A Brief History of Stablecoins Exploding in Silence or Dying in Silence?

Author: Solaire, YBB Capital

Algorithmic stablecoins have been quiet for a long time, but we believe that there should be a decentralized stablecoin without over-collateralization in the crypto world. This article will explore its history and some new innovations.

Introduction

Stablecoins have always been a critical part of the crypto world, accounting for 8.6% (approximately $124.5 billion) of the total market value of the blockchain. Centralized stablecoins backed by the US dollar and US Treasury bonds, such as USDT and USDC, have always dominated the market. However, centralized stablecoins are always subject to central control. For example, Tether has the ability to freeze USDT in any address, and their security is guaranteed by centralized entities. This clearly goes against the original intention of blockchain existence. In the exploration of decentralized stablecoins, two main branches have emerged: over-collateralized stablecoins and algorithmic stablecoins. Although over-collateralized stablecoins can maintain stability in the highly volatile crypto market due to their high collateralization ratio, their capital efficiency is low due to their minimum collateralization ratio of 1.5-2 times. The market for algorithmic stablecoins has always been the most brutal. Although they have the highest capital efficiency, their model of near-zero collateralization always leads to their demise. After the failure of LUNA, this track has disappeared for a long time. But I have always believed that there should be a decentralized stablecoin without over-collateralization in the crypto world, and this article will explore the history and some new ideas about algorithmic stablecoins.

What are algorithmic stablecoins?

Generally speaking, algorithmic stablecoins are stablecoins that do not require any reserves or collateral. They fully regulate their supply and circulation through algorithms. This algorithm controls the supply and demand relationship of the currency, aiming to peg the price of the stablecoin to a reference currency (usually the US dollar). Generally, when the price rises, the algorithm will issue more coins, and when the price falls, it will buy back more coins from the market. This mechanism is similar to seigniorage, which is the central bank’s way of regulating the supply and value of the currency through the issuance or destruction of currency. For some algorithmic stablecoins, their functionality can be modified based on community suggestions, and this modification is achieved through decentralized governance, so the power of seigniorage is handed over to the users of the currency rather than the central bank.

In summary, algorithmic stablecoins are different from common stablecoins like USDT and USDC in terms of decentralization. They do not require reserves and are independent. Since algorithmic stablecoins are currencies based on the intrinsic relationship between mathematics, monetary economics, and technology, they introduce a stablecoin model that may be more advanced than centralized stablecoins.

A Brief History of Algorithmic Stablecoins

The early attempts that influenced later algorithmic stablecoins can be traced back to 2014 when economist Robert Sams proposed a model called “Seigniorage Shares,” which maintained price stability by automatically adjusting the money supply. This concept was partially inspired by modern central bank monetary policies. Following that, BitShares attempted to adopt a hybrid model that was primarily based on asset collateral but also included elements of algorithmic adjustments. This can be seen as an important step in the development of algorithmic stablecoins, although it was not a pure algorithmic stablecoin itself.

In 2017, a project called Basis (formerly known as Basecoin) gained widespread attention. The project aimed to maintain the value of stablecoins through a complex three-token system. However, due to its incompatibility with U.S. securities laws, the project was eventually forced to shut down at the end of 2018.

In 2019, Ampleforth introduced a new model called “elastic supply,” which not only adjusted the issuance of new tokens but also adjusted the quantity of existing tokens in users’ wallets to achieve price stability. Around the same time, Terra also released its stablecoin, which used a composite model that included taxation, algorithmic adjustments, and asset collateral, minted through its native token. Of course, this token is also widely known as LUNA.

Terra LUNA

LUNA, as the most representative project among algorithmic stablecoins, is also one of the most notorious projects in the crypto world. Its history is like a flash grenade, shining brightly for a moment and then disappearing in an instant. Today’s reexamination of LUNA is only meant to learn from history and discover some insights for the future.

