Ups and downs, is it a demon or a fairy? Understanding Ampleforth's monetary experiment

Written by: Derek Schloss and Stephen McKeon, Partners at the tech venture capital Collaborative Fund

Compiled by: Leo Young

Ampleforth has recently gained significant attention in the market, with new projects continuously integrating similar functionalities into their protocols. It is worth taking some time to understand Ampleforth, its design and pricing mechanism, the psychological and demand-driven factors behind it, and to explore its future evolution.

Ampleforth (AMPL) employs a "elastic supply" monetary policy, meaning that the total supply of AMPL changes with its unit price. The principle is as follows:

• Every day at 10:00 AM Beijing time, the Ampleforth smart contract will increase or decrease the total supply of AMPL, with the daily adjustment referred to as "Rebase."

• All wallet balances are adjusted proportionally. After the Rebase, the proportion of holdings for token holders remains the same as before the Rebase. Rebase is not dilution, as all account balances are adjusted proportionally, whether the adjustment is positive or negative.

• The change in wallet balances does not involve any airdrops or trades; it is simply the function of the AMPL smart contract at work.

• The daily Rebase is determined by the market price of AMPL. If the trading price of AMPL is more than 5% above the target price, the amount of AMPL in wallets will increase after Rebase. If the trading price of AMPL is more than 5% below the target price, the amount of AMPL in wallets will decrease after Rebase.

• The target price was set at 1 USD in 2019. In 2019, the target price was 1 USD, and now in 2020, accounting for inflation (based on the Consumer Price Index CPI), the target price is 1.011 USD. Therefore, the balance range is between 0.96 USD and 1.06 USD (+/- 5%). If the market price (oracle price) is within this range, no Rebase occurs.

Understanding Rebase through Analogy:

Stock Splits, Cattle, Gold, and Fiat Currency

Analogous models help investors understand how wealth changes with Rebase. The following will explore four other types of assets with increased supply: stocks, cattle, gold, and fiat currency.

Let’s start with stock splits in the stock market.

To control the price per share, companies will split their stock, lowering the unit price (or increase the unit stock price through a reverse split). For example, if a company does not want its stock price to exceed 100 USD and it reaches 90 USD, it can perform a 2:1 split. If I have 100 shares, after the split, I will have 200 shares.

This proportional distribution is similar to AMPL. If I have 100 units of AMPL and a 10% Rebase, I now hold 110 units of AMPL. Each wallet's balance will also increase proportionally.

What will the price be after the split?

Answering this question is not easy. In a 2:1 stock split, the opening price per share drops by half (45 = 90 - 45), so my total stock value remains unchanged (10090 USD = 20045 USD). When I teach about stock splits, I always use cake as a metaphor. Cutting a cake into smaller pieces does not change the total weight of the cake, just as splitting stocks into more shares does not change the fundamentals of the company. Changing the total number of shares does not affect the value of the company's stock.

However, one important point is that AMPL, as a commodity currency, is not a stock, and the underlying protocol is not a company. The value of corporate stock is based on the discounted value of future cash flows, a valuation framework that does not apply to commodity currencies, so using stock splits as an analogy does not provide a complete picture of AMPL. The assessment framework for price adjustments based on commodity prices requires a slightly different approach.

For example, if we have 100 cows that give birth to 25 calves, we would not immediately say that the price of cows has decreased by 20%. An increase in the number of cattle would create new value; if there were no new value, farmers would abandon feeding them. If a farmer's herd increases by 20% and there is an oversupply of cattle in the market, the market price of each cow would also decrease accordingly.

However, price changes depend on market expectations of the supply increase and the extent to which the increase enters the market. If merchants anticipate an influx of cattle into the market, prices will adjust in advance. We expect the market to have no reaction to the increase in supply (after all, the calves have not yet grown up).

In this analogy, cattle are consumer goods, not commodity currencies (at least not since modern times). Although there are digital consumer goods, AMPL is not one of them. Consider the supply adjustment of consumer goods; it is not as simple as stock splits that merely increase supply. This introduces a concept where the increment creates an increase in existing total value, but this analogy is still not perfect.

Let’s take gold, the oldest commodity currency, as an example. What happens when the supply of gold increases? An increase in supply will appreciate the party increasing the supply (e.g., miners). If miners increase the supply by 1%, the increment will not increase the amount of gold in an individual's safe. Even if the supply increases, the amount of gold an individual holds remains unchanged.

The overall market balances, and with specific demand, the increment enters the market, leading to a decrease in market price. If an individual does not receive an equivalent share of the supply increment, their wealth value will also decrease accordingly. An increase in supply (output) causes a decrease in the value of current holders (stock), and investors can use the stock-to-flow ratio to value commodity currencies.

Finally, let’s look at fiat currency. When the Federal Reserve prints more dollars, does your money increase? Perhaps it does. For example, the newly issued money might be sent to you as aid. If you are the recipient, your cash holdings will increase. However, the newly issued money will not be distributed proportionally among all holders. For instance, foreign dollar holders will not receive the remittance.

