Author: Lawrence Lee
In late July, Liquity, the leader in decentralized stablecoins, announced that its V2 version will introduce risk-neutral stablecoins called “Delta Neutral Stablcoins.” Ethena Finance, a newly funded project, also aims to hedge its reserve assets through risk hedging to achieve decentralized high capital efficiency. In this article, we will delve into these stablecoin protocols that attempt to achieve the impossible triangle.
The Impossible Triangle
Chart: Mint Ventures
The field of stablecoins in the crypto industry has always faced an impossible triangle, where price stability, decentralization, and capital efficiency cannot be achieved simultaneously.
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Centralized stablecoins like USDT and USDC have the best price stability and capital efficiency on-chain, with up to 100% efficiency. The only problem is the risks associated with centralization. The suspension of new business by BUSD due to regulatory issues and the impact on USDC caused by the SVB incident in March this year clearly illustrate this point.
Algorithmic stablecoins that emerged in the second half of 2020 attempted to achieve under-collateralization based on decentralization. Projects like Empty Set Dollar and Basis Cash quickly collapsed. Luna, which followed, used the entire blockchain’s credit as implicit collateral and did not require over-collateralization in the process of minting UST for users. It achieved the three goals of decentralization, capital efficiency, and price stability for a considerable period of time (from 2020 to May 2022). However, its credit eventually collapsed and spiraled into death. There have also been projects like Beanstalk that introduced under-collateralized tokens, but they did not attract much attention from the market. The difficulty of stable anchoring is the fatal flaw in the development of these tokens.
Another approach started with MakerDAO, aiming to achieve price stability by over-collateralizing underlying decentralized assets, sacrificing some capital efficiency. Currently, Liquity’s LUSD is the largest stablecoin supported entirely by decentralized assets. However, to ensure the stability of LUSD price, Liquity has relatively low capital efficiency. The collateral ratio of the entire system is consistently above 250%, which means that each circulating LUSD requires at least 2.5U worth of ETH as collateral. Synthetix’s sUSD is even more extreme. Due to the higher volatility of the collateral SNX, Synthetix typically requires a minimum collateral ratio of over 500%. Low capital efficiency means a low ceiling for scale and low attractiveness to users. The main issue that Liquity aims to address in the planned V2 version is the low capital efficiency of V1. Synthetix also plans to introduce other assets as collateral to reduce the requirement for the minimum collateral ratio in its planned V3 version.
Early DAI (before 2020) actually had the problem of low capital efficiency. Due to the small market value of the entire crypto market at that time, the collateral ETH of DAI fluctuated greatly, and the price of DAI also fluctuated greatly as a result. In order to solve this problem, MakerDAO introduced the PSM (Price Stability Module) in 2020, which allows centralized stablecoins such as USDC to be used to generate DAI. DAI partially gives up decentralization in the trade-off between decentralization, capital efficiency, and price stability, thereby bringing more stable price anchoring and higher capital efficiency to DAI, and better supporting the rapid growth of DAI with the overall development of DeFi. FRAX, which was launched at the end of 2020, also uses centralized stablecoins as its main collateral. Currently, DAI and FRAX are the top two circulating decentralized stablecoins, which proves that their strategies are appropriate and provides users with stablecoins that better meet their needs. However, it also indirectly indicates that maintaining decentralization constrains the scale of stablecoins.
However, there are still a series of stablecoins that attempt to achieve high capital efficiency and strong price stability while maintaining decentralization. They all try to provide users with stablecoins that:
- Are generated from decentralized assets (such as ETH) to avoid regulatory risks;
- Can be generated with $1 of assets without over-collateralization, making it more conducive to scalability;
- Maintain stable value.
In fact, this is also the most intuitive and theoretically superior type of decentralized stablecoin. We use the term “Decentralized Reserve Protocol” to name this type of stablecoin based on Liquity V2. It should be pointed out that, unlike stablecoins generated by traditional over-collateralization, for users, once their assets are exchanged for this type of stablecoin, the assets used to generate stablecoins belong to the protocol and are no longer associated with the users. In other words, users are more like conducting an ETH -> stablecoin swap operation. This type of stablecoin is more similar to centralized stablecoins like USDT, where $1 of assets can be exchanged for $1 of stablecoins, and vice versa. The only difference is that decentralized reserve protocols accept cryptographic assets as collateral.