LUNA Historical K-Line (Data source: CoinGecko)

Terra is a blockchain built on the Cosmos SDK and Tendermint consensus, originally aimed at solving e-commerce payment issues with cryptocurrency. However, traditional cryptocurrencies are too volatile to be used like fiat currencies, and centralized stablecoins like USDT have regional and centralization issues. Therefore, Terra aims to create a rich and decentralized combination of stablecoins, such as the Korean won, Thai baht, and U.S. dollar.

To achieve this goal, Terra needs to introduce a universal minting mechanism. Shortly afterward, on a day in April 2019, a minting method was proposed by Terra’s co-founders Do Kwon and Daniel Shin in the Terra Money whitepaper. It involved using LUNA (Terra’s native token) to mint stablecoins for different countries. Let’s take UST (Terra’s USD stablecoin) as an example, and I’ll briefly explain this method.

– First, UST is pegged 1:1 to the U.S. dollar;

– If UST exceeds the pegged price, you can convert 1 U.S. dollar worth of LUNA into 1 UST. At this point, the value of UST exceeds 1 U.S. dollar, and you can earn the price difference by selling it;

· Conversely, if UST is below the peg price, you can always exchange 1 UST for 1 USD worth of LUNA.

This model has been questioned since its launch, and from the birth of LUNA to the eve of its downfall, various well-known figures in the crypto community have warned that LUNA is nothing more than a Ponzi scheme. But even so, many people continue to flock to this dangerous place, so why is that?

Seigniorage

To understand a Ponzi scheme, you first need to understand the motive behind designing this scheme, and the widespread adoption of UST not only helps increase the price of LUNA, but also has a crucial benefit point – seigniorage.

Seigniorage is an economic concept that describes the revenue obtained by the government through the issuance of currency. Specifically, this term is commonly used to refer to the difference between the face value of the currency and its production cost. For example, if the cost of producing a $1 coin is 50 cents, then the seigniorage is 50 cents.

In the crypto world, all three types of stablecoins have seigniorage. Stablecoins collateralized by fiat currency generally charge a seigniorage fee of around 0.1% during the minting and burning process. Overcollateralized stablecoins derive income from transaction fees and interest paid by holders. As for algorithmic stablecoins, they have the highest seigniorage rate. By introducing the mechanism of pegging to a volatile token, stablecoins can convert all funds entering the system into seigniorage, which is the creation out of thin air. This mechanism significantly reduces the startup cost and to some extent improves the anchoring speed, but it also comes with inherent fragility.

Anchor Protocol

LUNA is a miracle in the history of algorithmic stablecoins. Prior algorithmic stablecoin projects have either failed in a very short time or have been unable to grow. LUNA not only ranks third in the stablecoin sector but is also one of the few companies that have connected payment services.

Before Terra’s demise, it actually had an excellent financial ecosystem and two payment systems built on the Terra protocol, CHAI and MemaLianGuaiy. CHAI has even seamlessly connected with domestic payment channels in South Korea and has cooperation with numerous enterprises, including NIKE Korea and Philips. Within Terra’s financial ecosystem, there are also protocols for stocks, insurance, asset splitting, and more. In fact, Terra has been very successful in bringing the benefits and convenience of blockchain into the real world.

Unfortunately, all this prosperity was built on Do Kwon’s scam, rather than steadily promoting various use cases for UST. Do Kwon pressed the accelerator button called Anchor Protocol, which accelerated the success of Terra but also accelerated its demise.

Anchor Protocol is a decentralized bank within the Terra ecosystem that offers a very attractive savings product, a 20% APY non-loss UST deposit service (the initial design was 3% APY, but Do Kwon insisted on 20%). In a situation where real-world banks cannot even offer a 1% interest rate, UST has a 20% APY. So Do Kwon discovered the mysterious button for massive UST minting and stable dumping.

