Why so many Algo-Stables end up in the Dead-Zone
What if I told you I was building a $1 stablecoin and its average price over weeks has been $0.75?
That has been the fate of DSD — Dynamic Set Dollar. Since Dec 25th, ESD- Empty Set Dollar has also met the same fate. It is worth noting that DSD and ESD have for weeks stayed locked in a $0.6o-something range.
Let me ask another question: if a $1 stablecoin stayed in the $0.60-range for an extended period of time, would you be inclined to buy a bond, even with a high APY % in the event that coin went to $1? Probably not unless you had the economic power to magically move it to $1. Would you buy it at $0.60 on a bet it would go to $1? Why would you? The coin has no more utility than DAI or USDC and there are no real sources of demand or credible ways to profit from bonds.
As a result, these coins may well be in the algo-stable dead-zone. They have forfeited the reputation as a “stable” coin, have no clear path use-case demand or profit-motive-demand to pull itself out of the dead-zone. Their only value may have been to enrich a handful of people who exploited the immature crypto monetary system before the coin taps out.
What went Wrong?
Imagine building a plane while flying it. How would that go? Empty Set Dollar has a market capitalization of $341 Million. It launched on November 2nd 2020 — about 2 months ago. Do you think you could test and refine an economic system in that much time? The answer- as determined by ESD’s persistent price between $0.60 and $0.75- is no.
BAC and MIC are on the same trajectory with a recent average at roughly $0.75.
Efficient monetary systems that stabilize the peg take time to build
Consider how many years it took the Central Banks to fully stabilize sovereign currencies. Crypto projects are attempting to replicate these results overnight (and without the stabilizing advantages fiat has in terms of high demand- in terms of their use in paying taxes, being a transaction currency of choice etc.).
The mechanism algo-stables have taken could be called decentralized peg stabilization (DPS): in the case of MIC and BAC, self-interested economic actors through Share tokens and Bond tokens, as well as through buying and selling of the stablecoins for their own profit — are expected to naturally stabilize the stablecoins at $1.
However, keep in mind that their predecessor, central banks (whose currencies like algo-stables are also uncollateralized) utilize a mixture of centralized and decentralized peg stabilization mechanisms. Central banks will buy and sell bonds, shares, change interest rates dynamically. To manage fully decentralized peg stabilization the way algo-stables are doing is an even taller order, and to successfully do so Day 1 or Month 1, 2, or 3 is highly unlikely. Refined monetary systems that naturally stabilize take time; having one that’s fully decentralized is possible, but not in the first month, maybe not in 6 months.
How Algo-Stables can Use Guardrails until their Monetary System is Mature
Let’s keep in mind that independent economic actors prioritize their own profits. With some exceptions they have no interest in stabilizing the algo-stable coin per-se. With an immature crypto monetary system, actors will find that destabilizing the algo-stable up and down earns them profits by way of more seignorage or bond profits. Therefore, until the algo-stable monetary system is mature, guardrails are needed to stabilize the peg: they include centralized stabilization and restrictions on sub $1 trading.
Algo-stables should gradually move from a Mostly Centralized peg stabilization mechanism with restrictions on sub $1 trading to a Decentralized stabilization mechanism with fewer restrictions and more free-wheeling monetary activity by independent economic actors, over a period of time. These guardrails permit the crypto monetary system to mature WHILE maintaining the peg by using stronger stabilization techniques and restricting bad actors.
There are two guardrail concepts here (these mechanisms guard the stablecoin peg until the crypto monetary system is mature), so let me explain them both briefly (and more so below):
- Centralized stabilization: the project would lead efforts with its own Stabilization Fund funded through treasury to move the peg of its stablecoin to $1. (of course decentralized stabilization will parallel centralized efforts by way of shares, bonds).
- Restrictions on Bad Actors: we all want a free market where actors can do as they please, and bear the risks and profits/losses. However, in immature monetary systems — which every algo-stable has at the moment, bad actors can flourish at the expense of the rest by gaming the system and de-pegging the coin. Until the monetary system is stable, selective rules on trading the stablecoin below $1 must be enacted. Later, as the system matures, they can be lessened.
