Restoring algorithmic stablecoins to their peg

  
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Article originally published on Medium by Eep

Over the past few months, multiple algorithmic stable coin projects have launched, to create a trustless, decentralized, and scalable store of value pegged to the US dollar.

Millions of dollars have been invested into them due to their high speculative value, as investors can earn high returns from dividends when the price of the token is above $1 and purchase debt at a considerable discount when the price of the token is below $1.

Current problem

Despite some initial success, none of the purely algorithmic stable coin designs have managed to hold the peg for a sustained period. All four major pure algorithmic stable coins (Empty Set Dollar (ESD), Dynamic Set Dollar (DSD), Basis Cash (BAC), Mith Cash (MIC)) are currently below their $1 peg. This is because the debt system those tokens rely on to raise the price back to the peg has failed.

The debt systems that tokens use depend on enough people buying debt bonds/coupons to return the token’s price to the peg. If the price is not able to return to the peg, people who purchased bonds/coupons are stuck with useless bond/coupon tokens.

A prolonged period where the price is below $1 decreases speculator interest, which causes people to exit and decreases the likelihood that the price will ever return to $1. This results in a death spiral where the price of the token slowly falls to $0.

As Benjamin Simon said in A Deep Dive into Algorithmic Stable coins, “The moment that there are no longer enough speculators who believe that the network is resilient, the network will no longer be resilient.” The sections below will go over possible reasons why the two major algorithmic stable coin designs are currently failing to maintain the peg.

Empty Set Dollar / Dynamic Set Dollar

ESD and DSD stakers don’t earn anything while the price is under the peg. That increases the likelihood that another money-making opportunity like the release of a new project or a rise in the price of Bitcoin will cause people to sell their tokens and exit the platform. This results in the death spiral scenario detailed above.

In addition to the flaws with the debt system mentioned in the previous section, the debt coupon system those tokens utilize is also unattractive to many people due to the possible risk of losing your investment forever if the coupon is not redeemed within 30 days, which requires the price of the token to return to $1.

Basis Cash / Mith Cash

Unlike ESD/DSD, Basis Cash and Mith Cash stake liquidity tokens to earn share tokens, which are received even while the price of the Cash token is under the peg. Share tokens serve as an incentive for speculators to provide liquidity because they are staked in the Boardroom, which receives a portion of any newly minted Cash tokens.

One of the factors that affect the number of Cash tokens minted is the amount the price is above the price of $1. Consequently, the price of the share token is based on the price of the Cash token. If the price of the Cash token is far above $1, the price of the share token will also be high because the Boardroom will receive a lot of tokens.

The opposite is also true; if the Cash token falls below $1, the price of the Share token falls because the Boardroom will no longer receive any tokens, which drastically reduces the income of liquidity providers. When they remove liquidity and exit, the price of both the Share and Cash token fall further, which can result in a death spiral as the platform becomes less attractive to potential liquidity providers.

Solution

  • Add incentives for people to buy/hold the Cash and Share tokens, provide liquidity, and purchase bonds when it is below $1.

  • Add penalties when selling the token below $1.

Any measures implemented should be as simple as possible. Overly complex mechanics can lead to unintended side effects and increase the gas cost of transactions, which would drive away users.

Proposal

  • If the hourly TWAP of the Cash token is less than $1, add a tax when selling the Cash or Share token on Sushiswap/Uniswap.

  • The Cash token tax would be split between staked liquidity providers and the bond treasury, while the share token tax would be split between staked liquidity providers and the Boardroom.

  • People who lock their tokens in the staking contract would get a larger share of the rewards the staking contracts give as well as the tax.

Effects

  • Increase the incentive for liquidity providers to remain staked since they will receive dividends from the tax.

  • Creates an incentive for people to buy bonds since there will be a guaranteed payout waiting for them once the price of the Cash token returns to the peg, unlike the current system where they have to wait for tokens to be minted into the boardroom.

  • Adds an incentive to remain staked in the Boardroom and not dump the share token.

  • A tax has a low impact on gas cost while the TWAP is ≥ $1.

  • Both the tax and locked staking would discourage panic selling and reward people for being dedicated to the platform even when yields are lower.

  • The tax also makes whale manipulation more costly and transfers tokens from manipulators to honest actors.

  • Bonus: The tax would prevent the front-running bot from operating while the price is below $1.

Unlike other proposed measures to maintain the peg, these measures are simple to implement and don’t require constant governance. This is in line with the decentralized vision of algorithmic stable coins.