Interpretation of decentralized reserve stablecoins: In the face of the impossible triangle dilemma, what kind of "solutions" did each protocol use?

By Lawrence Lee

At the end of July, Liquity, the leading decentralized stablecoin, announced that its V2 version will launch the risk-neutral stablecoin "Delta Neutral Stablcoins", and the newly financed Ethena Finance will also hedge its reserve assets through risk hedging , so as to achieve decentralized high capital efficiency. In this article, we will take a closer look at these stablecoin protocols that try to realize the impossible triangle.

Impossible Triangle

Mapping: Mint Ventures

There has always been an impossible triangle in the field of encrypted stablecoins, that is, price stability, decentralization and capital efficiency cannot be achieved at the same time.

Centralized stablecoins such as USDT and USDC have the best price stability on the chain and capital efficiency as high as 100%. The only problem is the risk brought by centralization. BUSD has stopped new business due to regulatory influence. The impact of the monthly SVB event on USDC clearly reveals this point.

Since the second half of 2020, the algorithmic stablecoin craze has tried to achieve insufficient collateral on the basis of decentralization. During this period, projects such as Empty Set Dollar and Basis Cash have quickly collapsed; since then, Luna has relied on the credit of the entire public chain as a Implicit guarantee does not require users to over-collateralize the process of minting UST. For a long time (2020-May 2022), it has achieved the combination of decentralization, capital efficiency and price stability, but in the end it is credit The crash turned into a death spiral; since then, projects like Beanstalk have appeared in undercollateralized tokens, but they have not attracted much attention from the market. The difficult and stable anchoring of such tokens is the root cause of its development.

The other path is to start with MakerDAO, through the over-collateralization of the underlying decentralized assets, hoping to achieve price stability on the basis of sacrificing certain capital efficiency. At present, Liquity's LUSD is the largest stablecoin fully supported by decentralized assets. However, in order to ensure the stability of LUSD prices, Liquity's capital efficiency is indeed low. The mortgage rate of the entire system is above 250% all the year round, which means that every 1 circulating LUSD requires more than 2.5U of ETH as collateral. Synthetix's sUSD is even more extreme. Due to the greater volatility of the collateral SNX, the minimum collateralization ratio required by Synthetix usually exceeds 500%. Low capital efficiency means low scale ceiling and low attractiveness to users. Liquity’s planned V2 version mainly wants to solve the problem of V1’s low capital efficiency. Synthetix is also in its planned V3 version It is planned to introduce other assets as collateral to reduce the minimum mortgage rate requirement.

DAI in the early days (2020 and before) actually also had the problem of low capital efficiency, and because the market value of the entire encryption market was small at that time, DAI’s collateral ETH fluctuated greatly, and the price of DAI also fluctuated greatly. In order to solve this problem, MakerDAO has introduced PSM (Price Stability Module, which allows the use of USDC and other centralized stablecoins to generate DAI) since 2020. DAI is partly part of the balance between decentralization, capital efficiency and price stability. Abandoning decentralization has brought more stable price anchoring and higher capital efficiency to DAI, thereby better helping DAI to grow rapidly with the overall development of DeFi. FRAX, which was launched at the end of 2020, also uses centralized stablecoins as the main collateral. At present, DAI and FRAX are the top two circulation scales in the category of decentralized stablecoins, which of course proves that their strategies are appropriate, providing users with stablecoins that better meet their needs, but it also shows that "maintain decentralization" Constraints on the scale of stablecoins.

But there are still a series of stablecoins that try to achieve high capital efficiency and strong price stability while maintaining decentralization. They all try to provide users with a stablecoin that:

• Generated by decentralized assets (such as ETH), avoiding censorship risks;
• Using 1 dollar of assets can generate 1 dollar of stable currency, without over-collateralization, which is more conducive to scale;
• Stablecoin value remains stable.

In fact, it’s also the most intuitive theoretically best decentralized stablecoin. We use Liquity V2's name for this type of protocol - Decentralized Reserve Protocol to name this type of stablecoin. It should be pointed out that, unlike traditional stablecoins generated by over-collateralization, for users, after their assets are converted into such stablecoins, the assets used to generate stablecoins are owned by the protocol and are no longer associated with users. In other words, the user is more like doing a swap operation of ETH -> stable currency. This type of stablecoin is more similar to centralized stablecoins such as USDT, where $1 of assets can be exchanged for $1 of stablecoins, and vice versa. It's just that the assets accepted by the decentralized reserve protocol are encrypted assets.