To maintain this scam, Do Kwon has also approached madness in the later stages of Terra, maintaining UST’s annualized rate through refinancing and buying BTC (there was a proposal to reduce the annualized rate to 4% at the time, but Do Kwon understood that massive dumping was more dreadful). But paper always burns, and on the night when UST migrated from Curve 3Pool to DAI killing 4Pool, when UST liquidity was at its lowest, a carefully planned short attack directly caused UST to decouple. Even BTC, as the second layer shield, failed to protect UST’s fixed exchange rate and instead fed the short attackers. Thus, the giant empire of Terra collapsed in an instant.

Parallel Universe

If there were other parallel universes, Do Kwon did not greedily press the button, or did not encounter the attack on the night of UST migration. Could Terra avoid the deathly outcome? The answer is no. In the parallel universe where UST was not attacked, UST would still eventually die due to its inherent flaws. It is extremely difficult to peg to another currency, and even without a short attack, many uncontrollable events would bring down this fragility.

Schwarzschild Radius

The Schwarzschild radius is a physical parameter of celestial bodies, referring to the point at which any celestial body collapses into a black hole when it is smaller than its Schwarzschild radius.

In fact, this principle applies not only to celestial bodies but also to algorithmic stablecoins like LUNA, and even to centralized stablecoins that adopt the “gold standard”. Since LUNA and UST are twin entities, each is the Schwarzschild radius of the other. Once UST decouples or LUNA experiences liquidity issues while the minting mechanism continues to operate, they will collapse into a “black hole” at an extreme speed.

As for centralized stablecoins collateralized by the US dollar or US Treasury bonds, their Schwarzschild radius can be seen as the security of centralized entities. This centralized issue includes not only the stablecoins themselves but also banks and custodians. Although we all understand that both USDT and USDC have been around for many years and have survived countless FUD attacks, their history is relatively long only compared to the crypto world. No one can guarantee that there are centralized institutions in this world that are too big to fail. After all, even Lehman Brothers went bankrupt. Once there is a situation where collateral is lost or cannot be redeemed for US dollars (USDC also almost encountered this crisis in March of this year), they will instantly be run on and become a “black hole”.

In looking back at the history of real-world currencies, these mechanisms have actually collapsed into black holes. For example, the collapse of the gold standard was due to the imbalance of gold reserves during times of war and the central bank printing a large amount of banknotes. The gold reserves simply could not match the total amount of banknotes printed, and the common people had no knowledge of how much gold reserves the banks actually had. It was only when a run on the banks occurred that everyone realized that the banknotes in their hands were worthless, and excessive printing of money by the central bank became a legitimate practice (the modern paper currency system). Another situation is when a currency is pegged to another currency, such as the indirect pegging of the pound to the German mark. Britain briefly participated in the European Exchange Rate Mechanism (ERM), which is a semi-fixed exchange rate system among multiple countries’ currencies. In the ERM, the exchange rates of participating countries’ currencies fluctuated within a relatively narrow range, with the German mark often serving as an “anchor” currency. This can be seen as an indirect pegging. However, due to various factors (including the rise in interest rates due to German reunification and the need to lower interest rates to stimulate exports in the UK), maintaining a fixed exchange rate in the ERM became increasingly unsustainable for Britain.

The famous Black Wednesday event in history occurred at this moment. Soros discovered the vulnerability in this system and together with some long-term currency speculators and multinational corporations engaged in short selling of weak European currencies in the market, forcing these countries to spend huge sums of money to stabilize their currency values.

On September 15, 1992, Soros decided to heavily short the pound, and the pound’s exchange rate against the mark fell all the way to 2.8. At this point, the pound was already on the verge of exiting the ERM system. On the 16th, even though the UK Chancellor of the Exchequer raised the domestic interest rate to 15% within a day, it had little effect. In this battle to defend the pound, the UK government used $26.9 billion in foreign exchange reserves, and the central bank repurchased £2 billion worth of pounds every hour, but still couldn’t maintain the exchange rate above the minimum of 2.778. In the end, they suffered a disastrous defeat and were forced to exit the ERM system. Soros, on the other hand, made nearly $1 billion in profits from this battle and gained fame. The method of shorting LUNA is almost identical to this.

