Algorithmic stablecoins falling out of favor? No, they are making a comeback

Editor's Note: This article comes fromBabbitt Information (ID: bitcoin8btc)Editor's Note: This article comes from

Babbitt Information (ID: bitcoin8btc)

Babbitt Information (ID: bitcoin8btc)

, Author: Messari analyst Ryan Watkins, Compiled: Screen, published with permission.

After a little hype in Q4 2020, many of them collapsed and fell out of favor. Reflexivity propelled these early experimental projects to great heights on the ascent, only to kill them on the descent. Today, the bellwethers of the hype cycle, including ESD and DSD, are now priced 90% below their planned anchor of $1. Many critics have jumped to conclusions that these experiments are doomed to fail under their current design. Well...they were right.

In the first of two reports on algorithmic stablecoins, we cover algorithmic stablecoins market potential, problems, revival, and the most promising fiat pegged existing or upcoming on the market project.

first level title

Big picture of the industry

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today's market

• Stablecoins are important. Last week, the total market capitalization of stablecoins surpassed $50 billion. Users need to store and transfer value on the public chain, so they need to continue to adopt this stable method.

• In the past 12 months, the trading volume of stablecoins has reached 1.5 trillion US dollars, and it will exceed 1 trillion US dollars in the first quarter of 2021 alone.

• There are many reasons why stablecoins will continue to be adopted:

• They are easily accepted as a payment method because only an address on the public chain is required

They offer users greater autonomy, privacy, and interoperability compared to existing payment solutions that require KYC and often restrict access

They are programmable, which makes it simple for developers to use them to build and deploy applications with global distribution

Whether it is a global financial giant adopting stablecoins as a payment technology, or an exchange that requires stablecoins as transaction collateral and specifies trading pairs, or Ethereum users are using stablecoins throughout DeFi, it is clear that stablecoins are creating real the value of. It is an indisputable fact that stablecoins are the killer application of public chains. Stablecoins are a better means of storing and moving dollars around the world.

tomorrow's market

While the size of the offshore dollar market (dollar deposits held outside the United States) is hard to estimate, data from the Bank for International Settlements (BIS) suggests it could exceed $57 trillion. It might sound crazy, but this is the market where stablecoins are starting to eat away.

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(Source: Zero Hedge)

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Problems with current stablecoins

While stablecoins have seen a lot of adoption in crypto circles so far and are in good shape so far, they are far from perfect. Currently, the leading stablecoins by market capitalization are centralized (like USDT) and holders face censorship, seizure and counterparty risk.

Censorship of transactions and seizure of assets (albeit justified in some cases) are worrisome. It contradicts many properties of public blockchain assets, such as permissionless access, resistance to censorship, and resistance to seizure. While there have been few examples of these happening so far, with the development of stablecoins inevitably facing more pressure from governments around the world, it is safe to assume that the pressure to adopt these measures will increase."Counterparty risk also compromises the uniqueness of public blockchain assets. A stablecoin backed by a single issuer exposes holders to potential solvency risk should the issuer run into any trouble. The potential negative impact of single-issuer or semi-centralized stablecoins could become systemic as stablecoin adoption eats into their multi-trillion dollar addressable markets."Not only are the aforementioned properties of centralized stablecoins against the spirit of cryptocurrencies, but practically speaking, these stablecoins are less socially scalable. Social scalability is important because the more trust there is in using a stablecoin, the less dependent users will be on it. Decentralization is not just an ideal. It literally allows the blockchain to work its best for the broadest range of individuals and businesses around the world, because it reduces the level of trust everyone needs to rely on a system. While not all systems need to be decentralized, the financial system -- more broadly

money

--Need to decentralize.

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Decentralized Stablecoins Today

Fortunately, the industry has produced decentralized alternatives and grown considerably so far. The Dai issued by the market leader MakerDAO has been launched in December 2017 and has been in operation for more than three years. There has been no serious decoupling (there has been a temporary slight deviation). During this period, Dai experienced the brutal bear market in 2018, many currencies including Ethereum plummeted by more than 90%, and Black Thursday (March 12, 2020), many currencies plummeted by more than 50% in a single day, but Dai survived. Dai is also the most liquid decentralized stable currency and the most widely used currency, which can be used in both CeFi (such as Coinbase) and DeFi scenarios.

Since Dai is so powerful, why do we need algorithmic stablecoins?

