One article to understand all kinds of stable coins: USDT, DAI, FEI, Basis Cash, ESD mechanism full analysis

Is decentralized stablecoin a pseudo proposition? It’s too early to say for sure.

One article to understand all kinds of stable coins: USDT, DAI, FEI, Basis Cash, ESD mechanism full analysis

Over the past year, the circulation of stablecoins has exploded. However, few people understand how these stablecoins actually work.

Circulation is exploding. However, few people understand how these stablecoins actually work.

For some reason, the creators of stablecoins are obsessed with making these designs seem inscrutably complex. Almost every white paper gets bogged down in equations and newly invented jargon, as if their authors are trying to convince you: trust me, you’re not smart enough to understand this.

But I don’t agree with that. In my opinion, the underlying design in all stablecoins is very simple. I will show you visually and thus understand how all stablecoins work.

We can think of each stablecoin protocol as a bank. They each hold assets and owe debt; they all try to capture value in some way and distribute that value to the “equity” holders.

One article to understand all kinds of stable coins: USDT, DAI, FEI, Basis Cash, ESD mechanism full analysis

The chart above shows a full-reserve bank (also known as a 100% reserve bank). On the left are its real assets, which are the physical dollar reserves it holds; on the right are its liabilities (called “digital dollars”), which are claims on the reserve assets.

In an all-reserve bank, each liability is anchored 1:1 to the assets of the reserve. If the holder of a digital dollar requests cash back, the holder receives physical dollars and the corresponding digital liability is destroyed. This is how Tether, USDC, BUSD and all other fiat-backed stablecoins work.

One article to understand all kinds of stable coins: USDT, DAI, FEI, Basis Cash, ESD mechanism full analysis

The equity in the bank belongs to the shareholders (the investors in the bank), who make money from the fees charged by the bank. In the Tether case, the owners of the Tether company are the shareholders and they make their profits from Tether’s minting and redemption fees.

Every liability of a full-reserve bank should be kept closely tied to the U.S. dollar because it is always convertible to $1 in reserves. As long as the bank ensures convertibility, arbitrageurs can effortlessly maintain its exchange rate.

This model of a full-reserve bank above can help us understand how crypto banks are different.

Full Reserve Crypto Stable Coin
Let’s start with the question, how should you create a crypto full reserve bank with a stable dollar as a liability?

Given that cryptocurrencies are simply redefining money, the first thing you would do is to swap out dollar assets for crypto assets. But cryptocurrencies are unstable, so a 1:1 backing won’t work if your liabilities are in dollars. If the value of cryptocurrencies goes down, banks will not have enough collateral.

Therefore, you need to ‘overcollateralize’, i.e. increase the value of the collateral to give you a cushion in case the cryptocurrency falls.

This is basically how MakerDAO works.

One article to understand all kinds of stable coins: USDT, DAI, FEI, Basis Cash, ESD mechanism full analysis

Stabilized Currency DAI The current exchange rate is essentially stable. This is because the reserve assets are significantly larger than the total liabilities (DAI), which ensures the safety of the entire system. I won’t go into the other details of MakerDAO, interested readers can click to read this article “What is MakerDAO?

Now let’s look at Synthetix.

Synthetix takes a different approach: instead of holding a diverse basket of crypto assets, Synthetix issues its sUSD stable coin against a bunch of its own SNX tokens. This SNX is also an “equity token”, in other words, the only asset Synthetix allows as a deposit is its own equity. Because of the high volatility of SNX, Synthetix requires each sUSD in circulation to achieve an overcollateralization of 600%.

One article to understand all kinds of stable coins: USDT, DAI, FEI, Basis Cash, ESD mechanism full analysis

The exchange rate of sUSD is also currently stable.

Both MakerDAO and Synthetix are similar to traditional full-reserve banks, except that they are both over-collateralized because their collateral assets are cryptocurrencies. To some extent, their pegs are secure because the stable coins can be converted to their underlying assets through a redemption mechanism. And, both are designed with an interest rate system that targets the ideal price ($1).

Algorithmic Central Banks
There is another type of stablecoin that is often referred to as an “algorithmic central bank”.

Algorithmic central banks’ stablecoins are not redeemable at all and have no depositors (savers) in the traditional sense. This makes them less like traditional banks and more like central banks. (Note: Central banks tend to use methods other than redeemability to keep prices stable).

Each algorithmic central bank works in a slightly different way. To analyze an algorithmic central bank, we try to understand how it works and functions in two important situations: when the stablecoin is above the peg, and when the stablecoin is below the peg.

Structurally speaking, the simplest algorithmic central bank is probably Fei.

Fei raised a lot of eyebrows when it was recently launched, but it immediately broke the peg as soon as it went live. Simply put, Fei can use supply and demand to drive prices to stabilize around an anchor target. An explanation of how Fei works is shown in the following diagram.

One article to understand all kinds of stable coins: USDT, DAI, FEI, Basis Cash, ESD mechanism full analysis

Currently, FEI’s peg is broken.

Note that Fei is not overcollateralized and the majority of its assets are in cryptocurrencies. This means that in a black swan event, Fei’s assets could be significantly lower than its liabilities, making it impossible to secure the exchange rate peg.

While the animation above gives a more visual sense, the real mechanics of Fei are actually quite complex. fei uses Uniswap for all trading activity and a technique called “re-weighting” for the actual transactions. It also uses “direct incentives” (which are actually a form of capital control).

But the end effect is the same: the agreement participates in the open market and pushes the actual price to the peg.

Another similar algorithmic central bank is the Celo protocol, which generates a stable coin called Celo Dollar (cUSD). celo Dollar uses CELO as its reserve collateral (a native Celo blockchain token), as well as a diversified portfolio of other cryptocurrencies.