(Some people may think that since the collateral does not belong to the users, such stablecoins do not have the leverage function and lose one major use case of stablecoins. However, the author believes that stablecoins in our real life do not have the leverage function either. Centralized stablecoins like USDT and USDC have never had the leverage function. The core functions of a currency are settlement tools, accounting units, and stores of value. Leverage is only a special function of CDP-type stablecoins, not a general use case of stablecoins.)
However, the reason why past stablecoin protocols have not been able to consistently provide such stablecoins is because there is a simple yet difficult problem to solve: decentralized asset prices fluctuate greatly, so how can they ensure the redemption of the stablecoins they issue at a 100% collateralization ratio?
From the balance sheet of a stablecoin protocol, the collateral deposited by users is considered as assets, while the stablecoins issued by the protocol are considered as liabilities. How can we ensure that the assets will always be greater than or equal to the liabilities?
A more intuitive example would be: when ETH = 2000U, a user sends 1 ETH to the protocol and mints 2000 stablecoins. So when ETH drops to 1000U, how does the protocol ensure that these 2000 stablecoins can still be redeemed for assets worth 2000U?
From the development history of decentralized reserve protocols, there are mainly two approaches to solving this problem: using governance tokens as reserves and hedging reserve asset risks. Based on the method of hedging reserve asset risks, there are decentralized reserve protocols that hedge protocol risks and decentralized reserve protocols that hedge user risks. Let’s learn about each of them.
Chart: Mint Ventures
Decentralized Reserve Protocols Using Governance Tokens as Reserves
The first type of protocol uses the protocol’s governance token as the “new collateral” for the protocol. When the price of collateral assets drops dramatically, the protocol will mint more governance tokens to redeem stablecoin holders. We can refer to this as a decentralized reserve protocol using governance tokens as reserves. In the example mentioned above, when ETH drops from 2000U to 1000U, the decentralized reserve protocol using governance tokens as reserves will use 1000U worth of ETH and 1000U worth of protocol governance tokens to redeem the 2000 stablecoins held by users.
Protocols that adopt this approach include Celo and Fei Protocol.
Celo
Celo is a stablecoin project launched in 2020. Previously, it existed as an independent L1 solution. In July of this year, the core team proposed transitioning Celo to the Ethereum ecosystem through the OP stack. The stablecoin mechanism of Celo is as follows:
Celo’s stablecoin is backed by a reserve pool composed of a comprehensive set of assets. The reserve ratio (the ratio of the value of reserve assets to the value of circulating stablecoins) is much higher than 1, providing the core underlying value for its stablecoin. Celo’s stablecoins are not minted through over-collateralization, but obtained by sending Celo tokens to the official stable module called Mento. Users can send 1 US dollar worth of Celo to receive 1 US dollar worth of cUSD stablecoins, or vice versa, send 1 US dollar worth of cUSD to Mento to exchange for 1 US dollar worth of Celo. In this mechanism, when the market price of cUSD is lower than 1 US dollar, someone will buy cUSD at a lower price to exchange for 1 US dollar worth of Celo. Likewise, when cUSD is higher than 1 US dollar, someone will mint cUSD by using Celo to sell, ensuring that cUSD does not deviate too far from its pegged price. There are three mechanisms to ensure the adequacy of the reserve pool funds: 1. When the reserve ratio is below a certain threshold, Celo produced by block rewards will be added to the reserve pool to supplement capital; 2. A certain percentage of transfer fees can be collected to supplement capital (currently not activated); 3. A stable fee can be collected in the trading module of Mento to supplement reserve capital. To enhance the security of the reserve funds, the asset portfolio is diversified and currently includes Celo, BTC, ETH, Dai, and the carbon credit token cMCO2. This is safer than using project tokens as collateral alone (Terra has a similar solution, with Luna as the invisible margin for its native stablecoin). Source: Mint Ventures Celo Research Report
As can be seen, Celo is similar to Luna, both being L1s centered around stablecoins. They also have similar minting and redemption mechanisms as Luna/UST. The main difference is that when the entire system enters a potential under-collateralized state, Celo will first use $CELO generated from blocks as collateral for the protocol to guarantee the redemption of its stablecoin cUSD.