Well, Dai is not perfect. Let's start with a quick recap of how MakerDAO works. At its core, Maker is a lending protocol, and Dai is issued as a by-product of lending demand. Dai circulates by borrowing (Dai) against collateral (usually ETH) that users deposit into Maker vaults. These loans are over-collateralized to ensure that even if the price of the asset backing Dai suddenly drops sharply, Dai will always be backed by collateral. Maker regulates the amount of Dai in circulation by adjusting the loan interest rate, thereby affecting the price of Dai.

Maker's model introduces some problems. For one, it's not capital efficient. Every dollar of DAI will always require more than $1 worth of funding to back it, making for a very capital-intensive system that makes it difficult for Dai to scale as demand grows. The problem is that when Dai is above its anchor, arbitrage cannot take place because there is no 1:1 convertibility between Dai and its collateral. When Dai rises above $1, users need to invest more than $1 (say, $1.5) to mint $1 worth of Dai. Also, in the same arbitrage scenario, once a user mints and sells their Dai, they are still stuck in debt, which they need to repay in order to get their collateral back. This makes it impossible for Dai to arbitrage in a closed loop like Tether, which provides simple 1:1 convertibility of USD 1 and USDT in a bank account.

This is not theory, this is reality. On Black Thursday, when investors were both fleeing to Dai to protect against volatility, and buying Dai to pay off their Vaults (CDPs) on the brink of liquidation (due to plummeting ETH prices and increased collateral requirements), the price of Dai rose significantly during the day. At one point, it swelled by as much as 40%. Maker finally had to bring in USDC as collateral to restore the peg, which has not been restored until three months later. Later, Combound started liquid mining, and the miners piled up Dai there to mine COMP. Dai was also much higher than its anchor price within a few months, and the circulation could not keep up with the demand."share "The Maker community is well aware of these problems and has since introduced some solutions, such as its Peg stabilization module. But the current situation is that Dai will not scale with the demand for Dai, but with the demand for leverage.

The second most promising decentralized stablecoin solution is Terra, an application-specific blockchain built using the Cosmos SDK specifically designed to deliver algorithmic stablecoins. Terra’s UST stablecoin has quickly become the second largest decentralized stablecoin in the industry since building a bridge to Ethereum and launching liquidity mining for its new synthetic asset protocol, Mirror.

The token LUNA has real intrinsic value in the form of Terra transaction fees. This intrinsic value essentially provides a support for the system, as participants are theoretically more willing to burn stablecoins for LUNA when the stablecoin is below the anchor point than as a pure volatility absorbing token. But if Terra's transaction fees are what ultimately support Terra's stablecoin, then if Terra's stablecoin grows much faster than Terra's transaction fees, it's hard to say how big this scale will be (Terra has an opinion on the daily UST issuance for this reason. quantity is limited).

Also, unlike Dai, which inherits the security of Ethereum, Terra, as an independent blockchain, must build its own security. That's fine, but considering Terra validators are primarily fee-incentivized (no inflation rewards), it's hard to imagine it being as secure as Ethereum. The security of Ethereum is guaranteed by miners (and ultimately POS verifiers), and the incentives for miners are not only fees, but also scarce monetary assets. Not to mention that most Terra validators are running nodes on AWS.

Against this background, it is not difficult to see that although existing solutions are solid, there is still room for improvement.

first level title"A Note on Cryptococular Stabilisation: Seigniorage Shares"The main problem with the latest generation of algorithmic stablecoins is that they are effectively like Ponzi schemes. I know this is a provocative statement, but let me explain."shares"Most of today's first-generation algorithmic stablecoins, such as ESD, DSD, and Basis Cash, can be traced back to a paper written by Robert Sams in 2014 titled

shares

holder. When the stablecoin price falls below $1.00 (shrinkage), the stablecoin is removed from circulation by burning the stablecoin in exchange for new shares. What this model does effectively is to differentiate the system into speculative assets that absorb all volatility and stable assets that act as stable objects.

