Debase_explained

Mar 1, 2021

9 min read

Stabilizer Pool 4: Fractional Reserve and Hedging

Credit: Roger Deakins

This is Part 1 in a series of three articles explaining Stabilizer Pool 4 (SP4). The goal of SP4 is to build an algo-stable asset with collaterals and supporting expansionary policy with real asset-backed inflation. In this article, we will specifically discuss:

Overarching goal of Debaseconomics: creating a modular general strategy where we can add different tools during contraction or expansion of the monetary policy

Problems with Algorithmic Stablecoins

In general, algo-stables have two main functions: to expand their supply when they are overpriced and to contract when they are underpriced. The current methods of rebasing and coupons are being explored, but are met with some resistance in terms of time lag and real inflation.

Compared to alternatives like offchain-collateral stablecoins and onchain-collateral stablecoins, algo-stables see a wider deviation of value. The all time high and all time low of these assets are significantly lower than algo-stables.

On the other hand, algo-stables are showing huge spikes and volatility in pricing.

Crash course: what does the standard deviation value mean? It shows the volatility of prices. For a pegged asset, the lower the volatility (standard deviation), the better.

Whilst it is good to observe standard deviation as an independent metrics, it is also useful to expand that to the total market cap. The larger the market cap, the less impact of volatility, hence lower standard deviation.

Within the category of algo-stables, debase has a volatility index of 1.866 but considering a low market cap of over US$2 mil, that is better compared to other assets with higher market cap.

Between onchain collateral and algo-stable mechanisms, there is no doubt about certain biases in the data. For a start, USDC, USDT and DAI have existed for a longer period and achieved the low standard deviation in the last 90 days through many other activities. In addition, USDC, USDT and DAI are created against collaterals, with the initial purpose to be pegged at $1.

However, it is still noteworthy that algo-stables are valuable in their ability to change the supply to corresponding market activities. The mechanisms are still in their infancy.

Thus, merging both on-chain collateral (backed by assets) and algo mechanism (elasticity in supply without an underlying asset to back the value) can be useful in finding a balance between elasticity in token supply and price stability to an extent.

Capital Efficiency and Collateral Model

A problem with onchain collateral is capital efficiency.

How is an asset valued at $1 created onchain? It is through onchain collaterals. Users provide 150% of assets to mint $1 in value to be used. Each $1 minted is thus operating at a 66.7% capital efficiency of collaterals.

What if, we take the same 66.7% capital efficiency to back each $1 minted, using that as reserves and using the other 33.3% as capital to respond elastically to changes in market movement? There, we benefit from both on-chain collateral and algo mechanisms.

dStable: SP4 Mechanism

Introducing dStable, a stablecoin minted based on part collaterals and part algorithmic supply elasticity. The stablecoin of DEBASE will still exist, and it interacts with SP4 as part of the assets.

TLDR_ELI5: Think of SP4 as a cookie jar. Everyone adds cookies (ETH + DEBASE) to the cookie jar. Part of the cookie jar is kept as reserves. The rest is sold for a profit. With the profits, we buy ingredients to make more cookies. The owners of the cookie jar can get more cookies than the original cookies added in.

TLDR_ELIFinance: SP4 functions like a bank with investment arm. Collaterals added will be used as reserves (like a bank) and the remaining collaterals will be used to gain yields in other protocols (investment). Interest paid on the vault will be used to buy back DEBASE. Profits from the vault will be rewarded to Degov holders and to keep part of it in the protocol.

Details

The main solution is to “back” any new token introduced with real value being created. For example, a government can issue treasury bonds with positive yields, because it generates profits from that bond money and returns the principle with yield to the investor.

Similarly, SP4 aims to bring real value to justify the inflationary pressure (elastic token supply), in turn reducing the probability of external speculation. Speculation will still exist, and they will be in a more sophisticated context, like derivatives, justifying value with technical analysis.

Mechanism to mint dStable

  1. Users add assets (ETH+ 50% of ETH’s value in DEBASE) into a pool
  2. Users will be guaranteed a low but stable return on assets. For illustration, let’s say the return is 8% annually. This will always exist, even during bad times like black Thursday.
  3. dStable is created from the collateral added. Instead of a 150% collateral ratio, dStable is issued at a 100% collateral ratio. That means, for $1,000 worth of ETH and 500 DEBASE. 500 DEBASE will be locked during the period the vault is open. Users will receive 1,000 dStable. Upon redemption, users will have to close the vault to redeem the ETH and DEBASE. Users will still be required to pay a minting fee, which is used to buy back DEBASE. But the 8% return (from the example) can be higher than the fee payable, netting a benefit for users.
  4. When assets are added into the pool, 66.7% of it goes into the reserve pool.
  5. The reserve pool is mainly used in a money market fund, in a low risk market.
  6. USDC will be used to borrow against the reserve pool, and the USDC will be used in a money market fund for a low and stable yield. For example, using ETH as collaterals to borrow USDC on Aave, and using USDC to earn returns on Coinflex’s FlexUSD. Since Aave is a P2P market while Coinflex is a Repo market, the returns on Coinflex is higher than Aave.
  7. To protect the value of ETH from dropping too low, a put option with a lower strike is purchased. At the same time, it is possible to sell ETH calls at a higher strike to offset the prices of puts. However, this does limit the upside should ETH rise in value.
  8. As we expand further to discuss the reserve pool, an alternative is to define the reserve pool dynamically with a bonding curve or other traditional financial tool. But this conversation is secondary to the main mechanism that we are currently discussing. In the meantime, a simple model can be created, to allow the parameter of the reserve pool to be determined dynamically, but setting it at 66.7% initially.
  9. The remaining collateral (33.3%) is used to earn yields from other platforms. These can be riskier platforms of higher returns. For example, being an options seller on an options platform.
  10. Yield accrued in #5 will be returned to the pools via the treasury, which can mint new dStable, share returns with DEGOV holders or buy back more DEBASE. This is to justify the increase in dStable tokens, backed by actual yield generated from the platform.
  11. dStable has a bottom threshold value, due to the reserves. It does not go below that level. Once it reaches that threshold, an emergency pause will be executed and no minting of tokens can be done. The vaults with collaterals will execute the put options and be liquidated.
  12. At the same time, the protocol will receive partial protocol fees and added to the treasury. Funds in the treasury is to be used in times of crisis and other low probability but fat-tail events. This is to remain capital efficient whilst still protecting against black swan events.
Simple illustration of how $1 is backed with capital efficiency and risk mitigation.