Source: https://reserve.mento.org/
Currently, the total collateral in the Celo system is $116 million, with a total stablecoin issuance of $46 million. The overall overcollateralization rate is 254%. Although the system is in an overcollateralized state, for users who want to use its stablecoin cUSD, they can exchange 1U worth of CELO for 1 cUSD, with excellent capital utilization. Of course, in terms of the composition of collateral, half of Celo’s collateral comes from centralized USDC and semi-centralized DAI, so Celo cannot be considered a fully decentralized stablecoin.
Currently, Celo’s stablecoin scale ranks 16th among decentralized stablecoins (excluding UST and flexUSD, which are no longer pegged, it ranks 14th).
Source: https://defillama.com/stablecoins?backing=CRYPTOSTABLES&backing=ALGOSTABLES
Fei
In early 2021, Fei Protocol, which raised $19 million from institutions such as A16Z and Coinbase, attracted widespread attention in the market due to its combination of the hottest algorithmic stablecoin concept at the time. In the initial stage of their project launch (end of March), it attracted 639,000 ETH for minting the stablecoin FEI, generating a total of 1.3 billion FEI, making it the second largest decentralized stablecoin after DAI (which had a circulating market capitalization of $3 billion at the time).
Subsequently, due to the over-saturation of demand for FEI during the genesis phase (users mainly wanted to obtain Fei Protocol’s governance token TRIBE), there was a severe oversupply of FEI, and the newly launched stablecoin FEI had no use case, so FEI remained below $1 for a long time. Soon after, it experienced market volatility in May, and the panic of price decline caused users to redeem FEI, leading to the protocol’s decline since its launch.
In the V2 version launched at the end of 2021, Fei Protocol proposed a series of measures to try to bring the protocol’s development back on track, including modifying its price stabilization mechanism. In V2, FEI can be directly minted with collateral such as ETH, DAI, LUSD, etc., at a 100% collateralization ratio. After generating the stablecoin, the user’s collateral is included in the Protocol Controlled Value (PCV). When the protocol’s collateralization ratio (=PCV/ circulating FEI) is above 100%, it means that the protocol’s assets are appreciating well and there is no pressure to redeem FEI. The protocol will issue additional FEI to buy TRIBE, thereby reducing the protocol’s collateralization ratio. Similarly, when the protocol’s collateralization ratio is below 100%, it means that the protocol may not be able to fully redeem all FEI. The protocol will issue additional TRIBE to buy FEI, thereby increasing the protocol’s collateralization ratio.
Under this mechanism, the governance token TRIBE becomes the reserve collateral of the entire FEI system in the event of potential risks, and can also generate additional income during system growth (this mechanism is similar to the Float Protocol launched with Fei V1). Unfortunately, Fei V2 was launched at the peak of the entire bull market, and since then the price of ETH has been falling all the way. Fei also suffered a loss of 80 million FEI in a hacking attack in April 2022 and eventually decided to terminate protocol development in August 2022.
The decentralized reserve protocol backed by governance tokens essentially dilutes the rights of all governance token holders to ensure the redemption of stablecoins. During the bull market cycle in the market, with the increase in the scale of stablecoins, governance tokens also rise, easily forming an upward spiral. However, during the bear market cycle in the market, as the reserve assets on the protocol’s asset side decline, the total market value of governance tokens will also decline with the market. If more governance tokens need to be issued at this time, the governance tokens are likely to further decline, forming a death spiral of governance token prices. If the market value of governance tokens decreases to a certain proportion below that of stablecoins, the credibility of the entire protocol’s commitment to redeeming stablecoins in the eyes of stablecoin holders will also be compromised, ultimately accelerating the exodus and leading to the death spiral of the entire system. Whether it can survive the bear market is the key to the survival of such stablecoins. In fact, the reason why Celo can survive in the current bear market is closely related to the overall “over-collateralization” status of the protocol. The reason why the protocol is in an over-collateralization status is also because when the market was at its peak, Celo allocated a relatively large proportion of its reserve funds to USDC/DAI and BTC/ETH, enabling the protocol to remain secure even as the CELO price dropped from 10 to 0.5.