You might argue that the government's issuance of more money will lead to increased interest, and bank deposits will increase accordingly, but this involves another concept: money as a holdable investment asset. The cash you keep at home does not earn interest, and it is interesting to consider whether central bank digital currencies will change this phenomenon. An increase in the money supply will lead to price inflation, meaning a decrease in purchasing power per unit.

The effects of fiat currency issuance are too broad to discuss in detail here. However, we can conclude that the increase in fiat currency does not get distributed proportionally to all holders, so comparing fiat currency to AMPL is not appropriate.

Thus, the supply model of Ampleforth is similar to stock splits and increases in cattle, but completely different from gold and fiat currency.

Pricing Mechanism

Let’s look at some numbers related to Rebase.

• Daily Rebase is calculated as (oracle price - target price) / 10. If the oracle price for the day is 2 USD and the target price is 1.01 USD, then after the Rebase, each wallet's AMPL balance increases by 9.9%, i.e., [(2.00 - 1.01) / 10].

• By regulation, negative adjustments have a cap of 10%, while positive adjustments have no cap.

In practice, Rebase causes prices to move in the direction of "geometric mean market makers" on Uniswap. The system controls the weighted geometric mean of the reserve constant. This means that X in the following formula is a constant:

Positive adjustments will increase the total amount of AMPL in the liquidity pool, which means the price of AMPL must decrease for X to remain measured, and the opposite is true for negative adjustments.

For example, if before Rebase on Uniswap, 200 AMPL is exchanged for 1 ETH, after a 10% Rebase, there will be 220 AMPL. Some might think to enter a trade in a millisecond after Rebase to profit 1.1 ETH.

That won't work because after the adjustment of AMPL in the pool, the price immediately changes from 200 AMPL per ETH to 220 AMPL per ETH. In other words, the price of AMPL against ETH decreases (the same applies to USD). This eliminates the need for arbitrage trading; Rebase itself brings prices closer to the target price by adjusting the liquidity pool.

It is important to recognize that the Uniswap price is different from the AMPL oracle price, and we list the following table to explain the important reasons.

Assuming no buying or selling after Rebase, we use the Uniswap price to guide Rebase. If someone spends 1,000 USD to buy 500 AMPL at a price of 2 USD and then stops trading to wait for Rebase, twenty-two days later, if the AMPL price returns to 1.06 USD, the total value remains unchanged, and AMPL becomes 942.

Next is the aspect of psychology. The Uniswap price is not the oracle price. The price on Uniswap is different from the issuance of commodity currencies and is similar to stock splits.

If market participants believe the increment has value, it will not proportionally decrease the asset holding value before Rebase; we will see that centralized exchange asset trading prices are higher, while Uniswap adjusts prices immediately. This leads to arbitrage behavior, pushing up Uniswap prices while centralized exchange prices decrease until the two prices converge.

Returning to stock splits, it is important to note that the price principle is not just about cost friction; it also involves psychological factors. When the stock price exceeds 100 USD, investors feel it is expensive. Extensive academic research shows that investors act based on reference points. For stock investors in the twentieth century, 100 USD per share was a reference point. Part of the reason for stock splits is to adjust according to reference points, aligning with investor psychology.

Ampleforth's adjustments also have a reference point: 1 USD in 2019. The response to the reference point can be seen as a behavioral bias, but it does indeed impact economic outcomes. Programmable cryptocurrencies offer functionalities that traditional assets cannot achieve, so the psychological effects of daily Rebase have not been studied or understood. This is one of the most fascinating experiments in the current crypto asset space, as it will validate the fusion of psychology and economics in monetary design.

Rational individuals may debate whether the value of a monetary network increases as the total amount of the monetary commodity increases. However, ultimately, the value of money must be socially constructed. Money has value because people believe it has value, and vice versa. Network value is the result of the aggregation of market beliefs.

As the price and supply of AMPL continue to adjust, the investment perspective primarily focuses on network value. Our view is that, compared to supply, network value depends more on demand. For Ampleforth, supply is contingent upon demand.

So, what drives demand?

The Psychology of Ampleforth

https://www.ampleforth.org/dashboard/

In July, the network value of Ampleforth surged, then retraced 65% from its peak. What drove the increase in demand? More importantly, what are the long-term drivers of demand?

Consider the following three points:

1. Incentive effects
2. Short-term speculation
3. Increased economic utility of AMPL

Incentive Effects

The initial rise in AMPL demand illustrates the role of incentives. One question we have often debated in observing Ampleforth is, what attracts more people to participate? For AMPL to become a commodity currency in Ethereum or other ecosystems, the Ampleforth system needs more participants.

Enter the era of yield farming.

On June 23, 2020, the Ampleforth team launched the incentive program Geyser, which rewards users providing liquidity for the AMPL-ETH trading pair on the non-custodial decentralized exchange Uniswap. Liquidity brings liquidity, which is a catalyst for demand.

Users providing AMPL-ETH liquidity on Uniswap can earn liquidity provider (LP) rewards, and they can also stake LP tokens in Geyser (background reading: Placehoder's "Proof of Liquidity"). Users providing more liquidity on Uniswap and staking in Geyser can earn more AMPL rewards through the project.