*** (Some people may think that the collateral is not owned by the user, so such a stablecoin does not have the leverage function, which will lose a major use case of the stablecoin. But the author believes that the stablecoin in our real life is not It has the function of increasing leverage. Centralized stablecoins such as USDT and USDC have never had the function of increasing leverage. Settlement tools, accounting units and value storage methods are the core functions of currencies. Leverage is only a type of CDP (Collateralized Debt Position) Specific features of stablecoins, not general use cases of stablecoins)***

However, the reason why the previous stablecoin protocols did not continue to provide such stablecoins is because the above-mentioned stablecoins have a problem that is simple to say but difficult to solve: the price of decentralized assets fluctuates greatly, how can it be 100% stable? Guaranteed redemption of the stablecoins they issue under the mortgage rate?

From the balance sheet of the stablecoin agreement, the collateral deposited by users is an asset, while the stablecoin issued by the agreement is a liability. How can we ensure that the asset will always be greater than or equal to the liability?

Or a more intuitive example is, when ETH = 2000U, a user sends 1 ETH to the protocol to mint 2000 stablecoins, then when ETH drops to 1000U, how does the protocol ensure that the 2000 stablecoins can still be exchanged for value? 2000U of assets?

From the perspective of the development history of the decentralized reserve protocol, there are two main ideas to solve this problem: using governance tokens as a reserve and reserve asset risk hedging. According to the risk hedging method of reserve assets, it is divided into a decentralized reserve agreement for protocol hedging risks and a decentralized reserve agreement for users to hedge risks. Next, let's understand one by one.

Mapping: Mint Ventures

Decentralized reserve protocol with governance tokens as reserves

The idea of the first type of agreement is to use the governance token of the agreement itself as the "new collateral" of the agreement. When the price of collateral assets drops sharply, the agreement will mint more governance tokens to redeem stablecoin holdings People's stable currency, we can call it a decentralized reserve protocol with governance tokens as reserves. In the above example, when ETH drops from 2000U to 1000U, the decentralized reserve protocol with governance tokens as reserves uses 1000U worth of ETH + 1000U worth of protocol governance tokens to redeem 2000 stablecoins in the hands of users.

Protocols that take this approach include Celo and Fei Protocol.

Forehead

Celo is a stablecoin project that has been online for 20 years. They previously existed as an independent L1. In July this year, the core team proposed to transition Celo to the Ethereum ecosystem through the OP stack. Celo's stablecoin mechanism is as follows:

Celo's stable currency is backed by a reserve pool composed of a comprehensive asset. The reserve rate of the reserve pool (the ratio of the value of the reserve asset divided by the value of the stable currency in circulation) is much higher than 1, which provides the best value for the intrinsic value of its stable currency. The core underpinning Celo stablecoin is not minted by over-collateralization, but is obtained by sending Celo tokens to the official stable module Mento. Users send Celo worth $1 to get stablecoins such as cUSD for $1. Send $1 worth of cUSD back to Mento in exchange for $1 in Celo. Under this mechanism, when the market price of cUSD is lower than $1, someone will buy cUSD at a low price in exchange for $1 Celo. Similarly, when cUSD is higher than $1, someone will use Celo to mint cUSD to sell, arbitrage The presence of investors will ensure that cUSD will not deviate too far from its anchor price. There are three mechanisms that will be used to ensure sufficient funds in the reserve pool: 1. When the reserve rate is lower than the threshold, the Celo produced by the block will be included in the reserve pool to replenish capital; 2. A certain rate of transfer fee can be charged to supplement Capital (currently not enabled); 3. A certain stability fee is charged in Mento's trading module to replenish reserve capital. In order to improve the security of the reserves, its asset portfolio is more diverse, currently including Celo, BTC, ETH, Dai and carbon credit token cMCO2, which will be safer than just using project tokens as collateral (Terra is similar to this solution, Luna is the invisible margin of its native stablecoin) Source: Mint Ventures Celo Research Report

It can be seen that Celo is similar to Luna. It is an L1 centered on stablecoins. It is also very close to Luna/UST in terms of minting and redemption mechanisms. The main difference is that when the entire system enters a potential undercollateralized state , Celo will first use the $CELO produced by the block as the collateral of the agreement to ensure the redemption of its stable currency cUSD.

source:

At present, the Celo system has a total collateral of 116 million US dollars, a total of 46 million US dollars of stable coins issued, and an overall over-collateralization rate of 254%. Although the entire system is in an over-collateralized state, for users who want to use their stable currency cUSD , they can exchange 1U worth of CELO for 1 cUSD at any time, and the capital utilization rate is excellent. Of course, from the perspective of collateral composition, half of Celo’s collateral comes from centralized USDC and semi-centralized DAI, and Celo cannot be considered a completely decentralized stable currency.