Decentralized reserve protocol for hedging reserve asset risks (risk-neutral stablecoin protocol)
The idea of the second type of protocol is to hedge the risks of the protocol’s reserve assets so that when the prices of the collateral assets plummet, the hedging can generate profits and ensure that the assets of the stablecoin protocol can always repay the debt. We call this type of protocol a decentralized reserve protocol for hedging reserve asset risks, or a risk-neutral stablecoin protocol. In the example above, after receiving 1 ETH worth 2000U, the decentralized reserve protocol for hedging reserve asset risks will hedge this 1 ETH (such as by opening a short position on an exchange). When ETH drops from 2000U to 1000U, the decentralized reserve protocol for hedging reserve asset risks uses 1 ETH worth 1000U + 1000U worth of hedging profits to redeem the 2000 stablecoins held by users.
Specifically, depending on the specific hedging party, there are decentralized reserve protocols for protocol hedging risks and decentralized reserve protocols for user hedging risks.
Decentralized Reserve Protocol for Protocol Hedging Risks
Stablecoin protocols that adopt this approach include Pika Protocol V1, UXD Protocol, and Ethena, which recently announced financing.
Pika V1
Pika Protocol is currently a derivative protocol deployed on the Optimism network. However, in its initial V1 version, Pika planned to launch a stablecoin, and its hedging was achieved through Bitmex’s inverse perpetual contract. The inverse perpetual contract (also known as a coin-margined perpetual contract) is also one of Bitmex’s inventions. Compared to the more popular “linear perpetual contract” that tracks the price in U denomination, the characteristics of the inverse perpetual contract track the price in terms of the coin denomination in U denomination. The profit example of the inverse perpetual contract is as follows:
A trader goes long 50,000 contracts of XBTUSD at a price of 10,000. A few days later the price of the contract increases to 11,000.
The trader’s profit will be: 50,000 * 1 * (1/10,000 – 1/11,000) = 0.4545 XBT
If the price had in fact dropped to 9,000, the trader’s loss would have been: 50,000 * 1 * (1/10,000 – 1/9,000) = -0.5556 XBT. The loss is greater because of the inverse and non-linear nature of the contract. Conversely, if the trader was short then the trader’s profit would be greater if the price moved down than the loss if it moved up.
Source: https://www.bitmex.com/app/inversePerpetualsGuide
A little analysis reveals that the inverse perpetual contract is a perfect match for decentralized reserve protocols that hedge reserve asset risks. In our previous example, assuming when ETH = 2000U, after receiving 1 ETH from the user, Pika Protocol uses 1 ETH as margin to short 2000 contracts of ETH’s inverse perpetual contract on Bitmex. When the ETH price drops to 1000U, Pika Protocol’s profit = 2000 * 1 * (1/1000 – 1/2000) = 1 ETH = 1000U. In other words, when the ETH price drops from 2000U to 1000U, Pika Protocol’s reserve increases from 1 ETH to 2 ETH, and it can still effectively redeem the user’s 2000 stablecoins (not considering transaction fees and funding costs). The product design of Pika Protocol V1 is exactly the same as the product design of NUSD mentioned by Bitmex founder Arthur Hayes in his blog post, and it can perfectly hedge the long position in coin denomination.
Unfortunately, inverse perpetual contracts have characteristics of inverse and non-linear returns (the change in the base currency is not linearly related to the change in the contract). They are not very easy for ordinary users to understand and are not as popular as linear perpetual contracts (U-based perpetual contracts) in the development process. In mainstream exchanges, the trading volume of inverse perpetual contracts is only about 20-25% of that of linear perpetual contracts. BitMex, which is affected by regulations, has gradually declined from a first-tier contract exchange to a state with a market share of less than 0.5%. Pika believes that linear perpetual contracts cannot meet their hedging needs, and the market space for inverse perpetual contracts is relatively small. In its V2 version, it gave up stablecoin business and officially turned to derivatives exchanges.
UXD
UXD Protocol is a stablecoin protocol running on the Solana network, which went live in January 2022. UXD completed a $3 million financing led by Multicoin in 2021 and raised $57 million in IDO. In January of this year, UXD decided to cross-chain into the Ethereum ecosystem and went live on Arbirturm in April, with plans to go live on Optimism later. When it first went live, UXD Protocol supported users to deposit SOL, BTC, and ETH to mint its stablecoin UXD at a 1:1 USD value. The collateral deposited by users is hedged through Solana’s lending and perpetual contract exchange Mango Markets short positions to realize the redemption of stablecoins. The funding fees collected from short positions are used as protocol revenue, and the funding fees paid are funded by the protocol. For a considerable period of time after going live, the UXD protocol operated well, and the protocol even needed to limit the issuance cap of UXD. This is because the overall open positions of Mango Markets were below the hundred million-dollar level. If the short positions of UXD reached tens of millions of dollars, there would be a potential risk of inability to redeem. In addition, too many short positions would make the funding rate more likely to become negative, thereby increasing hedging costs.