Like FEI, Celo also uses Uniswap, a product that continuously buys and sells Celo Dollars on the market. celo initially has a large reserve of assets and the reserve is intended to be over-collateralized at all times. If Celo’s assets fall below 200% of its liabilities, the system attempts to recapture the asset reserves by charging transaction fees for CELO transfers.

Thus, the main difference between Celo and Fei (other than their trading mechanism) is their asset holdings and the rules surrounding collateralization.

One article to understand all kinds of stable coins: USDT, DAI, FEI, Basis Cash, ESD mechanism full analysis

Celo Dollar’s pegged exchange rate is currently stable.

One more algorithmic stablecoin is Terra’s UST, which is collateralized by Luna (the native token of the Terra blockchain). Like FEI and Celo, the Terra protocol acts as a market maker for the stablecoin; if the stablecoin system runs out of assets, it restocks them by increasing the LUNA supply.

One article to understand all kinds of stable coins: USDT, DAI, FEI, Basis Cash, ESD mechanism full analysis

UST’s pegged rates are currently stable.

FEI, Celo and Terra do not allow redemptions. Instead, they create their own currency in the open market (i.e., they are willing to buy and sell the spread).

On the surface, this may seem very different from redeemability, but it is actually a much closer continuation of the body. Economically speaking, a credible commitment to market makers is the same as allowing minting and redemption.

Imagine a stable coin with ETH as collateral, call it a STBL token. The protocol is always willing to make ETH/STBL pairs in the market, meaning that the protocol is willing to sell 1 STBL for $1.01 ETH and buy 1 STBL for $0.99 ETH. If the STBL is below the pegged rate, it will keep trading STBL until it runs out of ETH.

If STBL is changed to use mint and redeem, it may let anyone mint 1 STBL for $1.01 ETH and redeem 1 STBL for $0.99 ETH. If STBL is below the pegged rate, it will keep redeeming ETH with STBL until it runs out of ETH.

The end result of the above two approaches is the same.

In a traditional central bank, becoming a market maker rather than allowing redemptions gives the central bank more discretion. But algorithmic market making is different because smart contracts can make firm, self-executing commitments. From this perspective, market making and redeemability are two paths to the same goal: providing liquidity and ensuring pegged exchange rates.

Now, we understand the “central bank” style of stablecoin. But there is another peculiar type of algorithmic stablecoin: Seigniorage Shares (mint tax stablecoin).

(Note: Seigniorage Shares was proposed by cryptocurrency economist Robert Sams in 2014 and has not yet been fully implemented. In the Seigniorage Shares model, the stablecoin token itself is a separate token from the cumulative value and debt-financed tokens.)

Seigniorage Stabilized Coins
The most classic example of a “Seigniorage Shares” stablecoin is Basis Cash. it has also become the quintessential algorithmic stablecoin, from which many other designs have since been derived.

Here is a video introduction of how Basis Cash works, you can also click to read the article.

The Basis Cash linked exchange rate has failed for now.

You can think of Basis Cash as working in two phases: While there are outstanding bonds, Basis Cash is in a contraction cycle and the money supply is not growing fast enough to pay off all the system’s debt. However, if demand continues to increase, eventually all bonds will be repaid, the system will enter an expansion cycle, and shareholders will once again be rewarded with newly minted Basis Cash.

The newly minted Basis Cash is a “mint tax”, i.e. the profit that the central bank makes from issuing new money.

A normal central bank would keep this money on its balance sheet for a rainy day. But Basis Cash pays all the taxes to its shareholders the moment it receives the cash.

You can visually see that Basis is “mortgaged very efficiently”. Having no assets on its balance sheet allows it to back a very large supply of stablecoins on zero asset reserves, but it also makes it vulnerable to a “death spiral” or confidence crisis. In fact, Basis Cash has encountered this latter situation.

It is important to understand how Basis Cash works. Most of the later algorithmic stablecoins are descendants of Basis designs, including the last one we will examine: the ESD.

The original version of ESD (now known as ESD v1), which was based on Basis Cash, was launched by an anonymous team claiming to be an absolutely fair stablecoin.

One article to understand all kinds of stable coins: USDT, DAI, FEI, Basis Cash, ESD mechanism full analysis

ESD v1’s pegged exchange rate has been broken and they have since moved to a new design.

ESD’s innovation is to fuse “share” tokens with “stablecoin” tokens. This means that stablecoins, if pledged, will generate more stablecoins. As you might guess, this causes the stablecoin to become very volatile and move away from the pegged exchange rate, sometimes as high as $2.00 and sometimes down to below $0.20.

So far, the pure “Seigniorage Shares” type of stablecoins have generally failed, and many Basis and ESD knockoffs (such as DSD) have suffered the same fate. This at least tells us that the design of stablecoins really matters. These illustrations should help you understand why ‘Seigniorage Shares’ are so vulnerable to a crisis of confidence.

Writing at the end
In the early days of DeFi’s development, many people believed that a decentralized stablecoin was fundamentally untenable. In hindsight, that conclusion was too hasty. Certain designs do look pretty good, and there’s still plenty of room for improvement.

But one thing is for sure: you shouldn’t insist that a decentralized stablecoin will be more powerful just because of a white paper. You need to think for yourself what that stablecoin needs to be to be considered stable. If you are confused, try to sort out the principles and draw a diagram, which is helpful, at least for me.

Note: As the author’s fund, Dragonfly, holds multiple positions in the assets mentioned in this article, the analysis is not recommended as investment guidance.

Posted by:CoinYuppie,Reprinted with attribution to:
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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