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Create an algorithmic stablecoin

secondary title"shares"When you stop and think about it, algorithmic stablecoins aren't really unbacked, they're backed by belief in the system. in the system"death spiral"shares"Has a dual role, one is to collect seigniorage, and the other is to provide support for the system when it shrinks. However, shares only have value as long as the system continues to operate and shares receive new issuance. This creates some problems. The main thing is that during a contraction, there is a chance that no one will want to support the system, and the lack of participation can be caused by an imbalance between supply and demand". The math behind these crashes is simple. The value of the stock is the net present value of the future growth of the system, and a large number of redemptions lead to a loss of confidence and value, causing both "stocks" and stablecoins to fall. Algorithmic stablecoins without collateral can only rely on

lender of last resort

Come to the rescue, basically users (coin holders) come forward to save the system. If no one takes action, the system and the stablecoin will continue the death spiral.

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Stablecoin distribution

This stablecoin distribution problem is not only detrimental to price pegs, but also detrimental to the wealth distribution of the project. The early minting DAO participants actually obtained the power to permanently control the newly issued tokens of the system, making the distribution of stable coins centralized. This is a bad start for a stablecoin hoping for widespread adoption. Extremely centralized stablecoin distribution makes the stablecoin system more vulnerable to supply shocks.

These three issues combined make these algorithmic stablecoins akin to Ponzi schemes. The motivation of participants to buy these stablecoins is not because they are useful, but because they want to chase the high returns of these stablecoins by expanding their usage. And these expansions are not motivated by the real use demand of stablecoins, but just to speculate on the growth of stablecoins. It's all just a cyclical game of speculation, and when these stablecoins are no longer "stable," the losers are the ones stuck.

Anyway, like The Emperor's New Clothes, the emperor doesn't actually wear clothes.

first level title"Renaissance"The holy grail of stablecoins is a stablecoin that is decentralized, scalable, capital efficient, and has minimal governance. Ahead of 2021, we've seen stablecoins attempt to achieve this ideal with over-collateralization on one end and purely algorithmic mechanisms on the other. However, as discussed above, the problem is that over-collateralized stablecoins (like Dai) are capital inefficient and not scalable, while purely algorithmic stablecoins (like ESD) are simply unstable. But what if there was something in between that could achieve the goals of decentralization, scalability, capital efficiency, and minimal governance?

partial reserve

Will contribute to the stability of algorithmic stablecoins during deflationary periods, providing stablecoin holders with 1:1 convertibility between stablecoins and underlying collateral, and providing more pegged confidence than pure algorithmic models.

There are many different ways to implement this idea, so below we highlight three of the most promising projects.

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• FRAX--New School Leader

Launched in December 2020, Frax pioneered the fractional-collateralized algorithmic stablecoin model. The Frax stablecoin system consists of two tokens and a pool contract (Collateral Vault) that holds collateral (initially only USDC). These two tokens are:

FRAX - Aims to be a $1.00 stablecoin with an algorithmically adjusted supply based on demand:"Frax Stake (FXS) - Governance token that generates fees and minting revenue, and partially collateralizes the protocol"Frax has been remarkably stable since launch, in large part because it is easy for traders to arbitrage when FRAX breaks off its peg. Frax is designed so that FRAX can be minted and redeemed for $1 at any time, even though it is only partially collateralized. When the price of FRAX is above $1, users can deposit a value of $1 into the system to mint new FRAX.

When the price of FRAX falls below $1, users can exchange FRAX from the system for a value of $1. The question is what asset is made up of the value of $1 that a user deposits or redeems from the system? This consistency is constantly changing, depending on a

collateral ratio

, this ratio determines the proportion of collateral and FXS in this $1 value. Simply understand, the FXS part is the algorithm ratio of FRAX, and the collateral part (currently USDC) is the mortgage ratio of FRAX.

To date, Frax has burned over 4 million FXS since its launch. Below is the change in collateral ratio over time and its impact on FXS burn.

Until February, the collateral ratio was adjusted depending on whether the supply of FRAX was expanding or contracting. When FRAX expands, the system will reduce the collateral ratio required to mint FRAX, which will reduce the collateral ratio and increase the ratio backed by FXS in the system. When the system is shrinking, it will increase the collateral ratio required to mint FRAX, thereby increasing the collateral ratio and reducing the system ratio supported by FXS. This ratio is adjusted every hour in increments of 0.25%.

"The collateral ratio has since changed and is now controlled by a PIDController that adjusts the collateral ratio based on a growth ratio that measures FXS liquidity compared to the total FRAX supply." 

