The contents expressed below are the author’s personal views and should not constitute the basis for investment decisions, nor should they be construed as recommendations or suggestions for engaging in investment transactions.
We have little control over why humans exist in this universe. As a civilization, we expend too much energy to bring calm and stagnation to a turbulent planet. Just turning the temperature up and down in our homes and workplaces consumes a lot of energy.
Because we instinctively understand that humans are just reeds fluttering in the wind, empowering individuals and institutions alike. Politicians tell us there is a plan, business leaders chart the way forward, and we hope it will always be successful. But reality throws unexpected conundrums time and time again, and leaders’ plans often fail. But what can we do, try again and again?
Just as civil society shows its composure, so too must the money that powers civilization. Fiat currencies are designed to depreciate slowly over time. Humans cannot understand the loss of purchasing power over decades or centuries when referring to the purchasing power of fiat currencies in the past. We are used to believing that today’s dollar, euro, yen, etc. will buy the same amount of energy tomorrow.
The behavior of Bitcoin and the crypto movement it spawned is extremely pathetic. Satoshi Nakamoto was a revolutionary at heart, and the love and anger of crypto believers led to bitcoin’s price volatility relative to fiat currencies and beyond pure energy itself. While believers profess to accept this volatility with conviction, we are only human and sometimes drop the gold standard. In difficult times, stablecoins have shown us their sweet melody, but many fail to realize that they are simply incompatible with the financial world we hope to create.
Many people have asked me what I think about stablecoins. The recent volatility surrounding Terra’s USD stablecoin, UST, pegged to $1 has prompted me to start a series of articles on stablecoins and central bank digital currencies (CDBCs). These two concepts are interrelated with the fundamental nature of the debt-based part of the banking system that dominates the global financial system.
This article will explore the broad categories of blockchain stablecoins — including fiat asset-backed, overcollateralized crypto, algorithmic, and Bitcoin-backed stablecoins. While there is currently no proven solution, the last part of this article will touch on my current view: Bitcoin-based stablecoins pegged to the U.S. dollar, which are also Ethereum Virtual Machine (EVM) compatible ERC-20 assets, is the best way to combine these two incompatible systems.
In this time of heightened downward volatility in the market, the only comfort is our breath. Our actions and thoughts are not completely under rational control, so we must breathe in and out slowly, methodically, and consciously. Only in this way can we faithfully spread the good word of the Lord.
“The Fremen have a saying: ‘God created the Arrakis to train believers.’ One cannot disobey the Word of God.” – Paul Atreides, ‘Dune’
As explained in the previous article “I Still Can’t Draw A Line”, banks are utilities that operate fiat value. They help individuals and organizations conduct business activities. Before the Bitcoin blockchain, banks were the only trusted intermediaries that could perform these functions. Even after Bitcoin, banks are still the most popular intermediaries, which makes some banks even reckless because they think the government can print money to bail out their actions.
Banks charge very substantial taxes on the time and fee for users to transfer value. Given that we now have instant and near-free access to encrypted communications, there is no reason why we should continue to pay so much and waste so much time at traditional banks.
Bitcoin creates a competitive peer-to-peer payment system with low cost in time and money. For many, accustomed to being benchmarked against fiat currencies and energy (i.e. a barrel of oil), Bitcoin is extremely volatile. To solve this problem, Tether created the first dollar-pegged stablecoin using the Omni smart contract protocol built on top of Bitcoin.
Tether creates a new digital asset class on a public blockchain, backed 1:1 by fiat assets held by banking institutions, which we now refer to as fiat-backed stablecoins. After Tether (also known as USDT) and USDC, various other fiat-backed stablecoins have sprung up, with assets in custody (AUC) in fiat held by each project proliferating as the pair grows. Currently, USDT and USDC have a combined fiat AUC of over $100 billion.
Because of the lack of infrastructure in the Bitcoin economy, our means of payment are still in US dollars or other fiat currencies. Because the traditional way of sending and receiving fiat currency is very expensive and complex, bypassing the bank payment system and sending fiat currency instantly and at low cost is a very valuable thing. I’d rather be sending someone USDT or USDC than using an expensive global fiat bank payment system.
The fundamental problem with this type of stablecoin is that it requires willing banks to accept the fiat assets backing the token. Transaction fees for stablecoins do not fall into the pockets of bankers, but there is a cost for banks to hold these huge fiat assets. Central banks are known to disrupt commercial banks’ lending business models, making it impossible for them to agree to agreements in which commercial banks hold billions of dollars to achieve decentralization.
