The Stablecoin Candidate
"So long as money is managed by government, a gold standard, despite its [many] imperfections, is the only tolerably safe system; but it is better to take money completely out of the control of government." - F. A. Hayek
In 1976 an Austrian economist and political philosopher named Friedrich Hayek postulated that through the incentives of the market and the discipline of competition, self-interested banks would do a better job at preserving the value of money than the government. He believed that the abolition of government-money is the cure to inflation through undisciplined state expenditure, instability, and economic nationalism.
He saw a world of free civilization where people, money and capital could move freely. Where money wasn't deemed "legal" by government but free to "spontaneously emerge like law, language and morals". Where only by the code of the market through self-interest can we reform the monopoly of money.
This world is being built right beneath your nose as we speak, a novel technology, called stablecoins.
Stablecoins, in its current iteration, serve as the liquidity bridge from the traditional fiat world – mostly using the Dollar as the reference currency – to the cryptographically-enhanced digital world we are moving toward.
However, building a secure and scalable protocol has proven to be remarkably difficult in both the fiat and crypto worlds. For example the "Asian Contagion" was an East Asian financial crises in which Thailand removed the US Dollar peg from the Thailand baht and sent currency devaluation shock waves all throughout Asia.
Another example in the crypto world is "Black Thursday" in which colossal amounts of ETH were liquidated from MakerDAO vaults with ZERO auction-bids (i.e. free ETH due to network congestion), oracle price discrepancy, and the sharp Ethereum sell-off. The amount of ETH gamed from MakerDAO from ‘keepers’ who took advantage of the volatility in a non-competitive auction is equal to $130 million dollars with today's current ETH prices.
As you can see, trying to not only develop but also sustain a stable currency is a daunting task. In order to successfully institute a stable currency in the digital asset space one needs proper development and also proper network effects. There are two stablecoin protocols that we are going to break down today, Cardano's Djed stablecoin and TerraLab's UST stablecoin.
Before we jump ringside to color cast the bout, we first need to establish your knowledge on stablecoin assets.
How it works
The current stablecoin environment is broken into 4 pillars:
Tether (USDT) is an example an off-chain collateralized stablecoin as it is pegged to the dollar deposited in central banks.
Off-chain fiat collateralized stablecoins are counter-intuitive to the ethos that underpins the crypto industry, yet they currently dominate.
They are also subject to centralization, counter-party risks, and regulatory constraints which was tangibly evident in the latest round of regulation bouts between the SEC and Tether.
A fiat-backed pegged stablecoin does not fit the new-money reform we are looking for.
MakerDAO (DAI) is an example of an on-chain-collateralized stablecoin as it is backed by deposits of other cryptocurrencies.
On-chain-collateralized stablecoins also have major flaws which stem from the volatility of the crypto markets. This volatility can cause events much like Black Thursday, as we discussed above.
A crypto-collateralized stablecoin is exposed to too much risk from extreme fractional reserve banking, which we'll talk about later.
Benchmark Protocol (MARK) is an example of an un-collateralized stablecoin as its price is stabilized via algorithms that respond to price volatility.
Benchmark is an elastic rebasing token that responds to supply and demand by rebasing the token all token holders own pro rata.
An algorithmic rebasing token is too rigid to eliminate volatility – as is the goal of a stablecoin – but rather only lowers it.
Cardano's Djed stablecoin is an example of a hybrid stablecoin in that it is an algorithmic crypto-backed pegged stablecoin. I know, its a mouthful, but for good reason.
For historical context, the Djed is an ancient Egyption symbol meaning 'stability' and in Egyption mythology was symbolic of the backbone of the god Osiris.
Cardano's Djed stablecoin is broken into two main iterations, Minimal Djed and Extended Djed. Minimal Djed is essentially the underlying thesis that in order to guarantee a peg the protocol must keep a reserve ratio significantly greater than one.
Djed behaves like an autonomous bank that is governed by the simplest law of supply and demand. To understand how an autonomous bank works, lets first expand your knowledge on the simplest version of how a central bank works.
A central bank is the enforcer of money supply which has both micro and macroeconomic consequences whether that supply is expansionary or contractionary. Their goal is to ensure that the real economy – often represented by GDP -- can operate efficiently to stimulate economic growth (ie inflation and employment). However, the real economy doesnt always operate smoothly, so the central bank (Federal Government) must step in.
A central bank has a few tools they can utilize to facilitate economic growth.
Firstly, they set the reserve requirement for commercial banks in which a commercial bank must hold X percentage of the total amount deposited into the bank as reserves, known as fractional banking. If the central bank wants to ensure more money circulates in the economy, they reduce the reserve requirement, and inversely they would raise the reserve requirement to tighten money supply. At the time of publishing, the reserve requirement is zero.