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(Source: Frax Website)

The rationale is that the higher the growth ratio, the more FRAX can be redeemed with a smaller overall percentage change in FXS supply. If redeemers sell the FXS they minted from the redeemed FRAX, the higher growth rate means that the price of FXS will slide less, reducing the possibility of any bad negative feedback loops.

In other words, the system is designed to ensure that when it issues FXS, the market has enough liquidity to absorb the new FXS without much slippage assuming the FXS are immediately dumped. As FXS liquidity grows relative to FRAX supply, collateral ratios decrease.

This change in how collateralization ratios are calculated is in part a response to the activity seen over the 10-day period between January 18th and January 28th, as users redeemed their underlying collateral with $50 million in FRAX , and sold FXS in deep illiquidity, the price of FXS plummeted by nearly 90%. At that time, the initial FRAX publicity and liquidity incentives led to a rapid expansion of the FRAX supply, reaching a peak of 135 million US dollars, while the circulating supply of FXS was about 2 million at the time of creation. As more and more FXS were mined and sold, the price dropped, and then as BTC fell from $40,000 to $30,000, the selloff of FXS was even greater. This begins the redemption cycle of FRAX as users quit mining.

However, it needs to be emphasized that throughout the panic, the price peg situation has been acceptable, which is also a good result of Frax's first test."(Source: Alexis Direr)"and"One thing you might be wondering after reading the explanation above is what happens to Frax’s existing collateral when the collateral ratio changes. Sometimes a protocol will have too much or too little collateral relative to its current collateral ratio. In this case, Frax must either convert excess collateral into FXS for burning (distributing value to FXS holders), or increase the amount of collateral in the system. For these cases, Frax employs two special swap functions called"。

repurchase

and

remortgage

When the system is undercollateralized relative to its collateral ratio, Frax allows anyone to increase the amount of additional collateral required in exchange for new FXS plus a 0.75% reward rate. The opposite happens when there is excess collateral in the system, Frax allows any FXS holder to call the buyback function to exchange the excess collateral value in the system for FXS, which is then burned by the protocol. Like any FXS that is burned, this value is effectively redistributed to all FXS holders.

When it comes to the value accumulation of FXS, there are many ways to accumulate the value of FXS besides coinage. First, every minting and redemption will incur fees for FXS holders. Currently, the minting fee is set at 0.2%, while the redemption fee is set at 0.45%.

In addition to charging acceptance fees, Frax’s other important billing method is to put its idle collateral into use. Instead of just letting its collateral sit idle in contracts, Frax puts it to work in DeFi. While Frax does not optimize for yield, but for security, Frax still earns about $3.5 million in interest on its collateral across all deposits.

So what's next for Frax?

First it plans to eventually integrate ETH as collateral so it can wean off centralized collateral. The Frax team realized that it could not claim to be a decentralized stablecoin if the primary collateral backing the stablecoin was centralized. An interesting idea of ​​how Frax introduces volatility collateral involves using a perfectly hedged asset pair, such as a 50:50 combination of sETH (synthetic ETH) and iETH (synthetic inverse ETH) from Synthetix, or some other A combination of futures and options on a hedged, non-synthetic asset.

To sum up, Frax essentially uses market forces to algorithmically calculate how much stablecoin FRAX should be, and how much should be collateralized. Frax does not assume that the market wants or needs a 0% collateralized stablecoin, but lets the market decide.

Frax's prospects for future development will depend on its performance and market strategy in the crisis. Stability in good times is only part of it, and the easiest part of building a stablecoin. The second part is showing resilience in cycles over time. Also, while Frax’s FXS burn was impressive, Maker’s March rehypothecation event taught us that accumulated burns can be reversed by crises in a single day. This also tells us that, like MKR, FXS ultimately depends on the buyer of last resort of FXS when the crisis is severe. Finally, and on a related note, Frax also needs to find a way to incentivize liquidity in the long run once the inflation reward is exhausted. Its collateral ratio can only increase as long as FXS liquidity increases relative to FRAX supply, so FXS liquidity may be a limiting factor in FRAX's need to gradually reduce collateral over time.

Furthermore, stability is only part of a stablecoin's success. If Frax is to grow, it needs to integrate with DeFi protocols to drive adoption, such as acceptance in the lending market, integration in yield strategies/vaults, use in liquidity pools, etc. If that’s not enough, it also needs to make headway in CeFi before it can challenge the dominance of mainstream stablecoins like USDT and USDC. By now the Frax team has delivered a promising product and now it is important to continue executing and bring Frax to market.