Unfortunately, Mango Markets suffered a governance attack in October 2022, and UXD lost nearly $20 million in this incident. At that time, the insurance fund balance of UXD still had more than $55 million, so UXD could be redeemed normally. Although Mango Markets subsequently returned the funds to the UXD protocol, Mango Markets has since declined, and the FTX incident caused funds to flow out of Solana rapidly, making it difficult for UXD to find a suitable exchange to hedge their long positions. After that, UXD protocol only supports USDC as collateral, and USDC does not need to hedge risks, so they invested users’ collateral USDC in various on-chain USDC vaults and RWAs. It was also after this that UXD decided to cross-chain into the Ethereum ecosystem and went live on Arbirturm in April, with plans to go live on Optimism later, and they are also continuously looking for suitable on-chain hedging venues.
Currently, the circulation of UXD is 14.3 million US dollars, and the balance of the protocol insurance fund is 53.2 million US dollars.
Source: https://dashboard.uxd.fi/
In addition, recently announced stablecoin protocol Ethena Finance will also hedge its reserve assets through risk hedging. Ethena Finance has received a $6 million investment from Dragonfly, with participation from centralized exchanges such as Bybit, OKX, Deribit, Gemini, and Huobi. Ethena’s financing institutions include many second-tier derivatives exchanges, which will be beneficial for its collateral hedging. In addition, Ethena also plans to cooperate with decentralized derivatives protocol Synthetix to open short positions as a liquidity provider and bring more use cases to its stablecoin USDe (allowing USDe to be used as collateral for certain pools).
For decentralized reserve protocols that hedge against risks, the advantages are obvious. By hedging the collateral with encrypted assets, the protocol can obtain a risk-neutral position overall, ensuring the redemption of stablecoins and achieving 100% capital efficiency based on decentralization (mainly depending on the hedging venue). If the protocol can hedge its position in a highly capital-efficient manner, the collateral reserves it possesses can also generate income in various forms. In addition, the funding rate can serve as protocol income, providing the protocol with more flexibility: these profits can be distributed to stablecoin holders to create interest-bearing stablecoins and provide more use cases for stablecoins; they can also be distributed to governance token holders.
In fact, the governance tokens of any stablecoin protocol have an implicit use case as the “lender of last resort” for stablecoins. Stablecoin protocols that hedge reserve asset risks can also use their governance tokens as a source of redemption for stablecoins in extreme cases. For stablecoin holders, holding this type of stablecoin provides an additional layer of protection compared to stablecoins that are backed solely by governance tokens. From a mechanism perspective, the logic of hedging reserve asset risks is more self-consistent and theoretically not affected by market cycles, without the need to test the resilience of governance tokens themselves during bear markets.
However, there are also many limitations to the development:
Centralization risks of hedging venues. Currently, centralized exchanges still dominate the liquidity of perpetual contracts, and the design of most decentralized derivatives exchanges is not suitable for hedging stablecoin protocols, inevitably exposing the protocols to centralization risks. These centralization risks can also be divided into two categories: 1) the inherent risks of centralized exchanges themselves; 2) due to the limited volume of hedging venues, a single hedging venue will inevitably account for a larger proportion of the protocol’s hedging positions. If a hedging venue encounters problems, it will also have a significant impact on the protocol. UXD Protocol’s extreme example of centralization risks is the loss and suspension of protocol operation due to the attack on Mango Markets.
There are certain limitations in the choice of hedging tools. Currently, the mainstream linear perpetual contract method does not perfectly hedge their long positions. Taking ETH as an example, stablecoin protocols require hedging of ETH-based short positions. However, the largest trading volume linear perpetual contract currently requires USDT as collateral, and its short-selling profit curve is also based on USD, which cannot perfectly hedge the ETH position. Even if stablecoin protocols use ETH to obtain USDT through borrowing, this would increase operational costs and the difficulty of risk management, and also reduce capital efficiency. From the example of Pika Protocol mentioned above, we know that reverse perpetual contracts are the perfect choice for decentralized reserve protocols attempting to hedge reserve asset risks, but unfortunately, the market share of reverse perpetual contracts is not large enough.