Credit Money

The modern monetary system is built on the credit of centralized governments. The money in our hands is essentially the debt of banks or governments, and government bonds are debts of debts. Modern currency is essentially “credit money”. Continuously issuing debt by the government will only lead to a continuous devaluation of the currency and accelerate the cycle of inflation. This monetary system may be the biggest Ponzi scheme in human history, but when people hear the word “money”, most people don’t think of anything other than fiat currency. This is because people have already accepted this Schelling point, where as long as a fraud persists long enough, it becomes “real”. If we want to establish a stablecoin on the blockchain, we may have to accept a certain Ponzi existence.

Changes in the purchasing power of the US dollar (Source: Tencent News)

Reflection

So, here are my personal views on how to establish a currency on the blockchain:

· Low volatility but allows for fluctuations, with sufficient liquidity;

· Not forcibly pegged to any fiat currency;

· Allocation based on tracking supply and demand indicators;

· Acceptance of a certain degree of Schelling point presence;

· Sufficient number of use cases to bridge real-world payments.

Floating Stablecoin, f(x) Protocol

f(x) is an ETH leveraged lending protocol designed to meet the demand for stable assets in the cryptocurrency field while mitigating centralized risks and capital efficiency issues. The f(x) protocol introduces a new concept called “floating stablecoin” or fETH. fETH is not pegged to a fixed value, but rather gains or loses a small fraction of the price changes of native Ethereum (ETH). In addition, a complementary asset called xETH is created, which serves as a zero-cost leveraged long ETH position. xETH absorbs most of the volatility in ETH price changes, stabilizing the value of fETH.

Source: f(x) Official

· fETH: Low volatility ETH asset, with a price that fluctuates at 1/10 of the native ETH price (β coefficient is 0.1). For example, if today’s ETH price is $1650, the minted fETH would be 1650, and the price would also be $1650. If tomorrow the ETH price drops to $1485, the price of fETH can still be maintained at $1633.5, and vice versa. It can be understood as 90% stablecoin + 10% ETH;

· xETH: Zero-cost leveraged long ETH position, used to absorb ETH volatility to stabilize the price of fETH (i.e., β> 1). These xETH can be traded in DeFi (supported by the demand system for long ETH positions).

The β coefficient can be adjusted under this mechanism.

β

In finance, beta is a measure that quantifies the volatility of an asset or portfolio relative to the overall market. It is a key parameter in the Capital Asset Pricing Model (CAPM) used to estimate the expected return and risk of an asset.

Calculation Method

Beta is calculated through regression analysis, typically comparing the returns of individual assets to the overall market (often represented by market indices such as the S&P 500). Mathematically, beta is the slope in the regression equation:

Asset Return = α + β × Market Return

Where α is the intercept term representing the expected return of the asset under risk-free conditions, and β is the slope representing the sensitivity of the asset to market returns.

Explanation

· β = 1: The volatility of the asset is consistent with the overall market volatility;

· β > 1: The asset is more volatile relative to the market, meaning that it may experience larger fluctuations when the market goes up or down;

· β < 1: The asset is relatively stable compared to the market, with smaller fluctuations;

· β = 0: The asset is not correlated with market returns, usually representing risk-free assets such as government bonds;

· β < 0: The asset is negatively correlated with market returns, meaning that it may generate positive returns when the market declines, hence serving as a hedge.

Working Principle

The f(x) protocol only accepts ETH as collateral and supports low and/or high volatility (β) tokens backed by this collateral. By providing ETH, users can mint fETH and/or xETH tokens, with the quantity based on the price of ETH and the current net asset value (NAV) of each token. Conversely, users can redeem fETH or xETH for NAV ETH from the reserve at any time.