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ESD--Transfer

Empty Set Dollar (ESD) was founded and launched fairly in August 2020 by an anonymous developer team, and is the leader of the new algorithmic stablecoin movement that swept the industry in the fourth quarter of 2020. Within three months of its launch, its market capitalization skyrocketed to over $550 million, its earliest community grew, and it attracted the attention of many talented people in DeFi who were impressed by the potential of algorithmic stablecoins.

However, at the same time as its rise, ESD fell as its stability model proved to be fundamentally flawed and participants lost confidence in the peg.

But the ESD story isn't over yet. An early failure is not a death sentence for it. There are many DeFi protocols, including Aave and Synthetix, which we now regard as blue chips, had a rough start. The lesson from both stories is that it doesn't matter that ESD's initial model of entry isn't perfect, what matters is that they have the right team and contributors to make the project a success, and that's the reality.

Today's ESD is a typical reversal. It's devastated, depressed, and getting closer to zero every day. Its first iteration, while ostensibly promising, failed and the community is now re-architecting the protocol. Whether ESD will be successful will ultimately depend on the community's ability to execute turnaround plans.

We covered many of the pitfalls of ESD in the section above on general issues with purely algorithmic stablecoins, so we won’t spend too much time repeating these arguments. However, before we delve into how ESD seeks to turn things around, it's worth a quick review of how ESD currently works and what its specific problems are.

In its current state, ESD is mainly composed of DAOs, liquidity providers, and token holders. The entire system works with only one token, which is both the stable "dollar" and the protocol's governance token. It expands and contracts its supply around a time-weighted average price (TWAP) oracle that incentivizes trading pools on Uniswap. It works as follows:"couponing "Unlike the seigniorage rewards of traditional stablecoins, ESD distributes seigniorage to DAO members and liquidity providers (LPs). When the price of ESD rises above $1, the system will allocate new ESD to the following groups: 77.5% to DAO, 20% to LP, and 2.5% to ESD vault. These expansions occur every 8 hours, during which time the supply expansion is limited to 3%.

To receive minting rewards as a DAO staker or LP, users must stake their ESD or LP shares respectively. Users who want to participate in the DAO must lock their ESD in order to obtain EDS shares (Empty Set Dollar Stake, ESDS), which is a non-transferable restricted token that represents the user's equity in the DAO. Once in the DAO, users will face an exit period of 15 epochs (5 days) if they want to unlock from the DAO. For LPs, it's as simple as providing liquidity to Uniswap, instead of taking shares through ESD's reward pool interface. Similarly, if LPs want to remove their liquidity, they also face an exit period of 5 epochs (about 1.67 days). In theory, once these groups receive new ESD, they will sell the ESD to bring the price back down to $1, this has not worked out very well in practice, as discussed below.

When ESD is below $1 and in contraction, ESD incentivizes users to use

The system removes ESD from circulation. Essentially, the protocol provides an incentive for users to burn their ESD (remove it from circulation) in exchange for a debt-like instrument called a coupon, once the protocol eventually goes into expansion Period, you can exchange ESD. When ESD has unused coupons when it enters the expansion, it will distribute 77.5% of its expansion rewards to coupon holders for redemption, 20% to LPs, and 2.5% to the ESD treasury. One thing you may have noticed is that LPs are always incentivized, this is to ensure the stability of liquidity even in contractions (that being said, in the end this was not the case).

The incentive to buy the coupon is based on a premium that is determined by when and how much the ESD falls below the peg point. The premium essentially allows users to burn their ESD in exchange for the right to get more ESD when the ESD re-expands. The initial risk, at least until subsequent adjustments, is that these coupons will expire if the ESD does not resume expansion within a certain period."bradley "There are some problems with the initial design of ESD. First, DAO stakers received new issuances but were slow to enter circulation. In fact, many stakers never put their rewards into circulation, but simply let their stake compound with new issuances, enabling them to earn more rewards as the system grows. So while the supply of ESD is expanding in response to the price being above its anchor price, the new supply has no direct impact on the price as it is not actually being sold into the market.

