Pantera Partners: Interpreting the Operating Mechanism and Development Trends of Algorithmic Stablecoins

This article was published on ChainNews, authored by Paul Veradittakit, Partner at Pantera Capital

Recently, stablecoins have become a very hot topic, so I thought that if I could provide some higher-level guidance, it would be quite helpful to everyone. In this field, there are centralized stablecoins that are pegged to fiat currencies, and there are algorithmic, uncollateralized decentralized stablecoins. Before diving into the main content, I would like to thank Lewis Freiberg from Empty Set Dollar and Dan Elitzer from Nascent. If you want to learn more about stablecoins, you can also check out the algorithmic stablecoin series from the Delphi Podcast.

1. Overview of Stablecoins

Stablecoins refer to tokens issued on public blockchains that are pegged to fiat currencies, with their value typically anchored to stable "conventional" currencies like the US dollar. The aim of stablecoin assets is to minimize volatility, allowing transfers and settlement transactions to be processed in USD on certain exchanges and DEXs, and providing traders with a good way to acquire crypto assets like Bitcoin and Ethereum without price fluctuations.

Influenced by the DeFi boom, stablecoins saw remarkable growth in 2020. In fact, last week, the Office of the Comptroller of the Currency (OCC) announced that federally regulated banks can use stablecoins for payments and other activities. As one of the primary regulators of domestic banks in the US, the OCC pointed out in a letter that blockchain holds the same status as other global financial networks like SWIFT, ACH, and FedWire, and recognized stablecoins and cryptocurrencies as legitimate alternatives for real-time payment systems. Currently, the total value of stablecoins has exceeded $30 billion, reflecting the increasing demand for price-stable assets from investors during turbulent times.

At this stage, there are about 200 different stablecoins in the cryptocurrency market, with Tether and Centre's USDC being the two largest stablecoins by supply in the cryptocurrency market. Tether, in particular, is favored by traders, and its market capitalization has surged rapidly in recent weeks, now exceeding $21 billion. Since the beginning of 2020, Tether's market cap has quadrupled, accounting for more than three-quarters of the stablecoin market share.

Image source: The Block Crypto

In the fast-changing crypto market, the growth of stablecoins is remarkable. Unlike real dollars, they can be easily held or transferred within the digital ecosystem, allowing investors to gain many advantages of blockchain technology and P2P value transfer. Moreover, traders view stablecoins as a "buffer" before investing in high-risk cryptocurrencies. After purchasing stablecoins with USD or other government-issued fiat currencies, traders can transfer stablecoins to cryptocurrency exchanges for trading cryptocurrencies like Bitcoin and Ethereum.

2. What are Algorithmic Stablecoins?

Algorithmic stablecoins use price-stabilizing algorithms to track a specific unit price—usually $1—operating on public blockchains supported by underlying cryptocurrencies like Ethereum (ETH). The price of algorithmic stablecoins is supported by market and technical mechanisms based on smart contracts, which lock up crypto collateral and implement price stabilization algorithms. Unlike other types of stablecoins, algorithmic stablecoins cannot be redeemed for USD on a 1:1 basis and do not have other crypto asset collateral backing, often exhibiting high reflexivity. The demand for algorithmic stablecoins is primarily driven by market sentiment and trends, and the supply of tokens is also influenced by these factors.

In 2013, the first instance of an algorithmic stablecoin was launched on the Bitshares blockchain. Although the rapid growth of DeFi in 2020 gave rise to algorithmic stablecoin projects like Yam and Based, the longest-running algorithmic stablecoin to date is Ampleforth (AMPL).

For AMPL and similar algorithmic stablecoins, the token supply changes with the price of the target asset (a situation known as "rebases"), and these changes in token supply affect every account holding the algorithmic stablecoin. "Rebases" operations typically occur at predefined intervals, meaning that the algorithmic stablecoin network is highly reactive. Generally, there are two ways to adjust the supply of algorithmic stablecoins to correct imbalances between supply and demand:

• When the price of the stablecoin rises, the algorithm increases the issuance of the stablecoin;
• When the price of the stablecoin falls, the algorithm decreases the issuance of the stablecoin.

For example, we can design the algorithm in such a way:

• If a stablecoin worth $1 drops below $1, the algorithm can automatically set market buy orders to push the price up;
• If a stablecoin worth $1 rises above $1, the algorithm can automatically set market sell orders to lower the price.