Fiat-backed stablecoins want to use a bank’s storage facility, but don’t pay anything for it. For me, this strategy will not survive. Billions may be fine, but it is impossible to expect commercial banks to allow fiat-backed stablecoins to have AUCs in the trillions.
Fiat-backed stablecoins will not be the payment solutions to support Web3 or a truly decentralized global economy. They cannot be digital payment services that connect the physical world quickly, cheaply and securely. We saw this dissonance when the Federal Reserve barred Silvergate Bank from being a partner in Facebook’s Diem stablecoin. Because Facebook’s user base is too large, if Diem is launched, it will immediately become one of the world’s largest currencies in circulation. It will compete directly with traditional fiat currencies, which is not allowed to happen.
The next iteration of stablecoins is a series of projects that overcollateralize major cryptocurrencies to remain pegged to fiat value.
In short, these stablecoins allow participants to mint a pegged fiat token in exchange for crypto collateral, the most successful of which is MakerDAO.
MakerDAO has two currencies. Maker (MKR) is the token that governs the system. It is similar to a bank’s share, but the bank’s goal is to have more assets than liabilities. These assets are mainstream cryptocurrencies such as Bitcoin and Ethereum, and MakerDAO, upon receipt of the crypto assets, pledged to create DAI, a token pegged to the U.S. dollar.
1 DAI = 1 USD
Users can borrow DAI from MakerDAO with a certain amount of crypto collateral. Since the price of crypto collateral can fall in USD value, Maker will programmatically liquidate the pledged collateral to meet the DAI loan. This is done on the Ethereum blockchain and the operation process is very transparent. Therefore, the level price of Maker’s liquidation can be calculated.
Here is a graph of DAI’s percent deviation from its $1 peg, a reading of 0% means DAI has held the peg perfectly. Maker has done a great job keeping the dollar peg.
The system is powerful because it has survived several price slumps in bitcoin and ether, and its DAI token remains valued at close to $1 on the open market. The downside of this system is that it is over-collateralized. It effectively removes liquidity from crypto capital markets in exchange for the stability of pegged fiat assets. As we all know, stagnation is expensive, and volatility is free.
f(x) for MakerDAO and other overcollateralized stablecoins: completely draining the ecosystem of liquidity and collateral. Maker token holders can choose to introduce risk into the business model by lending idle collateral in exchange for greater income. However, this introduces credit risk into the system. Who are reliable borrowers paying positive rates on cryptocurrencies and what collateral do they pledge? Is that collateral the original asset?
The benefit of fiat-part banking is that the system can grow exponentially without exhausting all the currency’s collateral. These overcollateralized stablecoins fill a very important niche, but they are always a niche for the fundamental reasons above.
The next iteration of stablecoins aims to completely remove the link to any “hard” collateral, and is only backed by fancy algorithmic minting and burning schemes. In theory, these algorithmic stablecoins could scale to meet the demands of a global decentralized economy.
The stated goal of these stablecoins is to create a pegged asset with less than 1:1 crypto or fiat collateral. Often the goal is to use assets other than “hard” collateral to back the pegged stablecoin. Given that Terra is the current topic, I will use LUNA and UST as examples to explain the mechanics of algorithmic stablecoins.
LUNA is the governance token of the Terra ecosystem.
UST is a stablecoin pegged to $1 whose “assets” are simply LUNA tokens in circulation.
Here’s how UST’s peg to $1 works:
Inflation: If 1 UST = $1.01, the value of UST to which it is pegged is overvalued. In this case, the protocol allows LUNA holders to exchange $1 worth of LUNA for 1 UST. LUNA is burned or taken out of circulation, UST is minted or put into circulation. Assuming 1 UST = $1.01, the trader earns a profit of $0.01. This pushes the LUNA price as its supply dwindles.
Deflation (where it is now): If 1 UST = $0.99, then UST is undervalued relative to its peg. In this case, the protocol allows UST holders to exchange 1 UST for $1 worth of LUNA. Suppose you can buy 1 UST for $0.99 and exchange it for $1 of LUNA, making a profit of $0.01. UST was burned and LUNA was minted. This causes the price of LUNA to go down as its supply increases on the way down. The biggest problem is that investors who now own the newly minted LUNA will decide to sell it immediately rather than hold it in the hope of a price increase. This is why LUNA is under constant selling pressure when UST trades at a price that has broken its peg significantly.