The problem of ESD below the anchor point is even more serious. Not only is the coupon mechanism flawed: users are not provided with any incentives to burn ESD immediately and support prices, thus causing a tragedy of public resources, and ESD’s DAO and liquidity incentives are also problematic. When ESD enters the expansion and there are no coupons to redeem, and when the price of ESD falls below $1, the liquidity becomes poor, an ESD community member

"These issues were clearly summarized in a January forum post.

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- bradley

Source: Dune Analytics

The black arrows indicate the mass withdrawal of members from the DAO on Jan. 1, which happened to be 5 days after TWAP fell below $1 on Dec. 27. This correlates perfectly with the 15 epoch waiting period for funds to transfer from bongding to liquid in the DAO. At the same time, it is noted that this large-scale exit from the DAO occurred in the context of poor liquidity. In fact, after TWAP<1 on December 27, liquidity immediately began to drop.

As mentioned earlier, this is all made worse by the fact that Uniswap does not price stablecoin pairs ideally and amplifies the volatility of stablecoins. In hindsight 20/20 was a disastrous "recipe". Obviously, when you consider that ESD now has $500 million in ESD in circulation, 85% below its peg, has nearly $50 million in coupons to repay, and has lost any confidence in its peg, it makes sense why ESD will be in trouble.

So what's next for ESD? Unsurprisingly, rather than attempting to save itself from this impossible pit, the community is more likely to quickly vote to reset the entire system and migrate to a new two-token model called Continuous ESD - a new two-token model in many ways. A partial collateral algorithm stablecoin system similar to Frax.

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• Source: ESD Blog

• In the coming months, ESD will migrate to a new dual-token model that will consist of ESDS (this time as a transferable governance token and seigniorage share) and ESD. The exchange rate between ESD v1 and ESDS in ContinuousESD will be determined some time before launch. The immediate advantages of migrating to the new dual-token model are:

Decoupling the incentive to lock circulating ESD from the growth of ESD

Decoupling Governance from Locking Circulating ESD Supply"RR USDC"Make it easier for existing ESD holders to reset the system (issuing ESD from scratch) while having equal ownership in the protocol

The new mode is a complete overhaul of ESD. No more DAOs, lockups, epochs, coupons or lack of collateral. As mentioned before, the new system is similar to Frax in many ways. At the core of the new system is a reserve owned by the protocol, which is the main stabilization mechanism for sustained ESD.

• When the price of ESD is above $1 and its supply needs to expand, any user can mint ESD by depositing 1 USDC into the reserve (USDC will be the initial collateral type). When the price of ESD is less than $1, ESD can be burned in exchange for

• --Reserve ratio*1 USDC. At launch, this ratio will be set at 1.00, so ESD will effectively be fully collateralized by USDC; however, the goal is for governance to slowly reduce this ratio over time as it tests and proves its secondary stability mechanism.

• The role of ESDS is to serve as the acceptance share of the agreement, supporting collateral and governance tokens. When the reserve ratio is higher than its target, ESDS can be bought and then burned by the reserve. Reserve ratios are typically higher than their targets because:

Income from ESD issuance (eg: new ESD is issued for $1 USDC when the collateralization ratio is 0.88, in which case the reserve will buy $0.12 of ESD, then burn it)

Reserve managed yield (like Frax, ESD will use reserve assets for DeFi, initially for Compound)

Growth of reserve investment (Eventually ESD will increase non-stable reserves such as ETH, which may increase in value making ESD's RR rise above the target)

Continuous ESD will perform this buying and burning aggregated, rather than on a single build like Frax. Additionally, ESD can mint and sell reserve assets when the reserve falls below its target.

At launch, all of these processes will be performed manually by governance; however, the ESD program will eventually automate these processes.

In theory, since Frax always guarantees $1 redemption, in a panic of FXS price drops, FRAX holders may rush to redeem their FXS so they can be the first to sell, because They know that the last holders of FRAX cannot redeem their FRAX for $1. Of course, this situation is extreme, and as said before, Frax has since changed their collateral ratio mechanism to better deal with this situation. In theory, ESD removes this dynamic—that is, the incentive for people to redeem early in the event of a bank run—by ensuring everyone gets an equal redemption value.

