The Anchor Paradox of Decentralised Stablecoins
You may have the ability to issue a token with a value higher than one U.S. dollar, but it's almost impossible to create a token that is both stable and exchanges 1:1 with the U.S. dollar, because the underlying logic is different.
Like a ship sailing on the ocean, to make it go faster, you only need to research the technology involved with the ship itself. But to keep the ship anchored in one place, you must use an anchor. Stablecoins need an anchor. The importance of on-chain stablecoins to public blockchains is self-evident.
Traders don't want all their on-chain assets to be in constant fluctuation; they need a type of token as a safe haven asset, and also a more universal and stable currency for pricing. In the early days, the pricing currency for trading pairs was usually BTC. To calculate the purchasing power changes of the held tokens, you had to consider the fluctuations of both the target token and the pricing token. Due to the single limitation of the trading pair, this also brought greater volatility to the token. Nowadays, stablecoins have become the main pricing currency.
Futures trading is a more intuitive example: since FIAT was introduced into futures trading, it quickly became the mainstream, occupying almost all the market of futures contracts priced in BTC/ETH. In widespread use, centralized stablecoins still occupy most of the market to date. The total value of centralized stablecoins circulating on the chain now exceeds one hundred billion U.S. dollars.
The issuance method of centralized stablecoins, in principle, is similar to many countries that use a linked exchange rate with the U.S. dollar: deposit U.S. dollars and issue an equivalent token. The U.S. dollar itself is the anchor of centralized FIAT, issued at a fixed ratio (for U.S. dollar stablecoins, it is 1:1), and market supply and demand have minimal impact on its exchange rate.
Among several mainstream FIATs---USDT/USDC/BUSD, there are differences: USDT is the oldest stablecoin issued by Tether, but its financial report is not public, posing a credit risk; USDC is a stablecoin issued by Circle, whose accounts are regulated by the U.S. government; BUSD is a stablecoin jointly issued by Binance and trust institutions, also regulated, with a 100% reserve rate---funds are not used for any investment other than reserves.
Of course, practitioners have never given up on researching decentralized stablecoins. Practically speaking, the issuance of centralized stablecoins always lacks resistance to censorship, as they are issued by centralized institutions, which contradicts Satoshi Nakamoto's concept. The current situation is that regulatory bodies are very strict with stablecoin issuing companies—they must block certain accounts if the regulators demand it. Cryptographic native, purely decentralized, these concepts are inherently attractive.
So far, there are two types of anchors for decentralized cryptocurrencies: supply-demand anchors and collateral anchors, each with its representatives: MakerDAO and its stablecoin DAI, and LUNA and its stablecoin UST. LUNA is a failed algorithmic stablecoin. However, it was a project that once operated successfully for a certain period and had a high market value. MakerDAO is still running steadily, but it also has systemic risks.
Here, I prefer to set aside the results-oriented view of the current node and systematically analyze decentralized stablecoins from a more underlying perspective, summarizing past failures, revealing current potential risks, and providing ideas for more reasonable decentralized stablecoins, as well as a basis for judging emerging stablecoin projects in the future.
Let's first introduce the two types of anchors.
The general logic of the collateral anchor is to use the collateral (mainstream currency) as an anchor and the governance coin's supply and demand adjustment as a buffer. The algorithmic stablecoin issuance method of the collateral anchor is similar to lending, so MakerDAO is often interpreted as a lending protocol. In MakerDAO, there is no real borrower; each borrowing smart contract prints new DAI, and DAI is destroyed every time it is repaid. Compared to traditional finance, MakerDAO's logic can be compared to directly mortgaging with the central bank—although this business does not actually exist.
Under normal circumstances, the collateral anchor always follows the principle that the market value of the collateral is greater than the total amount of stablecoins issued— for MakerDAO, each address has its own Vault, and each Vault needs to ensure that the value of its collateral is greater than the total amount of DAI; Synthetic adopts a global pool strategy, where all stakers jointly bear the fluctuation of the total pool.
When the value of a Vault is below the liquidation line (usually 150%-200% for BTC/ETH), liquidators can use an equal amount of DAI borrowed from that Vault to liquidate it and earn a penalty. If there is any remainder, it will be obtained by the mortgagor. This ensures under normal circumstances that the total amount of DAI on the market is always less than the price of the collateral, with the formula: This almost solves most problems, except for black swan events.
At this time, we need a buffer. The buffer means that in the face of extreme market conditions, this strategy can mitigate the situation, but it is powerless against a fundamental collapse. MakerDAO will face a situation during a black swan event where the liquidity provided by liquidators is insufficient in a rapid decline, causing the collateral to ultimately be unable to be liquidated even when its value is below.
At this time, MakerDAO's strategy is to issue additional MKR and sell it in the market to make up for these differences. This is the risk borne by MKR holders. So we can update a formula: Where R assumes a constant of the theoretical impact of each newly issued MKR on its price (Reduction). This makes the entire system more robust, but is this solution foolproof? The answer is no.