The more UST is used in commerce in the Web3 decentralized economy, the higher the value of LUNA. This minting and destroying mechanism is very useful on the way up. But if UST fails to reverse its downward trend, a death spiral could begin with the indefinite minting of LUNA in an attempt to get UST back into its peg.
All algorithmic stablecoins have some kind of minting/destroying interaction between a governance token and a pegged stablecoin. All of these protocols have the same problem: how to increase confidence in restoring the peg when the peg is trading below the fiat peg .
Almost all algorithmic stablecoins have failed due to the death spiral phenomenon. If the price of the governance token falls, the governance token asset backing the peg token is deemed untrustworthy by the market. At that point, participants started dumping their pegged tokens and governance tokens. Once the spiral begins, it is very expensive and difficult to restore confidence in the market.
The death spiral is no joke, it’s a confidence game based on the debt banking system. However, the game has no government that can force users to use the system.
In theory, profit seekers should be willing to defy the drop in collateral to save algorithmic protocols for huge profits on governance tokens created out of thin air. But that’s just an assumption.
Here is a graph of the percent deviation of UST from its $1 peg. As with MakerDAO, 0% means the peg is rock solid. As you can see, everything was fine until the UST broke off its anchor.
Many similar projects have failed or are failing. That’s not to say this model can’t work, at least for a while. I’m working on a specific algorithmic stablecoin project and holding its governance token. Currently the project is profitable at the protocol level which makes them attractive. The protocol has a similar structure to Terra, but in addition to its governance token, accepts other mainstream collateral to back its peg stability.
In theory, this model resembles a part of a bank that can scale to meet the needs of a decentralized Web3 economy, but requires near-perfect design and execution.
The only laudable goal of stablecoins is to allow fiat-pegged tokens to be issued on public blockchains. This has practical uses until the arrival of real Bitcoin economics. So let’s try to make the most of a fundamentally flawed premise.
The most primitive form of crypto collateral is Bitcoin. How can we turn Bitcoin with a 1:1 dollar value ratio into a hard-to-break dollar-pegged stablecoin?
Various top cryptocurrency derivatives exchanges offer inverse perpetual swaps and futures contracts. These derivatives contracts are based on BTC/USD but are margined in BTC. This means that profits, losses and margins are denominated in Bitcoin, while quotes are denominated in USD.
I’ll hold your hand while we do some math – I know it’s hard on your TikTok-damaged head.
Each derivatives contract is worth $1 Bitcoin at any price.
Contract Value Bitcoin Value = [$1 / BTC Price] * Contract Quantity
If BTC/USD is $1, the contract is worth 1 BTC. If BTC/USD is $10, the contract is worth 0.1 BTC.
Now let’s create $100 using a combination of BTC and a short derivatives contract.
Let’s say BTC/USD = $100.
At a price of $100 in BTC/USD, what is 100 contracts or $100 worth of BTC?
[$1 / $100] * $100 = 1 Bitcoin
Intuitively, this should make sense.
100 Synthetic USD: 1 BTC + 100 short derivatives contracts
If the price of Bitcoin tends to infinity, the value of a short derivatives contract in Bitcoin approaches the limit of 0. Let’s demonstrate this with a larger but less than infinite BTC/USD price.
Suppose the price of Bitcoin rises to $200.
What is the value of our derivatives contracts?
[$1/$200] * $100 = 0.5 bitcoin
Therefore, our unrealized loss is 0.5 BTC. If we subtract the unrealized 0.5 BTC loss from our 1 BTC pledged collateral, we now have a net balance of 0.5 BTC. But at the new BTC/USD price of $200, 0.5 BTC still equals $100. So even if the price of Bitcoin rises and results in an unrealized loss on our derivatives position, we still have $100 in synthetic dollars. In fact, it is mathematically impossible for this position to be liquidated upwards.
The first fundamental flaw in the system occurred when the price of BTC/USD was close to 0. As the price approaches zero, the contract value becomes greater than all bitcoins that will exist – making it impossible for short sellers to pay you back in bitcoins.
This is math.
Suppose the price of Bitcoin falls to $1.
What is the value of our derivatives contracts?
[$1 / $1] * $100 = 100 bitcoins
Our unrealized gain is 99 BTC. If we add the unrealized gains to the initial 1 BTC collateral, we arrive at a total balance of 100 BTC. At a price of $1,100, Bitcoin is equivalent to $100. Therefore, our $100 synthetic peg is still in effect. However, notice how a 99% drop in Bitcoin price increases the Bitcoin value of the contract by 100x. This is the definition of negative convexity, and shows how this peg breaks as the price of Bitcoin approaches 0.