Secondly, they are allowed to set policy rate, or Federal Funds rate, which is the interest rate commercial banks accept to borrow money from the central bank. The lower the Federal Funds rate, the lower real rates can go such as mortgage loans, auto and personal loans. Inversely, the higher the Federal Funds rate, the higher real rates get.
Thirdly, they buy or sell government securities issued by the U.S. Treasury who sells them to investors. T-bills, notes and bonds are all government-backed debt issuance's that the Fed uses to manipulate the Fed Funds rate.
Lastly, the central bank can create money or "print it", in order to buy up government securities that enter the banking system directly as payment, otherwise known as quantitative easing.
Now that you understand how a Central Bank works towards economic stabilization in the real world, let's hop back into Cardano.
Minimal Djed uses automated tools, similar to the tools of a central bank, using smart contracts to mechanize stability. The key difference to remember is, unlike a central bank, Djed always strives to keep a reserve ratio higher than 1. In essence, there should always be an equal-to or greater-than 1 peg between the circulating stablecoins and reserves.
This is to ensure things like bank runs dont happen. A bank run is when depositors of a bank all rush to withdraw at once either out of a collapsing economy or distrust in the institution holding the deposits. Now because banks usually only hold 10% of reserves, or in our present case zero, there would be 90% of missing capital that are owed to depositors. This happened during the Great Depression and in the Financial Crisis of '08.
So instead of monetary tools, Djed has parameters baked into the protocol itself to ensure the minimum reserve ratio can always buy back the current circulating supply of stablecoins. They do this by setting a minimum reserve ratio that when reached no longer allows users to buy stablecoins or sell back their reserve coins.
To prevent dilution of the reserves – the event of which there are excess reserves that limit the amount receivable to reserve coin holder through fees to properly incentivize reserve coin holder in participating – the protocol also sets a maximum reserve ratio in which users would no longer be able to purchase reserve coins.
It is important to note that Djed does not need a currency to peg to, just a target price that could be an index or weighted average of a volatile asset.
A full reserve bank has assets and liabilities. In Djed the liability is the minimum reserve ratio – the amount of reserve needed to buy back all circulating stablecoins. The asset is the reserve surplus, or any amount of reserve greater than the minimum reserve ratio plus fee coverage. The reserve surplus, or equity, is shared equally among reserve coin holders.
With the given parameters enforcing participants' ability to sell their reserve coins during market turmoil – a risk reserve coin participants are reward for with fees and margin – the reserves are exempt from becoming insolvent.
So it would essentially work like this:
- A user purchases reserve coins using ADA as long as the reserve ratio is within it's operable bounds.
- Reserve providers absorb the potential upside if the price of ADA increase while providing stability for users who purchase Djed. Inversely, reserve providers also absorb the downside of ADA price as well. Essentially a levered position on the price of ADA through fees and margin. If price of ADA goes up after the point of deposit, a reserve provider may redeem their initial deposit, plus fees generates from the protocol, plus the upside difference.
- Another user can now purchase Djed because there are enough reserves to effectively "collateralize" their deposit.
- A stablecoin holder enjoys the stability because of the risk the reserve providers take spread equally among reserve participants. Which means if the price of the base coin (ADA) drops, an arbitrage event is only beneficial to the stablecoin holder who can redeem their initial deposit plus the difference of the price at redemption from the price at deposit and the reserve participants pay that difference.
That's really it, it is extremely simple. Minimal Djed is now theorem-proof, formally verified, and proven in practice that it is a safe, mathematically simple and game-theory-driven stablecoin protocol.
But there are flaws.
For instance reserve coin bank runs can happen where reserve coin participants race to redeem their deposit from the reserve equity before the reserve reaches the minimum and disallows selling of reserve coins. Also, once the reserve reaches the minimum reserve ratio, because price of reserve coins fluctuates, a minimal price needs to be artificially set, which could be lower than the market price (ie buying 1 dollar with 2 dollars).
Another problematic issue that happened in the deployment of Minimal Djed on the Ergo blockchain was the draining of reserves from a malicious whale who had price foresight due to slow oracle exchange rate updates, allowing them to game the system and drain the reserves with consecutive buying and selling of reserve coins. The problem was fixed by reducing oracle update time from 60 minutes to 12 minutes and by increasing the fee from 1% to 2%.
Extended Djed is currently being worked on to fix these issues with continued rigorous theorem proving and will be made to be easily update-able with all Minimal Djed implementations across blockchains.
Let's dive in to Terra.