At present, the scale of Celo's stablecoin ranks 16th among decentralized stablecoins (if UST and flexUSD, which have been unable to Peg, are excluded, it ranks 14th).

source:

Fei

At the beginning of 2021, Fei Protocol, which received US$19 million in financing from institutions such as A16Z and Coinbase, attracted widespread attention in the market because it also had the hottest algorithmic stablecoin concept in the market at the time. In the initial stage of their project issuance (at the end of March), 639,000 ETHs were attracted to participate in the casting of the stablecoin FEI, and a total of 1.3 billion FEIs were generated, which also made FEI a decentralized stablecoin second only to DAI. currency (the circulating market value of DAI at that time was 3 billion US dollars).

Later, because the demand for FEI was oversatisfied in the creation stage in a short period of time (users mainly wanted to obtain the governance token TRIBE of Fei Protocol), the supply of FEI was severely oversupplied, and the newly launched stable currency FEI had no application scenarios. So FEI is under $1 for a long time. Soon after that, the market volatility in May ushered in. The panic of falling prices caused users to redeem FEI one after another, making the agreement sluggish since its launch.

Since then, in the V2 version that will be launched at the end of 2021, Fei Protocol has proposed a series of measures to try to bring the development of the protocol back on track, including modifying its price stabilization mechanism. In V2, FEI can be directly generated from ETH, DAI, LUSD and other collaterals at a 100% mortgage rate. After the stablecoin is generated, the user's collateral is included in the protocol controlled value (PCV, Protocol Controlled Value). When the mortgage rate of the agreement (=PCV/circulating FEI) is higher than 100%, it means that the asset appreciation of the agreement is in good condition, and there is no pressure on the redemption of FEI. The agreement will issue a part of FEI to purchase TRIBE, thereby reducing the mortgage rate of the agreement; Similarly, when the mortgage rate of the agreement is lower than 100%, there is a possibility that the agreement cannot fully redeem all FEI, and the agreement will also issue a part of TRIBE to purchase FEI, thereby increasing the mortgage rate of the agreement.

Under this mechanism, the governance token TRIBE becomes a backup cash for FEI's entire system in case of potential risks, and can also obtain additional income when the system grows (this mechanism is similar to the Float Protocol launched together with Fei V1). It is a pity that the launch of Fei V2 coincided with the high point of the entire bull market, and the price of ETH has been falling since then. Unfortunately, Fei suffered a hacker attack in April 22 and lost 80 million FEI, and finally decided to terminate the agreement in August 2022 develop.

The decentralized reserve protocol that uses governance tokens as reserves essentially dilutes the rights and interests of all governance token holders to ensure the redemption of stablecoins. In the bull market cycle of the market, along with the increase in the scale of stable coins, governance tokens also rise, and it is easy to form an upward flywheel. However, in the bear market cycle of the market, as the reserve assets on the protocol asset side decline, the total market value of the governance token itself will also decline with the market. At this time, if more governance tokens need to be issued, the governance token will be There could be further declines, forming a death spiral for governance token prices. However, if the market value of governance tokens falls below a certain percentage of stablecoins, the entire agreement’s commitment to stablecoins will no longer be credible in the eyes of stablecoin holders, which will eventually accelerate the escape and lead to a death spiral for the entire system . Whether it can survive the bear market is the key to the survival of this type of stablecoin. In fact, the reason why Celo can survive in the current bear market is inseparable from the overall "over-collateralized" status of the protocol. The reason why the protocol is over-collateralized The status is also because when the market was high before, Celo allocated a relatively large amount of reserves to USDC/DAI and BTC/ETH, so that the protocol can still maintain the security of the protocol when the price of CELO drops from 10 to 0.5.