The reason I ignore this is that if Bitcoin goes to zero, the entire system will cease to exist. At that point, there will no longer be a public blockchain capable of transferring value, as miners will not spend pure energy maintaining a system where native tokens are worthless. If you’re concerned that this is a real possibility, just keep using the fiat banking track – no need to try something that might be cheaper and faster.
Now, we have to introduce some centralization, which brings a whole bunch of other problems to this design. The only place where these inverse contracts are traded large enough to accommodate Bitcoin-backed stablecoins that can serve the current ecosystem happens on centralized exchanges (CEXs).
The first point of centralization is the creation and redemption process.
Send BTC to the foundation.
The foundation stakes BTC on one or more CEXs and sells inverse derivatives contracts to create sUSD, the synthetic dollar.
The foundation issues a public blockchain-based sUSD token. For ease of use, I recommend creating an ERC-20 asset.
In order to trade these derivatives, the foundation must create an account on one or more CEXs. The BTC collateral is not kept in the foundation, but now remains in the CEX itself.
Send sUSD to the foundation.
The foundation buys back one or more CEX short inverse derivatives contracts and then destroys sUSD.
The Foundation withdraws the net BTC collateral and returns it to redeemers.
There are two problems with this process. First, the CEX (for whatever reason) may not be able to return all the BTC collateral entrusted to it. Second, CEXs must collect margin from losers. As far as this project is concerned, when the price of BTC falls, the derivatives of the project are profitable. If the price falls too far, too fast, the CEX will not have enough long margin to cover it. This is where the various socialized loss mechanisms come in. TL;DR, we cannot assume that if the BTC price falls, the project will receive all the BTC profits due.
The foundation needs to raise funds for the development of the project. The biggest need for capital is a general fund that covers exchange-traded counterparty risk. Governance tokens must initially be sold in exchange for Bitcoin. This bitcoin is used exclusively in cases where the CEX does not pay out as expected. Obviously, this fund is not inexhaustible, but it would give confidence that the $1 peg can be maintained if CEX returns are lower than they should be.
The next step is to determine how the protocol will earn revenue. There are two sources of income:
- The protocol will charge a fee for each creation and redemption.
- The protocol will gain a natural positive basis for derivative contracts and the underlying spot value. Let me explain.
The stated policy of the Federal Reserve (and most other major central banks) is to inflate its currency by 2% per year. In fact, since 1913, the year the Federal Reserve was created, the dollar has lost more than 90% of its purchasing power when tied to the CPI basket.
BTC has a fixed supply. As the denominator (USD) grows in value, the numerator (BTC) remains the same. This means that we should always assign a higher value to the future value of the BTC/USD rate than the spot value. So fundamentally, the contango (futures price > spot) or funding rate (perpetual swaps) should be positive – meaning income for those shorting these inverse derivatives contracts.
One could argue that U.S. Treasuries have positive nominal yields and that there is no risk-free instrument nominally priced in Bitcoin — so it would be incorrect to assume that the U.S. dollar will depreciate relative to Bitcoin over the long term. While it’s true, as I and many others have written, negative real interest rates (ie, when nominal risk-free Treasury rates fall below GDP growth rates) are the only mathematical way the US can nominally pay its debt holders.
Another option is to increase population growth to more than 2 percent per year, which requires couples to collectively avoid contraception and other family planning methods. Population growth in 2021 is 0.1%, according to the U.S. Census Bureau. If you exclude immigration, the tax rate will be negative.
The final option is to discover some new and amazing energy conversion technologies that drastically reduce the cost of energy per dollar of economic activity. Both of these alternative solutions seem unlikely to materialize anytime soon.
Long Bitcoin vs. short inverse derivatives contracts should see positive returns year after year. Therefore, the greater the circulating supply of sUSD, the more Bitcoin is escrowed compared to shorting derivatives contracts, resulting in a substantial stream of compounded interest income. This provides a large pool of funds for governance token holders.
perfection is impossible
There is no way to create a stablecoin pegged to fiat currency on a public blockchain without many compromises. It is up to the users of the relevant solutions to determine whether a compromise is worth the goal of making fiat faster and cheaper on a public blockchain than on a bank-controlled centralized payments network.