In addition, ESD has auxiliary stabilization mechanisms to deal with the situation below 1 dollar. The first experimental mechanism will use a stability pool, which will incentivize (or disincentive) users to temporarily withdraw ESD from circulation. The stable pool will function like a savings account, with a floating interest rate that will be determined according to a curve, with interest accruing in real time and instantly redeemable. The ESD used to reward interest will be minted by the system, after which the reserve will buy back from the market and burn an equal amount of ESD, so that the circulating supply will not increase. A word of caution; however this is highly experimental and may in some respects succumb to similar issues of its previous coupon system. Perhaps the recently proposed alternative model "below sales tax" by Delphi would be more promising.

This is a brief description of Continuous ESD.

image description

After the first rough iteration of ESD, the rollout of Continuous ESD will be very methodical, with stabilization mechanisms and governance gradually tested out and automated over time. The ESS (core team) has been developing Continuous ESD since the beginning of 2021 and will be audited in the late Q1. Governance approvals are still in progress and governance will involve a series of pre-migration proposals, after which Continuous ESD will launch early in Q2.

The next few months will be critical to the success of the ESD transition. Continuous ESD will be backed by 100% USDC and will undoubtedly produce a stable ESD at launch, but if ESD is to truly become a decentralized stablecoin, it will eventually need to shed its reliance on USDC. Also, like Frax, aside from stability, the success of ESD will ultimately come down to its ability to integrate in DeFi and even CeFi and beyond. In this regard, ESD’s community will be an important advantage considering that it has many top funds and DeFi experts in its ranks.

With its thoughtful and cautious launch, ESD will not return to the top position of the algorithmic stablecoin world overnight. And that could give FRAX a window to extend its lead while it continues to execute and prove its model. But if the community is valuable, ESD's turnaround plan may be well developed.

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The Fei protocol, which will be launched at the end of Q1, introduces a new decentralized stablecoin model that partially collateralizes Ethereum. As you can see at the end of its white paper, Fei has attracted the attention of many of the brightest minds in DeFi, largely because of its promise to launch a scalable decentralized stablecoin backed by trustless collateral (Ethereum) currency. At the core of Fei are two concepts: protocol control value and direct incentives.

Protocol Control Value (PCV) refers to the fact that when users mint new FEI (stablecoins), the protocol takes ownership of the collateral it receives. FEI cannot be redeemed to get back the underlying collateral. This is in stark contrast to every other collateral-based decentralized stablecoin, including partially-collateralized stablecoins like FRAX and ESD (in serial ESD), and over-collateralized stablecoins like Dai, which is redeemable. Back to collateral.

FEI is sold according to the bonding curve and enters circulation in this way. When the price of Fei rises above $1.01, users can buy FEI from the bonding curve. At launch, the project will only support one bonding curve denominated in ETH, meaning users can only buy FEI with ETH; however, it eventually plans to support more curves denominated in other ERC-20 tokens. Assets deposited into the bonding curve are not redeemable and are owned by the protocol in perpetuity (this is why FEI cannot redeem its underlying collateral)."image description"Source: Fei Protocol Blog

To bootstrap growth, the protocol will allow users to mint FEI from the ETH bonding curve at discounts starting at $0.5 and growing at a sub-linear rate based on supply until a target is reached. this is called

The target supply of FEI will be set at 100 million FEI, which the Fei team believes will be large enough to integrate with other DeFi protocols. Once Fei reaches its target supply, at which point 1 USD of ETH will mint 1 FEI, then a buffer will be added to the curve (initially set at 1%) to provide room for price changes above USD 1 for all transactions Does not happen below the anchor point.

Bonding curves are smart for a number of reasons. The first is that, with strong incentives to mint FEI (you can basically buy $1 for less than $1), it will likely lead to supply very quickly and become the largest algorithm on the market One of the stablecoins. The second is that since the bonding curve is unidirectional, it will create a very large reserve that is owned by the protocol and may be put to use.

The second, and probably the most important, reason for saying bonding curves are smart is what Fei can do with the capital it raises from bonding curves. As previously mentioned, Fei retains the ETH raised through the bonding curve as protocol control value (PCV). Fei will initially use 100% of its PCV to provide liquidity to the FEI/ETH Uniswap pool, creating a liquid secondary market for FEI. To obtain the FEI needed for liquidity, the protocol will mint the FEI it owns. This additional FEI will be paired with every FEI purchased by users along the bonding curve, making the Uniswap market as deep as the circulating supply of FEI.

image description"Source: Fei Protocol Blog"Fei Protocol has many advantages as the main liquidity provider for FEI. The first is that it guarantees and controls the liquidity of FEI. Unlike the aforementioned algorithmic stablecoin protocols that allocate governance token inflation to incentivize third parties to provide liquidity for their stablecoins, the Fei protocol provides liquidity itself. Holders of FEI do not need to worry about the exhaustion of the incentive mechanism or the withdrawal of liquidity by giant whales in extreme events.

