens in other DeFi protocols to earn yield) as collateral to borrow MIM. As such, users are able to further capitalize on their assets.
The mechanics used to stabilize MIM mainly rely on arbitrage opportunities in the Abracadabra system. If the price of MIM is less than $1, users can purchase MIM for a lower price to repay their loans. This will result in higher demand for MIM and price trending back to $1. Conversely, if the price of MIM is greater than $1, users can open a collateralized debt position (assuming they own valid yield-bearing tokens) to borrow MIM and sell it in the open market for a higher value.
One level up, DeFi projects start playing around with the mix of algorithms and collateral. This is where the partial reserve-backed stablecoin comes in, with FRAX being arguably the most successful so far. It’s the first fractional-algorithmic stablecoin protocol, meaning its supply is partially backed by collateral and algorithms at the same time.
By leveraging the benefits of both designs, FRAX could potentially create scalable and trustless on-chain money. The collateral ratio adjusts according to the market price of FRAX so the stablecoin can always be redeemed and minted at $1 of value. Such mechanism stabilizes the price of FRAX when it deviates from a dollar, while allowing arbitragers to earn profit.
Essentially, the goal is to move from the initial 100% collateral ratio to an increasingly algorithmic makeup. This will largely depend on confidence in the utility of the FRAX token over time. Still, such model is agnostic and flexible, relying on the market demand for the stablecoin.
Through all the various experiments taking place, Stage 6 marks the rise of an iconic token representative for algorithmic stablecoin.
In the version of the world we live in, it would be Terra’s UST. It’s a purely algorithmic product that tracks the US dollar price, but we’ll skip the history since there are probably enough details circulating around nowadays.
Another lesser-known algorithmic protocol is Ampleforth. Its token AMPL is simpler than UST. AMPL increases and decreases the supply of all investors’ holdings as needed to meet its peg. This means it has more supply volatility than price volatility.
Stage 7 somewhat threads in and out through all the other stages. In between projects testing different mechanisms and incentive structures, there are those made simply to drive hype. They create winners and losers all the while making sure the projects profit from the game.
In the late 2020, there were Basis Cash (whose primary founders include Terra’s Do Kwon, we might add) and Empty Set Dollar. Both quickly flamed out, falling far off their $1 peg.
Another failed project was Iron Finance. It was a classic case of rug pull. Due to a lack of proper stabilizing mechanism, the protocol crashed after a massive selloff by crypto whales.
There are some smart contract considerations when dealing with stablecoin design. A typical protocol hard-codes UST value to $1 USD in the contract. This allows malicious actors to buy UST at a discounted price, deposit it into the protocol, and borrow more than they should have been able to with the same starting amount of USD. The collateral was then forfeited for a profit of borrowed asset - UST value.
While failures are necessary to get to more enhanced products, it’s no doubt scams, rug pulls, and exploits are hurting the industry’s reputation.
Just when you thought it can’t get any worse, we arrive at Stage 8. This is where the most trusted representative algorithmic stablecoin hits a major crash. It can be due to various factors, like design flaws and market conditions.
Obviously, the best case in point is Terra’s latest collapse. The golden child of algorithmic stablecoins exposed the dangers of being pegged to currencies that are constantly inflating. In the case of UST/LUNA, it was the US dollar.
Stage 8 easily transitions to Stage 9 where calls to regulate the industry grow louder. A global catastrophe is all it takes to get the attention of governments and regulators.
Soon after Terra’s fall from grace, regulation became a hot topic among political circles (more on this here). The key takeaways for regulatory frameworks surrounding the industry are:
Like the US dollar, UST is also backed by nothing but belief and common acceptance.
Societal collaboration is crucial, but it’s hard to strictly enforce through protocols.
The stablecoin industry and community must be involved in the regulatory process through informal forums of participation.
Stage 10 comes as a reaction to moves by authorities. We are probably at this stage now, if not already.
This is where the industry begins to find its own ways to prevent overregulation. Projects start to think about removing power from existing dominant currencies. While the UST is an algorithmic stablecoin that has managed to rise to global relevance, it’s still linked to some state-backed currency.
To carry out Stage 10 well, the industry needs to redefine how the community thinks about value. Outside of the blockchain space, value is most often measured by the consumer price index (CPI). It identifies the real value of an economy’s currency based on the things that its people buy. This helps governments to monitor for any signs of inflation.
The stablecoin industry most likely needs a crypto version of CPI, but it will have to go beyond the traditional tracking systems. A viable crypto CPI must measure global real product prices and find the right package of goods that consistently represents the real value of most people’s livelihoods. This elusive package is what that one ultimate algorithmic stablecoin will set as its peg - not a fiat currency. In other words, a truly decentralized stablecoin would be pegged to something not centralized.
One level up from a crypto CPI involves creating an industry-native measurement for what a stablecoin is worth. Some projects are already at this stage.
FRAX has launched its approach to a CPI that’s designed to fluctuate over time. The Frax Price Index (FPI) is a so-called “inflation resistant” algorithmic stablecoin. It tracks the CPI statistics published by the US government, using Chainlink’s oracle data.
The protocol is still quite new so its success remains to be seen. While it’s a step in the right direction, there are still some kinks to be sorted out. Governments calculate CPI based on a basket of goods that can be changed to reflect actual inflation figure. So a stablecoin that tracks a government’s CPI data may not be able to keep up with inconsistent fluctuations in purchasing power.
Ampleforth appears to avoid such issue by taking a different approach. AMPL is pegged to the value of the 2019 US dollar. This means that the stablecoin will increasingly deviate away from the present value of the dollar over time. Yet, the wealth of the token’s holder should remain the same as it was. AMPL’s mechanism serves as a hedge against inflation, while aiming to be a crypto-native unit of account.
The industry is probably dancing between Stages 10 and 11 right now. While there are promising projects happening in Stage 11, they will most likely be used by very crypto-native people for now - in short, only those in this game simply for the tech. To get to the next stage, projects that prioritize use cases over hype and profit must become successful.
Stage 12 is more like a nice-to-have. Here, we go beyond just the tech itself and into dealing with the collective mindset. This is where the industry introduces a crypto-native way for people to think about how much a thing is worth.
This requires foremost more successful decentralized stablecoin projects, units of measure, and use cases to emerge. Eventually, trust and understanding of the tech grow and lead to greater adoption.
With more users joining the community, more people can now think intuitively in two different currencies at once. You can easily compare two different stablecoins in your head or even measure the price of a real-world good to a stablecoin. At this point, a reliable, decentralized mode of payment is probably essential to catch up with the growing number of users.
As time evolves and more people come to trust and use the system, successful stablecoin projects will learn that it’s not so much about coming up with the most complex design. It’s far more useful to focus on building up a strong ecosystem.
Without stablecoins, there would also have been no progress in DeFi. Still, many current projects are trying to achieve too much too soon. They are looking for the game that removes all risks entirely. If there were to be a truly decentralized token with a stable value in the future, it would take quite a lot of discussions on whether it works.
The crypto economy will eventually expand so much that it no longer needs a collateral peg. Still, it’s not going to be a fast track. It will be more like a slow consensus-building journey to a truly decentralized stablecoin.
Introspections on all things Web3.
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