Of the four options presented, I like Bitcoin and derivatives-backed stablecoins the most, followed by overcollateralized crypto-backed stablecoins. However, each of these solutions anchors cryptocurrencies in large pools of funds. The problem, as I mentioned in Doomsday, is that these public networks require assets to be moved between parties in order to generate transaction fees that pay for network maintenance. Holding is toxic in the long run. So let’s not be complacent and continue our efforts to create a farm-to-fork Bitcoin economy.
Will Terra/UST survive?
Terra is currently at the deepest point of the death spiral. Please read this tweet thread from founder Do Kwon, what is happening right now is by design. The protocol is working and the fact that people are surprised by what is going on means they are not reading the white paper properly. Luna-tics also didn’t seriously enough question where Anchor’s 20% UST yield came from.
The spiral stops when the UST market cap equals LUNA. If left unchecked, the protocol will find a market cap balance. The question then becomes what is the final static market cap. Most importantly, when arbitrageurs buy cheap UST to create fresh LUNA, who will buy that LUNA? Why would you buy LUNA from someone who is selling it when you know there is billions of dollars of LUNA selling pressure as long as UST < $1.
Even if LUNA and UST survive this event, some genius protocol changes must be made in the long run to increase the market’s confidence that LUNA’s market cap will always exceed UST’s float. I don’t know how to do this. That’s why I only LARP. This basic question has been highlighted by many – check out this article by Dr. Clements for a more detailed discussion.
This is a chart of [UST Market Cap – LUNA Market Cap]. When this value is < $0, the system is healthy. An upward spike means that UST must be destroyed and LUNA issued to re-pegg UST to it.
Algorithmic stablecoins are not much different from fiat debt-backed currencies, except for one key factor: Terra and others like it cannot force anyone to use UST at any cost. They have to convince the market with their fancy designs that the governance token backing the protocol will have a non-zero value that grows faster over time than the number of fiat-pegged tokens issued. However, governments can always end up forcing their citizens to use their currency at gunpoint. Therefore, there is always an inherent demand for fiat currency, even if everyone knows that the “asset” backing this currency is worth less than the currency in circulation.
Another victim was a group of investors who shouted “Yeah, yeah, hooray!” For DeFi because of their passion for Terra. These investors will now be busy repairing their balance sheets rather than buying Bitcoin and Ethereum when they resume their downward trajectory.
This debacle is not over yet…
During a proper crash, the market seeks out those indiscriminate sellers and forces them out. This week’s slump was exacerbated by the forced sale of all Luna Foundation bitcoin to defend the UST:USD peg. As always, they still failed to defend the hook. This is why all anchoring in the face of cosmic entropy fails.
I dutifully sold $30,000 in Bitcoin and $2,500 in June puts. I have not changed my structured long crypto positions even though they are losing “value” in fiat currency terms. If anything, I’m evaluating the various altcoins I own and increasing my exposure.
I didn’t expect the market to pass these levels so quickly. The collapse came less than a week after the Fed raised rates to an expected 50 basis points. This market cannot cope with rising nominal interest rates. It strikes me that anyone can trust long-term risky assets at their all-time high price multiples not to succumb to a rise in nominal interest rates.
US April CPI rose 8.3% yoy, lower than the previous 8.5% yoy. 8.3% is still too hot to handle, and the Fed in fireman mode cannot give up its unrealistic pursuit of fighting inflation. Expect a 50bps rate hike in June, which will continue to undermine long-term risk assets.
Crypto capital markets must now determine who is overly exposed to the risk of anything related to Terra. Any service offering above-average returns that are deemed to have any contact with this kind of melodrama will experience a rapid exodus. Given that most people have never read how any of these protocols actually work in a distress situation, this will be an exercise in selling first, reading later. This will continue to weigh on all crypto assets as all investors lose confidence and prefer to grab the safety rug and hold fiat cash.
After the bloodletting is over, the crypto capital market must have time to recover. Therefore, trying to understand a reasonable price target is foolish. But what I will say is that given my macro view of the inevitability of eventual money printing, I will close my eyes and trust the Lord.
So, I am a buyer of $20,000 in Bitcoin and $1,300 in Ethereum. These levels roughly correspond to the all-time highs for each asset during the 2017/18 bull market.
We don’t know who among us is in cahoots with the devil and yet swears allegiance to God. So keep yourself away from the “buy” and “sell” buttons and the dust settles. Everything will be explained to the believers in due course.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/bitmex-founder-what-should-be-the-best-way-to-design-a-stablecoin/
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