The NAV of fETH and xETH fluctuates with the price of ETH, so at any given time, the total value of all fETH plus the total value of all xETH equals the total value of the ETH reserve. In this way, each fETH and xETH token has its NAV backing and can be redeemed at any time. Mathematically, the invariant holds at all times:

Where neth is the quantity of ETH collateral, peth is the ETH USD price, nf is the total supply of ETH, pf is the ETH NAV, nx is the total supply of xETH, px is the xETH NAV.

The protocol limits the volatility of fETH by adjusting its NAV based on changes in the price of ETH, so that a 10% return on ETH (for βf=0.1) is reflected in the fETH price. Simultaneously, the xETH NAV is adjusted to exceed the return on ETH, in order to satisfy the f(x) invariant (equation 1). In this way, xETH provides leveraged ETH returns (tokenization with zero financing cost) while fETH exhibits low volatility, and both remain decentralized and trustworthy.

Risk Model

In this concept, fETH relies on the existence of xETH. If the demand for xETH is not sufficient, the 0.1β coefficient of fETH cannot be maintained, or if the volatility is too high, the protocol introduces a CR formula to calculate the health level of the entire system.

CR is the total collateral value divided by the total NAV of fETH, and four risk levels are set based on percentages.

If the CR of the system drops to a risk level that threatens the ability to maintain βf=0.1, the system’s risk management system will activate four progressively stronger modes to guide the system back towards over-collateralization. Each mode sets a CR threshold, and when it falls below that threshold, additional measures are initiated to help maintain the stability of the entire system. As long as the CR is below its specified level, the incentives, fees, and controls described by each mode will remain in effect. For example, if mode 3 is active, it means that modes 1 and 2 are also active. When the CR rises above the relevant level, they will automatically be restored.

·Level 1——Stability Mode: When the CR value is below 130%, the system enters stability mode. In this mode, fETH minting is disabled, and redemption fees are set to zero. The redemption fee for xETH increases, and xETH miners receive additional rewards in the form of small stable fees from fETH holders;

·Level 2——User Rebalance Mode: When the CR value is below 120%, the system enters user balance mode. In this mode, users can earn rewards by exchanging fETH for ETH, and the remaining fETH holders pay stable fees in a similar manner as stability mode. This allows users to gain slightly higher returns than fETH’s NAV during redemption. In this mode, the redemption fee for fETH is set to zero;

·Level 3——Agreement Balance Mode Again: When the CR value is below 114%, the system enters agreement rebalance mode. This mode is similar to Level 2, with the difference being that the protocol itself can use reserves for rebalancing. This mode is unlikely to be triggered because Level 2 rebalancing actions are profitable and users can respond faster than the protocol. However, it creates an additional layer of protection. In this mode, the protocol uses ETH from the fETH reserves to purchase on the market and then burns fETH from the AMM. Using this mechanism, the NAV of fETH only decreases by the rebalancing stable fee obtained by the protocol in this case;

·Level 4——Recapitalization: In the most extreme case, the protocol has the ability to issue governance tokens and raise ETH for recapitalization by minting xETH or buying and redeeming fETH.

Conclusion

The f(x) Protocol proposes a method to create a stablecoin by controlling volatility. This idea is interesting but still has some obvious drawbacks, as fETH can only exist when the market is relatively stable and xETH has sufficient adoption. However, it is indeed a very innovative idea. It is inevitable for blockchain to establish a system similar to modern fiat currencies under the premise of decentralization (it can only be successful under centralization). Therefore, we need to focus on sufficient use cases and low volatility with liquidity. Personally, I believe that some meme tokens (such as Dogecoin) have the potential to develop use cases, and there are also other attempts besides f(x) in terms of stability. For something in its early stages, we should exercise patience and tolerance.

References

1. f(x) Whitepaper

2. Terra Money: Stability and Adoption

3. Decentralization of Currency

4. The Lord of the Algorithmic Stablecoin: After LUNA, there will be no next UST

5. Unveiling LUNA Coin: Why I believe attempts at algorithmic stablecoins are doomed to fail

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