Decentralized Reserve Protocol for Reserve Asset Risk Hedging (Risk Neutral Stablecoin Protocol)

The idea of the second type of agreement is to carry out some risk hedging of these encrypted assets on the asset side of the agreement. When the price of the collateral asset falls sharply, the hedging realizes the income so as to ensure that the assets of the stablecoin agreement can always repay the debt. We call this kind of protocol a decentralized reserve protocol for risk hedging of reserve assets, or a risk-neutral stablecoin protocol. In the above example, after receiving 1 ETH worth 2000U, the decentralized reserve protocol for reserve asset risk hedging will hedge the risk of this 1 ETH (for example, open a short order on the exchange), when ETH falls from 2000U To 1000U, the decentralized reserve protocol for reserve asset risk hedging uses 1000U worth of ETH + 1000U worth of hedging income to redeem 2000 stablecoins in the hands of users.

Specifically, depending on the specific hedger, it is divided into a decentralized reserve agreement for protocol hedging risks, and a decentralized reserve agreement for users to hedge risks.

Decentralized Reserve Protocol for Protocol Hedging Risk

Stablecoin protocols that adopt this approach include Pika Protocol V1, UXD Protocol, and Ethena, which recently announced financing.

Long V1

Pika Protocol is currently a derivatives protocol deployed on the Optimism network, but in its initial V1 version, Pika once planned to launch a stable currency, and its hedging was realized through Bitmex's inverse perpetual contract (Inverse Perpetual). The reverse perpetual contract (or coin-based perpetual contract) is also one of the inventions of Bitmex. Compared with the more popular "linear perpetual contract" at present, it uses the U standard to track the price of the currency. The characteristics of the reverse perpetual contract It uses the currency standard to track the price denominated in U. An example of the return of an inverse perpetual contract is as follows:

A trader goes long 50,000 contracts of XBTUSD at a price of 10,000. A few days later the price of the contract increases to 11,000. The trader goes long 50,000 contracts of XBTUSD at a price of 10,000. A few days later, the contract price rose to 11,000. The trader's profit will be: 50,000 * 1 * (1/10,000 - 1/11,000) = 0.4545 XBT price had in fact dropped to 9,000, the trader's loss would have been: 50,000 * 1 * (1/10,000 - 1/9,000) = -0.5556 XBT. The loss is greater because of the inverse and non-linear nature of the contract. Conversely, if the trader was short then the trader's profit would be greater if the price moved down than the loss if it moved up. If the price actually fell to 9,000, the trader's loss would be: 50,000 * 1 * (1/10,000 - 1/9,000) = -0.5556 XBT The loss is larger due to the inverse and non-linear nature of the contract. Conversely, if a trader is short, then if the price falls, the trader's profit will be greater than the loss if the price rises. source:

After a little analysis, it is not difficult to find that the reverse perpetual contract and the decentralized reserve agreement for risk hedging of reserve assets are a match made in heaven. Still our above example, assuming that when ETH = 2000U, after receiving 1 ETH from the user, Pika Protocol uses 1 ETH as a margin to short 2000 ETH reverse perpetual contracts on Bitmex, when the price of ETH If it falls to 1000U, the profit of Pika Protocol = 2000 * 1 * (1/1000-1/2000) = 1 ETH = 1000U. That is to say, when the price of ETH drops from 2000U to 1000U, the reserve of Pika Protocol protocol at this time changes from 1 ETH to 2 ETH, which can still effectively redeem the 2000 stable coins in the hands of users (the transaction fee and funding fee are not considered above) rate cost). The product design of Pika Protocol V1 is exactly the same as the product design of NUSD mentioned by Bitmex founder Arthur Hayes in his blog post, and it can always perfectly hedge the currency-based long position.

Unfortunately, for the vast majority of USDT-based crypto investors, the reverse perpetual contract has the characteristics of reverse and non-linear returns (there is no linear relationship between the rise and fall of the local currency and the rise and fall of the contract) , is not easy to be understood by ordinary users. In the subsequent development process, the development of reverse perpetual contracts (coin-based perpetual contracts) is far behind the current popular linear perpetual contracts (U-standard perpetual contracts) ), in mainstream exchanges, the trading volume of inverse perpetual contracts is only about 20-25% of that of linear perpetual contracts. BitMex, which has been affected by regulation, has also gradually degenerated from a first-tier contract exchange to a state where the current contract market share is less than 0.5%. Pika believes that linear perpetual contracts cannot meet their hedging needs, while the market space for inverse perpetual contracts is relatively small. In its V2 version, it gave up the stable currency business and officially turned to the derivatives exchange.

XD

UXD Protocol is a stablecoin protocol running on the Solana network and will be launched in January 2022. UXD once completed a $3 million financing led by Multicoin in 2021, and raised $57 million in IDO. In January of this year, UXD decided to cross-chain and enter the Ethereum ecosystem. Arbiturm was launched in April, and Optimism is planned to be launched later.

