Since December last year, a new trend has emerged in the DeFi field: algorithmic stablecoins. A number of related projects have also achieved significant growth, so we have to start to notice this trend.
Before delving into their essence and meaning, let's first focus on addressable markets. The number of stablecoins on Ethereum is huge: about 20 billion USDT, 3.5 billion USDC and 1 billion DAI (data at the time of writing). Most current transactions need to be serviced by some form of trusted stable currency (such as USDC or USDT), which also means that the issuing company has the right to freeze assets and manipulate balances.
DeFi Money Printing Machine
The DAI stablecoin issued by the Maker protocol explores another method that greatly reduces the possibility of "printing money out of thin air"-but the scalability is reduced. In addition, when most of the collateral used to mint DAI is not (USDC, wBTC, TUSD, etc.), it is currently difficult to believe that DAI can achieve "Trustless".
After years of development in the stablecoin field, it seems that an exciting breakthrough is being made: a new generation of stablecoins can provide scalability and reliable trustlessness. The subject is neither simple nor easy to understand, especially for novices. I will explain step by step.
Why do we need trustless stablecoins?
We have determined that there is a great demand for stablecoins, and none of the popular stablecoins on the market have achieved complete "trustlessness". What does this mean?
In short, "trustless" means that the entire system can operate smoothly without any trust center. The often-mentioned "anti-censorship" is another attribute of trustlessness. Therefore, starting from the actual situation, here are some questions that can help you evaluate the degree of trustlessness: the looser the authority, the lower the trustlessness of the project:
1. Can the token balance be confiscated or frozen?
2. Can the code or parameters of the protocol be updated? Under what conditions can it be updated? Who will update?
3. Does the agreement rely on third-party services, such as price feed (Oracle) that may be manipulated?
4. Who/through what can mint new tokens? Was it user-initiated (someone took action) or protocol-initiated (a protocol made a decision based on given parameters)?
The last question is particularly important because it highlights the core components of algorithmic stablecoins: their "central bank" is a smart contract: no one controls it, it only reacts to system parameters. We will explore in depth below.
Therefore, in this article, we will study the main models of the following protocols: Basic Cash, Empty Set Dollar (ESD) and Dynamic Set Dollar (DSD).
This article will not discuss the details of each agreement in depth, but draw a sketch framework based on the common parameters and design methods shared by these projects to show the core principles behind these stablecoins.
Centralized smart contract
The first interesting aspect is the "central bank" of the system, aka who/under what circumstances can mint new tokens? The mechanism of USDC and USDT is very much like a central bank: an entity is responsible for the project and mints new tokens.
Maker is just a smart contract that allows users to obtain DAI from certain collateral, so its method is different. Basically, Maker/DAI enables you to become your own central bank. Therefore, Maker's central bank is a smart contract, but it requires manual input to create DAI.
Algorithmic stablecoin is a step forward because it removes manual input during the minting process. In these systems, no one can mint a token-only the smart contract that operates it can. It is very elegant and minimalist, but a set of incentives needs to be carefully designed to ensure that the stablecoin can eventually hedge its anchor currency. In short, the central bank of the algorithmic stable currency is an autonomous smart contract.
How to achieve "stability"?
The use of algorithmic stablecoins, especially in the early days, often leads to anchoring and decoupling. In order for stablecoins to re-anchor a fixed exchange rate, the agreement usually uses different incentives.
When the transaction price of a stablecoin exceeds $1, the agreement will mint new tokens and distribute them to users who provide liquidity or lock their tokens to reduce the price.
When the trading price of the stablecoin is lower than 1 U.S. dollar, the "coupons or bond system" (coupons or bond) will be activated: users can destroy their stablecoins to obtain "coupons + premium". However, the coupon can only be redeemed when the price returns to more than $1.
As you can see, these mechanisms are simple. If you want to participate in the contract, you need to master some complex knowledge. By understanding and following these mechanisms to help the agreement reach "stability", this process can of course also gain benefits. Therefore, these measures have formed a stabilization mechanism to stabilize the price of stablecoins.
DSD stablecoin game
Active expansion phase
The expansion/contraction of algorithmic stablecoins is carried out by "period". The period of Basis Cash is calculated based on 24 hours, ESD and DSD are 8 hours and 2 hours respectively.
Since the supply of algorithmic stablecoins is elastic, its mechanism quickly passed the actual combat test. At the time of initial release, the circulating supply of stablecoins is usually low, and attractive incentives generate a lot of demand.
For example, Basis Cash initially issued 50,000 BAC tokens and distributed them to the first batch of pledgers. About a month later, the number of liquid tokens reached 40 million: The reason there are so many BAC tokens is because the transaction price of most of the time since its issuance has exceeded 1 USD.
ESD and DSD have gone through several expansion and contraction cycles, respectively, and the agreement is functioning as expected:
The DSD market value clearly shows the expansion/contraction phase
Take advantage of DeFi's composability
Another key principle of algorithmic stablecoins is composability. We usually think that composability refers to "How do I embed finished products/services in other projects?" Algorithmic stablecoins do not stop there. They use other protocols such as Uniswap as the core part of the system. Basis Cash, ESD and DSD have three The main ingredients:
1. Internal locking/collateralization mechanism for expansion stage (DAO or board of directors)
2. Destruction and exchange mechanism in the contraction phase
3. Uniswap/USDC or Uniswap/DAI
Their structure proves the understanding of DeFi and composability. By using Uniswap/USDC or Uniswap/DAI as the core of the protocol, it can help in many areas-because Uniswap is the main tool most familiar to DeFi users.
Although Uniswap is the main capital pool, the liquidity of other DEXs is also receiving increasing attention. With the launch of Omakase, Sushi has added two new incentive algorithm stablecoin pools: ESD/ETH and DSD/USDC.
Composability is the key to algorithmic stablecoins, and related projects have slowly achieved more integration in the ecosystem. In the next few months, we will see further developments, such as using algorithmic stablecoins as collateral tokens in lending platforms.
Oracle minimalism
Oracle is a basic parameter in the algorithmic stablecoin system: they are the true source of stablecoin prices. It is vital to ensure that Oracle is resilient and cannot be gamed.
For this reason, some old projects (especially Maker) tend to be complicated designs. In the early days, the input parameter of Maker was almost the original price of ETH. However, in order to prevent the system from "lightning liquidation" as much as possible, Maker established its own Oracle and used several delays and averages of the liquidation price to increase the inertia of the system.
Algorithmic stablecoins tend to be minimal and take advantage of the composability of DeFi. With Uniswap trading pairs, they already have enough price feeds and sufficient liquidity to be difficult to manipulate. Therefore, the Uniswap price is used as the base price and calculated at TWAP (Time Weighted Average Price) to avoid manipulation before resetting the price benchmark.
Although these systems are minimal, they are efficient and elegant: as these stablecoin projects develop, their liquidity on Uniswap also increases, making Oracle more flexible and more difficult to manipulate.
The development direction of DeFi in this field is exciting. Regardless of whether you plan to participate or not, it is very valuable to document them because they are a good example of the main trends in the field.