Returns of Collateral Provider

A user adds collaterals and opens a vault specific to the collateral pool. ETH will be added, along with DEBASE.

  1. 66.7% of ETH is kept as reserve, automatically buying put, selling call, borrowing USDC against ETH and lending it in the repo market.
  2. DEBASE is locked.
  3. 33.3% of ETH will be used to generate yields, either being an option seller, lending in other markets or other more aggressive means of generating yields
  4. When the collateral generates yield, part of it is used to buyback debase and burn it. The other part is creating dStable for collateral providers.
  5. When a user closes the vault, the amount of ETH is returned, together with the locked DEBASE. They will also receive yield in dStable, mentioned in #4.

Risk management model of SP4

When it comes to finance, the most important concept is risk. Specifically, how risk is managed, reduced, and hedged. In SP4, we are looking at a few risk management profiles:

  1. Using options as an insurance model for the reserve to protect against collateral prices falling
    Straddle strategy to protect reserve: Options will be exercised when it’s profitable. To reduce the cost of options, we use a protective collar strategy to straddle strategy to limit the losses. Limited profits are a tradeoff worthy in this strategy, as the goal of the reserve is not to make profits but to act as the lower bound in the collaterals.
  2. Being option sellers for dStable and set the strike price always at $1
  3. dStable, as the protocol, sells protective put options to users as insurance. That way, the protocol earns premiums by being put sellers and when prices fall, the premiums (and other yields from collaterals) are used to back the value up to $1. This becomes the insurance for price falling. This can also be purchased by users who are not LP.
  4. When dStable is less than $1, users are incentivised to add more collaterals to be minting dStable. Instead of rebasing, it is possible for the protocol to be issuing warrants that are redeemable for $1 within a specific timeframe.
  5. When dStable is more than $1, users can remove collaterals at a cheaper price, effectively using the mechanism as an individual derivative strategy.

Options for ETH reserve

If we buy options as insurance for ETH in reserve

if ETH falls >10%: exercise options

if ETH rise: use collaterals to borrow more

if ETH is 0–10%: the cost is reduced by selling an option with a higher strike price

Why this modular monetary policy is chosen

Ultimately, SP4’s model functions like a general modular monetary policy. This general process is the backbone of the algo stablecoin, with various specific mechanisms that can be executed, recommended, and added into the protocol when the situation calls for it. For example, other expansionary or contractionary monetary policy tools.

The general model

  1. Collaterals are added to the protocol.
  2. Part of the collaterals are added to the reserve. This can be determined dynamically.
  3. The rest of the collaterals can be used to generate returns, of which part of it goes to the ecosystem and part of it goes to a treasury. It is to be used as a general insurance pool for the protocol as a whole.
  4. What the protocol does with the non-reserve collateral can be executed in accordance to what the situation calls for. This is to maintain the flexibility required in algo stablecoins.

DEGOV: Network Security and Value Accrual

To secure the TVL, it’s important that the governance tokens are valuable enough to avoid economic attacks. A multi-sig mitigates this to some extent, but if governance tokens are just purely used for signalling (without any value accrued to them), governance participation might not be robust, and the decentralised decision-making of the community can’t be leveraged. Therefore even with a multi-sig, governance tokens should accrue value; the token holders are incentivised to spend their time accruing value to the protocol and (and thus themselves). Value accrual could be easily accomplished by sharing the protocol profits with the governance token holders who stake into voting contracts.

In the future, Degov can be integrated further to the mechanism behind emergency liquidity of assets and to repay interest rates accrued in Degov instead of dStable. The latter is potentially used during bear market, which creates an interesting dynamics of game theory analysis and risk management.

FAQ

  1. Why are we creating a new token instead of using DEBASE? We’re introducing a separate coin to prevent cross-pollination of various mechanisms in DEBASE.
  2. What is the main difference between DEBASE and dSTABLE? dStable does not rebase, so it makes it easier to integrate with other protocols.

Note

Pool design in collaboration with Lisa Tan and her team at EconsDesign