When it was first launched, UXD Protocol supported users to deposit SOL, BTC and ETH to mint its stable currency UXD according to the value of USD 1:1. The collateral deposited by users will be opened through Solana's lending and perpetual contract exchange Mango Markets Single hedging, through hedging to realize the redemption of the stable currency. The funding fee charged for empty orders will be regarded as the agreement income, and the funding fee paid will be advanced by the funds raised in the agreement. For quite a long time after going online, the UXD protocol has worked well, and the protocol even needs to limit the upper limit of UXD issuance. This is because the overall open position of Mango Markets is in the order of less than 100 million U.S. dollars. If the short position of UXD reaches tens of millions of U.S. dollars , it faces the risk of potential insolvency; in addition, too many short positions will also make the funding rate more inclined to become negative, thereby increasing hedging costs.

Unfortunately, Mango Markets suffered a governance attack in October 2022, and UXD lost nearly $20 million in this incident. At that time, UXD's insurance fund balance still had more than $55 million, so UXD could be paid out normally. Although Mango Markets subsequently returned the funds of the UXD agreement, Mango Markets has been in a slump since then. It also coincided with the FTX thunderstorm that caused funds to flow out of Solana quickly, and UXD could not find a suitable exchange to hedge their long positions. Since then, the only collateral supported by the UXD protocol is USDC, and USDC does not need to hedge risks, so they invest the user's collateral USDC in various on-chain USDC vaults and RWA. Also after this, UXD decided to cross-chain and enter the Ethereum ecosystem. Arbiturm was launched in April, and Optimism is planned to be launched later. They are also continuously looking for suitable hedging places on the chain.

Currently, the circulation of UXD is 14.3 million US dollars, and the balance of the agreement insurance fund is 53.2 million US dollars.

source:

In addition, Ethena Finance, a stable currency agreement that has just announced financing, will also use risk hedging methods to hedge its reserve assets. Ethena Finance received $6 million in financing led by Dragonfly and participated by Bybit, OKX, Deribit, Gemeni, Huobi and other centralized exchanges. Ethena's financing institutions include many second-tier derivatives exchanges, which will be helpful for its collateral hedging. In addition, Ethena also plans to cooperate with Synthetix, a decentralized derivatives agreement, to open short positions in Synthetix as a liquidity provider, and to bring more use cases to its stablecoin USDe (allowing USDe to be used as collateral for certain pools) ).

For the protocol hedging risk decentralized reserve protocol, its advantages are obvious. By hedging the encrypted assets of the collateral, the protocol as a whole can obtain a risk-neutral position, thereby ensuring the redemption of the stable currency, and finally achieving decentralization 100% capital efficiency based on globalization (primarily dependent on hedging venue). At the same time, if the agreement can complete position hedging in a capital-efficient way, the collateral reserves owned by the agreement can also generate interest through various forms. In addition, the funding rate can be used as agreement income, thus giving the agreement more Space for flashing and moving: These benefits can be distributed to holders of stable coins, creating interest-bearing stable coins and giving stable coins more use cases; they can also be distributed to holders of governance tokens.

In fact, the governance token of any stablecoin protocol has an implicit use case as the "lender of last resort" for its stablecoin. The stablecoin protocol for risk hedging of reserve assets can also use its governance token as its stable currency in extreme cases. The source of currency redemption. For stablecoin holders, holding this kind of stablecoin is an extra layer of protection than simply using governance tokens as a reserve of stablecoins. And from a mechanism point of view, the logic of reserve asset risk hedging is more self-consistent, and theoretically it will not be affected by the market cycle, and there is no need to test the resilience of the governance token itself in a bear market.

But development also has many limitations:

Hedging venue centralization risk. At present, centralized exchanges still occupy the vast majority of the liquidity of perpetual contracts, and the design of most decentralized derivatives exchanges is not suitable for stablecoin protocols to hedge, so it is inevitable that the agreement will face the central risk. The centralization risk here may be divided into two categories: 1. The inherent risk of the centralized exchange itself; 2. Because the total number of hedging places is small, a single hedging place will inevitably occupy a large proportion of the agreement’s hedging positions. If there is a problem in a certain hedging place, it will also have a greater impact on the agreement. UXD Protocol suffered losses due to the attack on Mango Markets and caused the agreement to stop functioning, which is an extreme example of this centralization risk.