When the crypto monetary system is more fully tested, such that the price cannot be manipulated as easily into giving economic actors profits for inducing volatility, then the project can shift to more decentralized stabilization where the project’s stabilization fund plays less of a role and there are fewer stablecoin trading restrictions in the system.
The over-confidence or naivete of algo-stables, one after another, that their economic system will hold the peg ABSENT any additional project-led effort to stabilize or restrictions on price-manipulation leads to algo-stables ending up in the Dead-Zone.
When kids first ride a bike, they use training wheels so they and the bike don’t tip over. When you first start, your technique at bike-riding is non-existent, later it’s modest, and finally when you know what you’re doing, you use normal wheels. Empty Set Dollar and Dynamic Set Dollar’s embryonic monetary system had no training wheels. And neither do Basis or MITH. The coin tanks because the supply is out of whack with demand (hence heavy selling and price decline), because there is incentive to tank the price and profit from bonds (hence volatility), and because trust has been lost by investors as a result of the volatility and price decline of the first two — so recovery is less likely (more so for ESD and DSD).
What would the the “training wheels” look like that would stabilize the peg UNTIL the decentralized peg stabilization model has been honed? It could be thought of in phases.
Summary of Phases
Phase 1: Immature Monetary System- — Strong Guardrails (first 6 months) : strong role for centralized stabilization fund, strong selective restrictions against Price Manipulation/Sub $1-trading.
Phase 2: Developing Monetary System — Medium Guardrails(month 6–12)- partial role for centralized stabilization fund, medium selective restrictions against Price Manipulation/Sub $1-trading.
Phase 3: Mature Monetary System — Relaxed Guardrails (month 12 and beyond)- lower role for centralized stabilization fund, minimal selective restrictions against Price Manipulation/Sub $1-trading.
It may take more than 12 months; these numbers are placeholders just to show the phase sequencing.
Guardrails: Exploration of Centralized Stabilization and Selective Restrictions on Sub $1 trading
Guardrail — Restrictions on Price Manipulation
Let’s talk about Penalties for Price Manipulation. Not only are algo-stable monetary systems new and untested, in their markets, you have single actors with over 10% of the currency- an impossibility for the US dollar which is in the trillions.
Let’s look at MITH. MIC % is hard to track because it is all over the place, so we can look at MIS and MIB as a proxy. Here are the concentrations of MIS in the boardroom and MIB:
You can see that 2 holders of MIB own about 50% of the supply. For MIS, 3 holders own 50% of MIS (that’s staked in boardroom). A larger number of actors have over 1% of the total supply. How likely is that with the US dollar that’s worth trillions?
One system is easier to manipulate than the other. The two are not comparable. I define price manipulation here as economic activity that de-pegs the stablecoin to benefit the actor.
When it comes to combatting price manipulation, bear in mind that stopping price manipulation is not the goal. Any restriction can always be avoided. The goal is to reduce the manipulation- make it harder, create more hurdles. Restrictions could include:
- Restrict those who make sub $1 Sell orders from purchasing Bonds. Utilize bond smart contract for doing so.
- Restrict those who make sub $1 Sell orders from buying below that price for X hours. Utilize stablecoin smart contract for doing so.
Guardrail— Selective Restrictions on Sub $1 trading
Sell-side pressure for algo-stables is greater than buy-side demand for algo-stables early on because most acquired the coin at a low cost basis (ie: they farmed it and the coin represents profit so they will readily sell) and use-case demand for the algo-stable is low (so they have few strong reasons to buy). Often, buying bonds for that coin is unattractive due to a persistent algo-stable price below the bond redemption trigger. Therefore coins cannot get out of the $0.70 “discount bin” because people sell the algo-stable more than they buy it and they become disillusioned with bonds.
To break out of this vicious cycle:
- Restrict large Sell orders for over X dollars when the price of the algo-stable is under $1. Utilize the token smart contract to do so.