On the other hand, some new algorithmic stablecoin projects (like Basis Cash and Empty Set Dollar) impose limits on "rebases" of token supply to eliminate the impact of supply changes on each wallet.

Image source: CoinGecko

Basis Cash is a new multi-token protocol based on the stablecoin Basis, which successfully raised $133 million in funding in 2018 but did not launch. Basis Cash, a fork of Basis, consists of three tokens:

1. BAC—an algorithmic stablecoin, with the current BAC token supply nearing 90 million;
2. Basis Cash Shares—when inflation occurs in the network, holders of Basis Cash Shares can request the issuance of additional BAC tokens;
3. Basis Cash Bonds—when deflation occurs in the network, users can purchase Basis Cash Bonds at a discount price, and when the network exits deflation, users can redeem BAC tokens with Basis Cash Bonds.

Basis Shares and Basis Bonds are designed to ensure that Basis Cash does not deviate from its pegged price of $1. For example:

• When the trading price of Basis Cash is below $1, users can destroy Basis Cash and purchase Basis Bonds, which will reduce the circulating supply of Basis Cash tokens. Basis Bonds have no interest payments, no maturity dates, and no expiration dates; as long as the trading price of Basis Cash rises above $1, users can directly redeem the Basis Bonds they purchased;
• When the trading price of Basis Cash is above $1, according to the smart contract, users can redeem Basis Bonds, and as the demand for BAC tokens gradually increases, new tokens will be minted and allocated to Basis Share holders.

The initial distribution amount of Basis Cash tokens is a total of 50,000 tokens, with token distribution prioritizing users who deposit DAI, yCRV, USDT, sUSD, and USDC tokens into the distribution contract. Subsequently, the distribution range will expand to users providing liquidity for the Basis Cash (BAC)-DAI Uniswap v2 trading pair, where users can deposit LP tokens into the distribution contract and receive Basis Shares.

Basis Cash launched on November 30, 2020, with a peak locked amount reaching nearly $200 million, which later decreased to $169 million. Initially, DeFi traders were eager to provide liquidity for the project, leading to an astonishing annualized yield of 10,000% for the BAC stablecoin liquidity pool. Currently, the daily yield and annualized yield for BAC/DAI are 1% and 365%, respectively, while the daily yield and annual yield for DAI/BAS are 2% and 365%.

Empty Set Dollar (ESD) is an algorithmic stablecoin inspired by Basis, launched in late August 2020, with a current market cap exceeding $100 million. The core of the protocol is the ERC-20 token ESD, which serves as both the stablecoin of the Empty Set Dollar protocol and a governance token. Currently, the total supply of ESD tokens exceeds 500 million, with daily yield and 30-day yield at 4% and 206%, respectively, and LP token daily yield and 30-day yield at 1% and 40%.

Basis Cash is still in its early development stage, while ESD has experienced multiple inflation and deflation cycles. ESD has three main functions:

1. Stability—by using a time-weighted average price (TWAP) oracle incentivized by Uniswap, ESD achieves spontaneous inflation and deflation of supply, aiming to stabilize the price around $1 to reward participants who promote stability within the protocol.
2. Composability—ESD follows the ERC-20 token standard, enabling seamless integration into the entire DeFi infrastructure.
3. Decentralization—ESD has always employed decentralized on-chain governance, with the community of token holders voting on any changes or upgrades to the protocol.

In fact, so far, in ESD's over 200 supply "epochs," 60% of the token time-weighted average prices have been within the range of $0.95 to $1.05, indicating that ESD's token stability is more than twice that of Ampleforth, considering that ESD has not been around for long, while Ampleforth is currently the longest-running algorithmic stablecoin.

3. ESD vs. Basis Cash

Like Basis Cash, ESD also utilizes bonds to "fund" the protocol's debt, but bonds must be purchased by destroying ESD tokens, and ESD can be redeemed if the protocol experiences inflation. However, unlike Basis Cash's "three-token" model, ESD does not have an inflation reward token like Basis Cash Bonds after the network repays its debt during inflation. To address this issue, ESD token holders can "stake" their ESD in the ESD decentralized autonomous organization (DAO) and receive token allocations based on the inflation rate, capped at 3%.