There are certain restrictions on the choice of hedging instruments. The current mainstream linear perpetual contract method cannot perfectly hedge their long positions. We still take ETH as an example. The stablecoin protocol requires ETH as collateral and ETH-based short order hedging. At present, the linear perpetual contract with the largest trading volume needs USDT as collateral, and its short-selling yield curve is also based on the USD standard, which cannot be perfectly hedged with the ETH of the position. Even if the stable currency agreement uses ETH to obtain USDT through some kind of loan, this will increase the operating cost and the difficulty of position risk management, and will also reduce capital efficiency. From the above example of Pika Protocol, we know that the reverse perpetual contract is the perfect choice for a decentralized reserve protocol trying to hedge the risk of reserve assets, but unfortunately the market share of the reverse perpetual contract is not large enough.

Scale growth is somewhat self-limiting. The growth of the protocol’s stablecoin scale means that there needs to be long-lasting and sufficient perpetual contract short positions for hedging. In addition to the complexity of obtaining enough short positions, the more short positions held by the protocol itself, the liquidation The higher the requirement for the liquidity of the counterparty, the more likely the funding rate will be negative, which means potentially higher hedging costs and operational difficulties. For a stablecoin worth tens of millions of dollars, this may not be a big problem. If you want to go further and reach a scale of hundreds of millions or even billions, this problem will obviously restrict its ceiling.

operational risk. No matter which form of hedging is adopted, it will involve relatively high-frequency operations of opening positions, rebalancing positions, and collateral management. These processes inevitably require manual intervention, which will cause considerable operational risks and even moral hazards.

Decentralized reserve protocol for users to hedge risks

Protocols that take this approach include Angle Protocol V1 and Liquity V2.

Angle V1

Angle Protocol will be launched on the Ethereum network in November 2021. They have previously received US$5 million in financing led by a16z.

Regarding the protocol design of Angle Protocol V1, readers can go to Mint Ventures’ previous research report to learn more, and we briefly describe it as follows:

Like other decentralized reserve protocols, Angle ideally supports users to use 1U worth of ETH to generate one of its stablecoins agUSD (Of course, the first stablecoin launched by Angle is agEUR anchored to the euro, but the logic is Similarly, for the convenience of contextual unification, we still use the US dollar stable currency as an example). The difference is that in addition to traditional stablecoin demanders, Angle’s users also include perpetual contract traders, which Angle calls HA (Hedging Agency, hedging agency).

Still the example we mentioned above, when ETH = 2000U, a user sends 1 ETH to Angle to mint 2,000 USD stablecoins, at this time, Angle will open a leveraged position worth 1 ETH for traders We open, we assume that HA uses 0.2 ETH (worth 400U) as collateral to open a 5 times leveraged position. At this time, the collateral of the agreement is 1.2 ETH, worth 2400U, and the liability side is a total of 2000U of stablecoins .

When the ETH rises to 2200U, the protocol only needs to keep the ETH that can be redeemed to the 2000U stablecoin, that is, 0.909 ETH, and the remaining 0.291 ETH (worth 640U) can be withdrawn by HA.

When ETH drops to 1800 U, the protocol still needs to retain ETH that can be redeemed to 2000U stablecoin, that is, 1.111 ETH. At this time, HA's margin position will become 0.089 ETH (worth 160U).

It can be seen that traders are essentially long ETH on the currency basis. When the price of ETH rises, they can not only get the increase of ETH itself, but also part of the "surplus" of the protocol (in the above example, the price of ETH rises 10%, traders earn 60%); and when the ETH price falls, in addition to the decline of ETH itself, they also need to bear the decline of the agreement collateral ETH (in the above example, the price of ETH fell by 10%, and the trader lost 60%). From the perspective of Angle Protocol, traders hedge the risk of falling collateral prices for the agreement, which is also the origin of its name hedging agent. Traders’ long leverage depends on the ratio between the protocol’s open hedged position (0.2ETH in the above example) and the protocol’s stablecoin position (1ETH in the above example).

For perpetual contract traders, using Angle to conduct long transactions in perpetual contracts has certain advantages: 1. They do not need to pay funding fees (centralized exchanges usually pay funding fees from long positions to short positions); 2. The transaction price is directly According to the oracle price, there is no slippage. Angle hopes to achieve a win-win situation for stablecoin holders and perpetual contract traders: stablecoin holders can obtain high capital efficiency and decentralization; contract traders can also obtain a better trading experience. Of course, this is only an ideal situation. In reality, there will be no traders to open long orders. Angle has introduced a standard liquidity provider (Standard Liquidity Provider, SLP) to provide additional collateral (stable currency) for the protocol to continue to guarantee Protocol security while automatically earning interest, transaction fees, and governance token $ANGLE rewards.