- Restrict cumulative Sell orders from a single ETH address to Y dollars over the course of a day. Utilize the token smart contract to do so.
- Utilize selective Sell restrictions in combination with Centralized stabilization (see below) to move price up and give confidence to economic actors to buy the algo-stable, moving the price up, without being dumped on.
These are just examples. While they may seem restrictive, they are in service of holding the peg and the need for them will decline as the algo-stable monetary system matures.
Guardrail- Centralized Stabilization
Let me make clear: I am not advocating purely central stabilization. Rather it ought to complement the existing decentralized mechanism (of economic actors buy/selling the algo-stable & using share and bond tokens).
The project should fund a Peg Stabilization Fund through issuing itself share tokens and stablecoins. The share tokens should not be used during seniorages and can be used to purchase the stablecoin on the market (the result will be a rising stablecoin price, which in turn will defray the selling pressure impact on the share token price, as the share token price is based on the stablecoin price and not vice-versa).
Additionally, the stabilizing fund can convert both tokens into mainstream stablecoins such as USDT or DAI which can then be used for purchasing its stablecoin (acquiring the mainstream stablecoins will minimize impact on the prices of the project’s tokens). The stabilizing fund can reduce impact on the algo-stable price by selling it for mainstream stablecoin over-the-counter (OTC). A locking period should be required of the buyer of the OTC algo-stable so its subsequent sale of the algo-stable won’t harm the price; a discount can be offered in exchange for this locking.
The funds of the Stabilization Fund can be fixed or variable (ie: a mechanism can issue currency to the fund from the project’s treasury if the algo-stable is below a certain price). The resulting expansion of stablecoin supply should not have significant impact on price if they are not sold on the market.
Over time, the role of the centralized Stabilization Fund may decline as the monetary system improves to make it harder to game, and aligns the incentives of the economic actors to profit by stabilizing the peg, not breaking it.
Failing the implementation of these guardrail measures, the new algo-stables will likely meet the fate of the prior ones (ESD, DSD) of being perpetually well under peg, if not now then in a month or two.
The Trap of Exclusively Focusing on a better Bond Mechanism
If you look at Empty Set Dollar, they repeatedly tried to improve their bonding and coupon mechanics. They couldn’t fix them fast enough to correct for exploitation of their immature monetary system and now they’re in the algo-stable dead-zone, circling the drain constantly at $0.60 and $0.70. Once you end up there, it’s hard to get out. They ignored the need for guardrails.
Let’s go back to the ‘flying a plane’ analogy. Let’s say instead of building it mid-air you were learning to pilot it. You had the manual out and everything. You were descending towards the ground and there was an auto-pilot button you could press to keep the plane in the air flying smoothly, but you kept your head in the manual, “I’m close to figuring it out!”…… and while doing so, you crashed in a ball of flames.
ESD and DSD are those wannabe-pilots. Trying to read the manual while the plane is crashing are algo-stable projects obsessing over bond mechanisms while the coin has completely de-pegged, lost market confidence, and through its ineffectuality, dissuaded buyers of their stablecoin and of their bonds, who don’t believe it will pull through to make their investment worthwhile. The auto-pilot button are guardrails such as centralized stabilization and selective restrictions against sub-$1-selling.
My sense is that BAC and MIC may fall into the same trap ESD did by over-prizing their ability to refine the system in a short amount of time. A better bond can be developed, but it will take time. Central stabilization and guardrails allow for this time.
Conclusion
Yes, algo-stables need to cultivate demand so they can rise out of the $0.70 discount bin. Yes, algo-stables need better bond mechanisms; since Supply > Demand for algo-stables generally pushing it below $1 in any case, this becomes crucial. Bond exploitation is high since actors profit from sub $1 prices; the further below peg, the better — finding a way to contract supply to raise the algo-stable price without encouraging de-pegging is a worthy goal. But because algo-stable monetary systems are untested, much damage can take place to the coin & its reputation UNTIL it can refine this approach, which may take months if not years, This is the need for centralized stabilization and rules against bad actors. Having these guardrails will buy the algo-stable project enough time to improve its monetary system.