The ultimate function of the ESD "staging" model is very similar to the Basis Cash Shares "three-token" system, requiring the "unstaking" of ESD tokens from the DAO during the "staging" period. ESD tokens will be temporarily "staged" for 15 epochs (5 days), during which these tokens cannot be traded by their owners or earn inflation rewards.

Binding ESD to the DAO brings liquidity risks, while purchasing Basis Cash Shares brings price risks, but both methods allow users the potential to earn inflation rewards in the future. However, the "staging" requirements for bound ESD from the DAO and unbound ESD also create additional "time risks" and liquidity shortages, which are unique issues for ESD.

Source: Lewis Freiberg

It is worth mentioning that stablecoins have brought new regulatory challenges. According to the US Congressional bill—the Stablecoin Tethering and Bank Licensing Enforcement (STABLE) Act—stablecoin issuers must obtain bank charters and regulatory approval before issuing any stablecoins. Algorithmic stablecoins like Basis Cash, as well as other stablecoin issuers currently operating without bank charters, fall under the regulatory scope of this act. There may be concerns about Basis.io being shut down or facing potential regulation in the future, which is why the founders of the Based and ESD algorithmic stablecoin projects remain anonymous. Although regulations are evolving, the innovation of algorithmic stablecoins is shaping the future of DeFi currency and can play a key role in achieving secure digital transactions while maintaining price stability.

4. Forks of Basis and ESD

As branches of the Basis Cash and ESD protocols, several new algorithmic stablecoins have emerged in the market. For example, Mithril Cash is a fork of Basis, and this algorithmic stablecoin project was launched on December 30, 2020. The economic model of Mithril Cash functions similarly to how central banks determine the target value of fiat currencies. By buying and selling bonds, Mithril Cash controls the overall supply of tokens to achieve a target value of $1. The smart contract executing the algorithm behind Mithril Cash token MIC will keep the token price between $0.99 and $1.01, ensuring long-term predictability and reliability.

The Mithril Cash protocol has three tokens:

1. Mithril Cash (MIC)—the stablecoin within the Mithril Cash system, targeting a value of $1. Currently, the circulating supply is nearly 29 million.
2. Mithril Share (MIS)—an ownership token that can earn inflation rewards; those who stake assets in the protocol can receive MIS tokens.
3. Mithril Bond (MIB)—these bonds each hold a value of one MIC, and can be redeemed for one MIC once their price exceeds $1. Both MIC and MIB are designed to increase the price and guide MIC to reach its target value.

With the growing demand for robust stablecoin options, Mithril Cash offers a very promising and reliable token model.

Dynamic Set Dollar is another new algorithmic stablecoin, which is a fork of ESD. This protocol has two main functions:

1. Value stability
2. Providing profit opportunities for speculators during inflation and deflation phases.

Dynamic Set Dollar has launched a price-reactive ERC-20 algorithmic stablecoin DSD, which improves upon the ESD protocol by including:

1. Increasing penalties for coupon redemptions to reduce the impact of bot trading programs manipulating token prices;
2. Shortening the epoch cycle time to 2 hours, making the protocol more responsive to price fluctuations.

With DSD, although bot trading programs can still execute token exchange transactions, the impact on the protocol will be significantly reduced.

5. The Influence of Stablecoins Will Continue to Grow

The emergence of stablecoins has facilitated trading and value transfer, effectively combining the efficiency, security, and speed of digital currencies with the stability of fiat currencies. Currently, the global trading volume of stablecoins has reached billions of dollars, and the demand continues to grow.

In an evolving economic and technological era, stablecoins play the role of disruptors in traditional payment and financial industries. In this era, financial products and systems offered by large tech companies are replacing traditional banking services. For example, Facebook's Libra stablecoin project could attract large-scale adoption from users, potentially reshaping the digital payment landscape and posing new challenges to the global financial system, the circulation of sovereign fiat currencies, and monetary policy.

US regulatory frameworks are also keeping pace with the times. For instance, the recent approval by the OCC for banks to use stablecoins highlights the growing demand from institutional clients for conducting banking operations and authorized payment activities using stablecoins. It is expected that in the next decade, approximately 70% of the additional value in the global economy will come from digital platforms, and stablecoins provide a secure, price-stable new payment system that is well-suited for dynamic financial markets.