Let's assume a situation: when the collateral plummets rapidly, its price is far lower than the already issued DAI. And at this time, the market funds available to buy MKR may be less than this difference, so in any case, the following situation will occur: Then, even if MKR is issued for debt auction, it will not be able to make up for these differences. In fact, if MakerDAO embeds this strategy in a smart contract, it will ultimately lead to the infinite issuance of MKR and its infinite price drop. Does this look familiar? Why does the theoretical impact of MKR in extreme situations seem to converge with LUNA's? Let's first understand the supply-demand anchor.
The supply-demand anchor is the opposite of the collateral anchor: the anchor is the supply and demand adjustment of the governance coin, and the buffer is the mainstream cryptocurrency treasury. The logic of the supply-demand anchor can be simply compared: many countries' currencies will try to maintain an exchange rate with the U.S. dollar over a certain period to maintain the stability of international trade. These countries will choose the same monetary policy as the United States: when the U.S. dollar is issued more, it will also be issued more; when the U.S. dollar is tightened, it will also be tightened to constantly achieve a balance in the currency supply-demand relationship.
The algorithmic stablecoin based on the supply
-demand anchor logic is more intuitive: for example, LUNA, when UST fluctuates in exchange rate with the U.S. dollar, users can directly exchange the same amount of UST (or exchange through the same amount of UST) based on LUNA's current exchange rate with the U.S. dollar. Arbitrageurs can exchange LUNA for UST and sell it to realize arbitrage when the UST price is higher than the U.S. dollar until the UST price equals the U.S. dollar and loses arbitrage space; similarly, when the UST price is lower than the U.S. dollar, they can buy UST to exchange for LUNA and then sell it.
In practice, these exchanges and arbitrage actions actually increase/decrease the issuance of UST and directly sell/buy back UST. Arbitrageurs act as the "central bank" executing monetary policy decisions. Obviously, such a system is more unstable than the collateral anchor, so it needs a mainstream cryptocurrency treasury as a buffer. When severe de-anchoring occurs (usually during market crashes), LUNA's LFG (LUNA Foundation Guardian, LUNA Fund Defense) will maintain its price by purchasing UST with the profits from the bull market (BTC/ETH/USDT). At most, LFG held assets worth several billion U.S. dollars.
Lessons from Failure: Looking back at LUNA's failure, its aggressive strategy quickly increased its market value amid FOMO sentiment, but also increased risks. UST's collateral interest made UST's short-term demand surge rapidly, breaking the original supply-demand balance. In the bear market, the dual pressure of shorting and UST interest made LUNA unsustainable. On the other hand, the centralized control of LFG is suspected of not being fully used for market support, still facing centralized risks.
The logic of decentralized stablecoins is always less intuitive than that of centralized stablecoins—1:1 collateral in U.S. dollars to get stablecoins. It's more like issuing a certificate that can be used like U.S. dollars temporarily. Its usability precedes the self-consistency of theory. We have witnessed LUNA's steady-state collapse, and MKR obviously has stronger risk resistance.
Nevertheless, after abstracting the underlying logic, we can issue a risk warning for collateral anchor stablecoins represented by MKR—they are not always safe. It is safe now because it has good risk control—a relatively high liquidation line and no Ponzi-like high storage interest. If MKR adopts more aggressive strategies, such as a lower collateral rate for a higher capital utilization rate or also issues collateral interest strategies to attract more users, then MKR will also have a higher probability of crisis.
In fact, if LUNA had not adopted the method of releasing interest to forcibly increase demand or strictly controlled the treasury, it could have survived longer.
Anchor Paradox: The supply-demand anchor and the collateral anchor are essentially twins, inheriting two attributes of the treasury and supply-demand regulation, acting in different places. Apart from hype factors, the prices of MKR and LUNA are only positively correlated with the issuance volume of stablecoins, although the reasons are different: MKR's price increase comes from fees, and LUNA's price increase is anchored to the total capacity of UST. The intrinsic value of MKR and LUNA as governance coins is only related to the issuance volume of stablecoins; on the other hand, they are each other's anchors or buffers.
This mutually supportive and mutually fulfilling logical relationship contains a fundamental framework of the "Anchor Paradox"—like two ships throwing anchors onto each other's ships. This is why decentralized stablecoins spiral into collapse in extreme situations—the stable state fails and breaks through the buffer, causing the stablecoin and governance coin to simultaneously regress to zero.
Outlook for the Future: In fact, it is almost impossible to issue a decentralized U.S. dollar—if it were possible, the Federal Reserve might not be needed on Earth. Perhaps we need to think differently. Instead of issuing a U.S. dollar, we might need to make Bitcoin/Ethereum the mainstream pricing method.
We almost never use Bitcoin or Ethereum to buy anything—when you need to buy something, you first exchange it for fiat currency. Even if you try to buy goods, such as Tesla, which once supported Bitcoin payments, you first calculate the exchange rate between Bitcoin and the U.S. dollar, and then pay with Bitcoin, which is essentially still priced in U.S. dollars. Ethereum and Bitcoin are only used as pricing currencies in some token or NFT transactions.
To become more widely used as pricing currencies, these tokens need a higher price, a trillion-dollar-level market cap obviously cannot support the daily economic activities of people worldwide; and less volatility, for the stability of trade. So, instead of thinking about how to issue a U.S. dollar, we should actively participate in the construction of the cryptocurrency industry. Maybe in the future, Bitcoin and Ethereum will become something like stablecoins.