Terra's UST is an example of an un-collateralized algorithmic pegged stablecoin, another mouthful, I know. UST's flagship peg is to the Dollar. UST uses the Luna token to maintain price stability, not enforce price stability. Luna is not considered collateral from a traditional definition or mechanism standpoint and should not be considered the backing of the UST stablecoin, but however inherits an endogenous relationship because of its arbitrage opportunity with UST.
So how is it that UST maintains stability?
UST is a stablecoin on the Terra blockchain in which operates via a Proof-Of-Stake consensus mechanism. The validators on the network play a foundational role in security and in stability through means of seigniorage. Seigniorage is the value of the currency minus the cost it takes to produce it. For example if it costs .67 cents to produce $1 dollar, the seigniorage would be ~.33 cents. In Terra's case the cost of mint is zero.
The arbitrage opportunity is very similar to the internal mechanism of Djed as well:
Whenever 1 UST < $1, UST holders may exchange 1 UST for $1 worth of LUNA.
Whenever 1 UST > $1, LUNA holders may exchange $1worth of LUNA for 1 UST
Arbitrageurs are incentivized to ensure price returns to the peg.
When demand for UST rises users swap Luna on-chain to UST and the internal mechanism burns Luna during the minting of new UST, called seignorage. A portion of this goes to the treasury to fund new projects building on Terra, as stated in the fiscal policy. Essentially this means the price volatility of UST is effectively transferred onto Luna's fluctuating supply and therefore Terra validators absorb short term volatility when UST contracts and expands its supply. The burn rate reward through seigniorage and transaction fees a Terra validator earns is automatically adjusted every week to match market volatility.
Now that you understand the internal mechanisms let's establish the birds-eye connection between Luna and UST. UST , as we stated above, is not backed by dollars or crypto but instead by the growth of the Terra ecosystem.
Huh? How does that work?
The Terra ecosystem intuitively and essentially harnesses the growth of the network and through the internal mechanism described above converts that growth into stability. The reflexive nature of the protocol allows for the adoption of the ecosystem to put deflationary pressure on Luna supply via burn-to-mint dynamics and therefore accrues value, now because Luna is used to arbitrage UST to keep the peg it always has utility, and utility is paid for via taxes, fees and seigniorage as explained above.
That's it really, it's a lot less simple than Cardano Djed, but very robust to say the least. Just like Cardano's Djed, however, Terra has it's own flaws as well.
For instance, the main problem is the fact that the UST token isnt backed by anything, it mainly relies on trust in the ecosystem with some non-baked-in protocol incentives which are less secure. For instance, a death spiral, something Mark Cuban knows all about in the Iron/Titan rugpull can happen wherein the holders of Luna lose faith in the system and market sell during an expansionary phase (ie peg below $1). The then reflexive nature of the Terra ecosystem then gets turned back on the ecosystem as increased selling pressure causes a downward spiral in the value of UST.
This somewhat happened in the latest May 2021 crash when UST lost its peg for 2 consecutive days, but would hardly be considered a death spiral. There were reasons outside of the internal mechanism for this, including Anchor Protocol liquidation that for the sake of brevity we wont discuss as it isnt important to the UST protocol itself.
Terra also has a dependency on off-chain liquidity being higher than on-chain liquidity to prevent on-chain attacks. The dynamic between price impact and lack of liquidity in an off-chain exchange could allow a bad actor to take advantage of oracle price indicating the inflated price impact by swapping your Luna on-chain at the inflated oracle-provided exchange rate. Now that you've swapped your Luna for an inflated value to UST you go back to the off-chain exchange and market sell and push the illiquid price back down. You then go back to the chain and swap your UST back for Luna and pocket the difference. Slippage may impact the profitability of such an attack, but with large enough positions, a protocol-level solution is required.
Proposals are underway to prevent things like this in the future.
The Terra Ecosystem is robust and has many avenues for spurring growth of the system via dApps utilizing UST, and because of the reflexivity of Luna/UST there is a lot of potential for a mature and resilient stablecoin. With that being said, the more connections and robust features in the system also create potential weak spots for the UST protocol, as illustrated in the Anchor protocol liquidation events directly impacting cascading sell pressure on Luna/UST. Rolling out with the upcoming September 9th Colombus-5 launch, UST will be connecting to many other blockchains. This further expands the growth of the system and may create more potential weak spots.
On the other hand, Cardano takes an extremely elegant and simple approach that doesnt require exogenous elements to dictate monetary and fiscal policy on key banking features of the protocol. With that being said, the reliance on a global reserve may or may not be reliable or secure when met with large demand, larger than the Ergo blockchain is exposed to and certainly what the Cardano blockchain will bring. When you take into account the external factors like blockchain congestion, transaction speed etc. there could be unforeseen issues in the reliance on a reserve ratio.
Only time will tell.