"In addition, Fei Protocol, as the main liquidity provider of FEI, can use a method called"

mechanism to stabilize the FEI. The description of direct incentives in the white paper is as follows.

Directly incentivizing stablecoins means that both transaction activities and the use of stablecoins are incentivized, and rewards and punishments will push the price towards the anchoring direction. Generally, this will include at least one incentivized exchange at the center. All other exchanges and secondary markets can arbitrage with Incentive Exchange. This helps maintain the anchor of the entire ecosystem.

How this works in practice is that when FEI is below the anchor, Fei provides a disincentive to sell below the anchor while providing an incentive to buy below the anchor. When traders sell FEI below the anchor point, a portion of their FEI is burned. When traders buy FEI below the anchor price, they will receive freshly minted FEI. These mints and burns apply directly to the trader's balance, proportional to the distance of the FEI from the anchor point. Incentives are enforced by the protocol by building functionality into FEI that states that a subset of transactions that interact with incentive addresses (in this case, the Uniswap liquidity pools that users transact with) will affect their wallet balances.

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Source: Fei Protocol Blog

The burn rate for selling below the anchor point will be proportional to the square of the price deviation and the size of the sell order. Conversely, the burn rate for buying below the anchor will be proportional to how far the price deviates, the size of the buy order, and when (in blocks) the anchor was last at $1. The formula used ensures that volatility below the peg is net deflationary.

However, the incentives described above are not guaranteed to bring FEI back to anchor. Given enough time for the minting reward to equalize the disincentives for burning (remember, the minting reward gets stronger over time), the protocol will open up functionality (any user can trigger a function, and rewarded for doing so) to support the price using the PCV Controller (a contract that approves withdrawals and reweighting of PCV from Uniswap).

Basically in the long-term below the anchor point, the Fei protocol can use its PCV to buy back FEI from the market and burn FEI. It does so by performing the following atomic transactions:

2. Use the withdrawn ETH to buy FEI from the remaining third-party liquidity to restore the peg status

3. Re-provide remaining protocol-owned value to Uniswap

4. Burn excess FEI

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• Source: Fei Protocol Blog

• The Fei Protocol will launch on day one with a DAO that will be controlled by TRIBE - the governance token of the Fei Protocol. While Fei aims to minimize governance and FEI will be primarily algorithmically stable, TRIBE holders will have governance over the following things:

Adjust the allocation of PCV to new or existing funds (Fei may use PCV in other protocols besides Uniswap, such as Compound and Aave).

Adjust or change protocol parameters, such as its direct incentive mechanism;

According to the team’s latest blog post, it is also possible that Fei could eventually leverage TRIBE to implement an out-of-pocket support mechanism for Fei, which would function similarly to Maker’s MKR debt auction, where MKR is minted and sold to support the protocol.

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Fei looks promising on paper, and its concept of protocol-controlled value could open up a new world for on-chain central banks. Fei will be the only algorithmic stablecoin protocol with trust-minimized collateral, which may provide it with additional credibility as a truly decentralized stablecoin.

However, as Fei tries to prove its stability, ETH collateral will also be a major focus. It is unclear how well Fei would perform in the unlikely event that Fei’s collateral value plummets, and whether weight rebalancing and direct incentives would be sufficient. Theoretically, under such circumstances, Fei may need to repeatedly adjust the weight to restore pg, but it will be very slow, because it takes a period of time (a few days each time) to adjust the weight, during which direct incentives will help burn FEI. Also, if this is not the case, there will be time for governance to intervene, perhaps in the form of a TRIBE support agreement.

Ultimately, similar to Continuous ESD, Fei's success in achieving stability will be reflected in its ability to integrate DeFi, CeFi, and other aspects. Fei's emphasis on the community should help in this regard, as mentioned at the beginning of this section, many of the big names in DeFi that might help it grow are helping Fei. As Fei founder Joey shared in a recent AMA, Fei has Robert and Stani among its partners and investors, which may allow it to gain significant integrations with Aave and Compound shortly after launch for practical use. Sex drives demand.

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