Growth has inherent limitations. The growth of stablecoin protocols means that there needs to be persistent and sufficient short positions in perpetual contracts for hedging. Apart from the complexity of obtaining sufficient short positions themselves, the more short positions the protocol holds, the higher the liquidity requirement for the counterparty during liquidation, and the funding rate is more likely to be negative. All of this implies potential higher hedging costs and operational difficulties. This may not be a big problem for stablecoins with tens of millions of dollars in scale, but if they want to further scale up to hundreds of millions or even billions, this issue will significantly limit their ceiling.
Operational risks. Regardless of the form of hedging, it will involve high-frequency opening, rebalancing, and collateral management operations, which unavoidably require manual intervention and may generate significant operational risks and even moral hazards.
Decentralized reserve protocols for hedging risks
Protocols that adopt this approach include Angle Protocol V1 and Liquity V2.
Angle V1
Angle Protocol was launched on the Ethereum network in November 2021. They had previously raised $5 million in funding led by a16z.
For the protocol design of Angle Protocol V1, readers can refer to Mint Ventures’ previous research report for more information. Here, we will briefly describe it as follows:
Like other decentralized reserve protocols, Angle ideally supports users to generate 1 agUSD stablecoin using 1U worth of ETH (of course, the first stablecoin introduced by Angle is agEUR, pegged to the Euro, but the logic is the same. For the sake of consistency in context, we will still use the example of a USD stablecoin). The difference is that Angle’s targeted users include not only traditional stablecoin users but also perpetual contract traders, which Angle refers to as HA (Hedging Agency).
Using the example mentioned earlier, when ETH is worth 2000U, a user sends 1 ETH to Angle to mint 2000 USD stablecoins. At this time, Angle will open a leveraged position worth 1 ETH for traders. Let’s assume that HA uses 0.2 ETH (worth 400U) as collateral and opens a 5x leveraged position. At this time, the protocol has a total collateral of 1.2 ETH, worth 2400U, and a total liability of 2000U in stablecoins.
When ETH rises to 2200U, the protocol only needs to hold ETH that can be redeemed for 2000U stablecoin, which is 0.909 ETH. The remaining 0.291 ETH (worth 640U) can be withdrawn by HA.
When ETH falls to 1800U, the protocol still needs to hold ETH that can be redeemed for 2000U stablecoin, which is 1.111 ETH. At this time, HA’s collateral position will become 0.089 ETH (worth 160U).
It can be seen that traders are essentially going long on ETH. When the price of ETH rises, in addition to benefiting from the increase in the value of ETH itself, they can also benefit from the “surplus” ETH of the protocol (in the above example, the price of ETH rises by 10% and traders profit by 60%); and when the price of ETH falls, they not only need to bear the decline in the value of ETH itself, but also the decline in the value of the protocol’s collateral ETH (in the above example, the price of ETH falls by 10% and traders lose 60%). From the perspective of Angle Protocol, traders hedge the risk of the price of collateral falling for the protocol, which is also the origin of its name “hedge agent”. The leverage ratio of traders depends on the ratio between the open hedge position (0.2 ETH in the above example) and the stablecoin position of the protocol (1 ETH in the above example).
For perpetual contract traders, there are certain advantages to conducting long trades in perpetual contracts through Angle: 1) They do not need to pay funding fees (centralized exchanges usually require long positions to pay funding fees to short positions), 2) The transaction price is directly based on the oracle price without slippage. Angle hopes to achieve a win-win situation for stablecoin holders and perpetual contract traders: stablecoin holders can obtain high capital efficiency and decentralization, while contract traders can also have a better trading experience. Of course, this is only an ideal situation. In practice, there may also be situations where there are no traders opening long positions. Angle introduces Standard Liquidity Providers (SLPs) to provide additional collateral (stablecoins) to continue to ensure the security of the protocol, while automatically earning interest, transaction fees, and governance tokens $ANGLE rewards.
The actual operation of Angle is not ideal. Although traders also have substantial rewards in $ANGLE, most of the time, the protocol’s collateral has not been fully hedged. The main reason for this, in the author’s opinion, is that Angle has not provided a product attractive enough to traders. With the decline in the price of $ANGLE tokens, the protocol’s TVL has also dropped from $250 million at launch to about $50 million.