The actual operation of Angle is not ideal. Although traders also have a lot of $ANGLE as rewards, most of the time, the collateral of the agreement has not been fully hedged. The core reason is that Angle does not provide A product that is attractive enough for traders. As the price of the $ANGLE token dropped, the protocol TVL dropped all the way from $250 million at launch to around $50 million.

The main collateral source of the Angle stablecoin - the hedge rate of the USDC pool source:

source:

In March 2023, Angle’s interest-bearing reserve assets were unfortunately hacked by Euler. Although the hackers eventually returned the corresponding assets, Angle’s vitality was severely damaged after that. In May, Angle announced the end of the above logic The product, they called Angle Protocol V1, and launched the V2 plan. Angle Protocol V2 changed to the traditional over-collateralization model and just went live in early August.

Liquity V2

Since its launch in March 2021, LUSD issued by Liquity has become the third largest decentralized stablecoin in the entire market (after DAI and FRAX), and the largest fully decentralized stablecoin. Research reports have been published in July 2021 and April 2023 respectively, discussing the mechanism of Liquity V1 and subsequent product updates and use case expansion. Interested readers can go to learn more.

The Liquity team believes that LUSD has achieved a relatively good level in terms of decentralization and price stability. But in terms of capital efficiency, Liquity is relatively mediocre. Since its launch, Liquity's system mortgage rate has been around 250%, which means that every circulating LUSD requires 2.5U worth of ETH as collateral.

source:

Liquity officially introduced its V2 features on July 28. In addition to supporting LSD as collateral, the core content mainly claims that it achieves high capital efficiency through delta-neutral hedging of the entire protocol.

At present, Liquity has not published specific product documents. The current public information about V2 mainly comes from the speech of the founder Robert Lauko at ETHCC, the introduction article published by Liquity before, and the discussion in Discord. We organize the following mainly based on the above information.

In terms of product logic, Liquity V2 is similar to Angle V1. It hopes to introduce traders to carry out leveraged transactions on Liquity, use the margin of these traders as the supplementary collateral of the agreement, and use traders to hedge the risks of the entire agreement. At the same time, for traders, Liquity provides them with attractive trading products.

Specifically, Liquity proposes two innovations. The first is the so-called "principal-protected leveraged transaction". Liquity will provide contract traders with a leveraged transaction product that protects the principal. After the user pays a certain premium, You can use this function, which can make it possible for them to recover a certain amount of U even if the ETH drops sharply. According to the example in the Liquity article, when the ETH price is 1000U, the user pays 12ETH (the principal is 10ETH and the premium is 2ETH), and the user can get 10ETH with 2 times the leverage to do a long position + downside protection, that is, when the ETH price doubles, 2 The long position with double leverage takes effect, and the user can get a total of 40ETH when the price of ETH goes down; when the price of ETH goes down, the put option purchased by the user takes effect, and the user can get back his own 10000U (10*1000) at any time.

source:

It can be seen that the innovation of Liquity's products based on Angle is mainly the "principal protection" function. Although Liquity did not explain the implementation method, but according to the product form and the discussion in Discord, the function of this "principal protection" is very similar to a call option.

Liquity believes that this combination product will be more attractive to traders because it can protect the principal. Call options can enable traders to obtain leveraged income when the price rises, and guarantee the principal when the price falls. From the perspective of traders, it may indeed be more attractive than Angle's pure leveraged trading products (of course, it depends on the specifics. Liquity’s pricing of the royalty). From the perspective of the agreement, the premium paid by the user can become a security cushion for the protocol: when the price of ETH falls, Liquity can use this part of the premium as supplementary collateral to redeem stablecoin holders; when the price rises, Liquity The value-added part of Liquity's own collateral can also be distributed to contract traders as profits.

Of course, there are obvious problems in this mechanism, that is, when traders want to close their positions halfway and get back their own ETH, Liquity will fall into a dilemma: traders have the right to close positions at any time, but if they If the position is closed, the proportion of Liquity's entire protocol position being hedged will decrease, and the security of the Liquity protocol will become vulnerable with the withdrawal of this part of the "collateral". In fact, the same problem has appeared in the actual operation of Angle. The hedging rate of Angle's system has been kept at a low level all year round, and traders' hedging of the overall position of the agreement is not sufficient.