The hedging rate of Angle stablecoin's main collateral source - USDC pool. Source: https://analytics.angle.money/core/EUR/USDC
Source: https://defillama.com/protocol/angle
In March 2023, Angle’s reserve assets for interest suffered a hack by Euler. Although the hacker eventually returned the corresponding assets, Angle was severely damaged. In May, Angle announced the end of the above logic product, which they called Angle Protocol V1, and launched the plan for V2. Angle Protocol V2 changed to a traditional over-collateralization model and was just launched in early August.
Liquity V2
Since its launch in March 2021, Liquity’s LUSD has become the third largest decentralized stablecoin in the market (after DAI and FRAX) and the largest fully decentralized stablecoin. We have published research reports on Liquity V1’s mechanism, subsequent product updates, and use case expansions in July 2021 and April 2023. Interested readers can learn more.
The Liquity team believes that LUSD has achieved a relatively good level in decentralization and price stability. However, in terms of capital efficiency, Liquity performs relatively average. Since its launch, Liquity’s system collateralization ratio has remained at around 250%, meaning that every circulating LUSD requires 2.5U worth of ETH as collateral.
Source: https://dune.com/liquity/liquity
Liquity officially introduced the features of its V2 on July 28. In addition to supporting LSD as collateral, the core content is to achieve high capital efficiency through delta-neutral hedging across the entire protocol.
Currently, Liquity has not publicly released specific product documentation. The public information about V2 mainly comes from founder Robert Lauko’s speech at ETHCC, previous introduction articles released by Liquity, and discussions on Discord. The following text is mainly based on the above information.
In terms of product logic, Liquity V2 is similar to Angle V1. It aims to introduce traders to engage in leveraged trading on Liquity and use the margin provided by these traders as additional collateral for the protocol to hedge the overall risk. At the same time, Liquity offers attractive trading products to these traders.
Specifically, Liquity proposes two innovations. The first is the so-called “principal-protected leveraged trading.” Liquity provides contract traders with leveraged trading products that protect their principal. After paying a certain premium, users can use this feature, which allows them to potentially recover a certain amount of U even in the event of a significant ETH price drop. According to the example in the Liquity article, when the ETH price is 1000U, users pay 12ETH (10ETH of principal and 2ETH of premium) to obtain a 2x leveraged long position with downside protection. This means that when the ETH price doubles, the 2x leveraged long position takes effect, and the user gains a total of 40ETH due to the increase. When the ETH price declines, the purchased put option takes effect, and the user can withdraw their initial 10,000U (10 * 1000).
Source: https://www.liquity.org/blog/introducing-liquity-v2
It can be seen that the innovation of Liquity’s product on the basis of Angle is mainly the “principal protection” feature. Although Liquity did not specify the implementation method, based on the product form and discussions in Discord, this “principal protection” feature is similar to a call option.
Liquity believes that this combination product can attract traders because it can protect their principal. A call option allows traders to profit from leverage when prices rise and ensures the principal when prices fall. From the perspective of traders, it may indeed be more attractive than Angle’s simple leverage trading product (of course, the specific pricing of the option premium by Liquity also needs to be considered). From the perspective of the protocol, the option premium paid by users can become a safety cushion for the protocol: when the price of ETH falls, Liquity can use this portion of the option premium as additional collateral to redeem stablecoin holders; when the price rises, the portion of the collateral value of Liquity itself can also be distributed to contract traders as profits.
Of course, there are obvious problems with this mechanism. When traders want to close their positions and withdraw their ETH, Liquity will face a dilemma: traders certainly have the right to close their positions at any time, but if they close their positions, the hedging ratio of the entire Liquity protocol will decrease, and the security of the Liquity protocol will become fragile with the withdrawal of this “collateral”. In fact, the same problem has appeared in the actual operation of Angle. The hedging ratio of Angle’s system has been at a low level for a long time, and traders’ hedging of the overall position of the protocol is not sufficient.
In order to solve this problem, Liquity proposes a second innovation, the officially subsidized secondary market.