To solve this problem, Liquity proposes a second innovation, an officially subsidized secondary market.

That is to say, the leveraged trading position (NFT) in Liquity V2, in addition to opening and closing positions like normal leveraged trading positions, can also be sold in the secondary market. In fact, for Liquity, their concern is that traders will close their positions, because this will bring about a reduction in the agreement's hedge ratio. When a trader wants to close a position, if other traders are willing to buy from the secondary market at a price higher than the intrinsic value of the current position, they will naturally be happy to see more cash, and for Liquidity In general, although this "current position intrinsic value" is subsidized by the agreement, the hedging rate of the entire system can be maintained through a relatively small subsidy, thereby improving the security of the agreement at a relatively small cost.

source:

For example, Alice opens a position of 10 ETH when the price of ETH is 1000U, and the premium is 2ETH. This position corresponds to the long position of 10 ETH + the value of principal protection. But at this time, ETH has dropped to 800U, and the value of the 12,000U of ETH invested by Alice can only be exchanged for 10ETH (8000U). A certain price in between sells his position in the secondary market. For Bob who wants to buy Alice's position, the behavior of buying Alice's position is a bit similar to buying at ETH 800U (8000U+ a call option with a strike price of 1000U), this option must be valuable, so This also determines that the price of Alice's position must be higher than 8000U. For Liquity, as long as Bob buys Alice's position, the mortgage rate of the agreement will not change, because the premium collected by the agreement is still in the agreement fund pool. If there is no Bob to buy Alice's position, the Liquity protocol will gradually increase the value of Alice's position over time (the specific form is not specified, but for example, reducing the strike price and increasing the number of call options can all increase The value of this position), the part of the subsidy comes from the protocol's premium pool (note that this situation will slightly reduce Liquity's overall overcollateralization rate). Liquity believes that not all positions need to be subsidized by the agreement, and the subsidy does not necessarily need to subsidize a large proportion of the position income, so subsidizing the secondary market can effectively maintain the hedging ratio of the agreement.

Finally, through these two innovations, there may still be no way to completely solve the lack of liquidity in extreme cases. Liquidity will also use a standard liquidity provider mechanism similar to Angle as a final supplement (the possible way is that the protocol will also allow users to deposit A part of V1 LUSD enters the stable pool to support the redemption of V2 LUSD in extreme cases).

Liquity V2 is planned to be launched in Q2 of 24.

In general, Liquity V2 has many similarities with Angle V1, but it has also made targeted improvements to the problems encountered by Angle: the innovation of "principal protection" is proposed, which is more attractive to traders. powerful products; a "secondary market for official subsidies" is proposed to protect the overall hedging ratio of the agreement.

However, Liquity V2 is still essentially the same as Angle Protocol. It is a stablecoin team trying to make a certain innovative derivative product across the border and feed back its stablecoin business. The ability of the Liquity team in the field of stable coins has been proven, but it is doubtful whether they can also design excellent derivatives, find a PMF (Product Market Fit, product matching market demand) and promote it smoothly.

Conclusion

A decentralized reserve protocol that can achieve decentralization, high capital efficiency and maintain price stability at the same time is exciting, but the exquisite and reasonable mechanism design is only the first step of the stablecoin protocol, but more importantly, it depends on the stability of the stablecoin. Use case expansion. The current decentralized stablecoins are generally making slow progress in the expansion of use cases. Most decentralized stablecoins only have a real use case of "mining tools", and the incentives for mining are not inexhaustible.

To some extent, Paypal's PYUSD event is a wake-up call for all encrypted stablecoin projects, because it means that well-known institutions in the web2 field have begun to set foot in the stablecoin field, and the time window left for stablecoins may not not for long. In fact, when we talk about the centralization risk of managed stablecoins, we are more worried about the risks brought about by unreliable custodians and issuers (Silicon Valley Bank is only the sixteenth largest bank in the United States, Tether and Circle is just an "encryption-native" financial institution), if there is a "too big to fail" financial institution (such as JP Morgan) in the traditional financial field to issue stable coins, the national credit behind it is not only It will make Tether and Circle lose their foothold in an instant, and it will also greatly weaken the value of decentralization advocated by decentralized stablecoins: when centralized services are stable and powerful enough, people may not need decentralization at all .

Until then, we hope that there will be enough use cases for decentralized stablecoins to reach the Schelling point of stablecoins (referring to the natural tendency of people to communicate without communication), although this is difficult.