That is to say, in Liquity V2, leveraged trading positions (NFTs) can not only be opened and closed like normal leveraged trading positions, but can also be sold on the secondary market. In fact, for Liquity, they are concerned that traders will close their positions because this will reduce the protocol’s hedging ratio. When a trader wants to close a position, if there are other traders willing to buy at a price higher than the current intrinsic value of the position on the secondary market, they can earn more cash, which Liquity naturally welcomes. For Liquity, although the “current intrinsic value of the position” is subsidized by the protocol, maintaining the hedging ratio of the entire system through a relatively small subsidy can improve the security of the protocol at a lower cost.
Source: https://www.liquity.org/blog/introducing-liquity-v2
For example, let’s say Alice opened a position of 10 ETH when the price of ETH was 1000U, with a premium of 2 ETH. This position corresponds to the value of being long 10 ETH and protecting the principal. However, if the price of ETH drops to 800U, the value of the 12,000U worth of ETH that Alice has invested can only be exchanged for 10 ETH (8,000U) at the moment. At this point, Alice can either close the position directly and obtain 10 ETH (8,000U), or sell the position on the secondary market at a price between 8,000U and 12,000U. For Bob, who wants to buy Alice’s position, buying the position is similar to buying a call option (8,000U + a strike price of 1,000U) when ETH is priced at 800U. This option must have value, so it determines that the price of Alice’s position must be higher than 8,000U. For Liquity, as long as Bob buys Alice’s position, the protocol’s collateral ratio does not change because the premium collected by the protocol still remains in the protocol’s funding pool. If Bob does not buy Alice’s position for a long time, Liquity Protocol will gradually increase the value of Alice’s position over time (the specific form is not specified, but for example, lowering the strike price or increasing the quantity of call options can increase the value of the position). The subsidized portion comes from the protocol’s premium pool (note that this situation will slightly reduce the overall excess collateralization ratio of Liquity). Liquity believes that not all positions need to be subsidized by the protocol, and the subsidy does not necessarily need to account for a large proportion of the position’s income. Therefore, by subsidizing the secondary market, the protocol’s hedge ratio can be effectively maintained.
Finally, even with these two innovations, it may still not be possible to completely solve the problem of liquidity shortage in extreme situations. Liquity will also use a standard liquidity provider mechanism similar to Angle as a final supplement (a possible approach is that the protocol will also allow users to deposit a portion of V1 LUSD into a stability pool to support the redemption of V2 LUSD in extreme situations).
Liquity V2 is planned to be launched in Q2 of the 24th year.
Overall, Liquity V2 shares many similarities with Angle V1, but it has also made targeted improvements to the problems encountered by Angle: introducing the innovation of “principal protection” to provide more attractive products to traders, and proposing the “officially subsidized secondary market” to protect the overall hedge ratio of the protocol.
However, fundamentally, Liquity V2 is still similar to Angle Protocol, where the stablecoin team attempts to create a derivative product with certain innovation and support their stablecoin business. The ability of the Liquity team in the stablecoin field has been proven, but it is doubtful whether they can also design excellent derivatives, find product-market fit, and successfully promote them.
Conclusion
It is indeed exciting to be able to achieve decentralization, high capital efficiency, and price stability in a decentralized reserve protocol. However, sophisticated and reasonable mechanism design is only the first step for stablecoin protocols. What is more important is the expansion of use cases for stablecoins. Currently, decentralized stablecoins are progressing slowly in terms of use case expansion. The vast majority of decentralized stablecoins only have one real use case, which is “mining tools”, but the incentives for mining are not inexhaustible.
To some extent, the issuance of PYUSD by LianGuaiyLianGuail is a wake-up call for all stablecoin projects, because it means that well-known institutions in the web2 field are starting to enter the stablecoin field, and the time window for stablecoins may not be too long. In fact, when we talk about the centralized risks of custodial stablecoins, we are more concerned about the risks brought by unreliable custodial and issuing institutions (Silicon Valley Bank is only the 16th-ranked bank in the United States, and Tether and Circle are only “crypto-native” financial institutions). If there really are “too big to fail” financial institutions in the traditional financial sector (such as JP Morgan) issuing stablecoins, the implied national credit behind them will not only make Tether and Circle lose their foothold instantly, but also greatly weaken the decentralized value advocated by decentralized stablecoins: when centralized services are stable and powerful enough, people may not need decentralization at all.
Before that, we hope that decentralized stablecoins can obtain enough use cases to reach the Schelling point of stablecoins (the natural tendency of people without communication), although this is difficult.
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