It is important to note that the blockchain not only tracks asset balances but also tracks the duration of asset holdings, which can be considered a killer application. What effect does this have on Ampleforth's incentive program? Geyser rewards not only based on the amount of liquidity but also according to the user's staking duration in Geyser, with up to three times the rewards for staking over 90 days.

Thus, it can be said that Geyser's success is not solely based on liquidity incentives. By adding a time component, it rewards users who do not withdraw their liquid assets. This has led to a ~70% retention rate since Geyser's launch, which is quite surprising.

Geyser has three types of incentives: 1. LP rewards on Uniswap; 2. Deposit amount rewards; 3. Deposit duration rewards. This has brought significant attention to Ampleforth and has also created some second-order effects.

One effect of Geyser is a substantial increase in the distribution of AMPL holders. In June 2018, Ampleforth was just a private project, and the network was controlled only by the team, advisors, and a small number of investors. In June 2019, Ampleforth raised 5 million USD in just seven seconds during its Bitfinex IEO, making headlines. By June 2020, about four thousand Ethereum wallets held AMPL, and then Geyser appeared.

As of the completion of this article, the number of wallet addresses holding AMPL is close to twenty thousand. Another effect of Geyser on Ampleforth is a significant increase in AMPL liquidity. The AMPL-ETH Uniswap liquidity pool is the largest pool on Uniswap in the past thirty days, with a total of 45 million USD, providing good market depth for the trading pair.

For a period, the AMPL-ETH liquidity pool accounted for more than half of the daily trading volume and one-third of Uniswap's total liquidity. In July, the trading volume of AMPL-ETH on Uniswap reached 500 million USD.

Ampleforth is optimizing the commodity currency use case; reliable currency requires reliable liquidity. This has stimulated the establishment of deep liquidity pools for incentive demand. After Geyser's success, the Ampleforth Foundation recently announced that 23.5% of tokens will be allocated over the next ten years to support Geyser or similar projects, focusing on decentralization, liquidity, network health, and broad rewards.

Short-term Speculation

The second demand driver is short-term investment, which includes FOMO, trends, and speculative trading. This concept is that demand brings demand. As assets gain upward momentum, more speculators flood in, hoping to make quick profits. It should be noted that while this will certainly push up the network value of AMPL, it is also unsustainable.

Speculation should not lead to the abandonment of a project. The same speculative demand exists for BTC and ETH. Each time these arise, the media will declare that Bitcoin is dead, and we do not like to draw the same conclusion for AMPL.

The boom-bust cycle is a significant characteristic of the maturation process of cryptocurrencies. Bitcoin has experienced demand surges in 2011, 2013, and 2017. Each time was followed by a significant drop, then a new high. For example, in the fourth quarter of 2013, the BTC network value was 1.5 billion USD, which then soared to 13 billion USD that quarter, only to halve in the first quarter of 2014, and then drop again in 2015.

In 2015, the market cap remained between 3 to 4 billion USD, never returning to 1.5 billion USD. At the beginning of 2017, BTC's market cap was 15 billion USD, soaring to 300 billion USD in the fourth quarter, and then maintaining between 60 to 70 billion USD at the end of 2018 and the beginning of 2019. It never fell back to 15 billion USD. An important metric for evaluating AMPL is that after demand increases and decreases, the network value of AMPL is higher.

Only time will prove the vitality of Ampleforth. Whether it succeeds or fails in the long term depends on the applicability of the protocol and the vitality of the community. Speculation is merely a window for the market to understand applicability, but short-term fluctuations in network value can also distract attention.

Gauntlet Network released a research report in August 2020, analyzing Ampleforth's trading from January 3, 2020, to June 22, 2020, while simulating different short-term trading strategies within the Ampleforth system and assessing their effectiveness.

The simulation found that the Rebase arbitrage trading strategy was the only trading model with significant profit potential among various market participants such as arbitrage traders, balanced traders, mean-reversion traders, and trend traders. Data simulations for the second half of 2020 will be very interesting.

Increased Economic Utility of AMPL

If an asset lacks economic effects, short-term incentives or short-term speculation for the protocol itself are unsustainable. To achieve sustainability, the Ampleforth protocol (and AMPL) must become a compelling economic product, with the product's persuasiveness relying on community user engagement.

Since the inception of Bitcoin, the network has been open, immutable, and transparent, coupled with verifiable scarcity, reshaping global individuals' and institutions' thinking about currency and digital value.

Many other crypto asset networks are also optimizing commodity currency use cases. By utilizing Bitcoin's economic design features (such as fixed total supply) while iterating other functionalities (such as privacy, governance, consensus), we have seen many different experiments creating new types of cryptocurrencies. Supply is just another dimension of design and not the main theme of many experiments. This is primarily because if the supply increases without being proportionally distributed to holders, it is detrimental to the holders' assets.

When the supply of an asset is fixed, the demand fluctuations for asset holdings are fully reflected in the price. In contrast, assets like AMPL with elastic supply absorb positive or negative demand shocks through supply adjustments, keeping prices relatively stable. Importantly, the "wealth" of holders *(units * price)* will still change with demand fluctuations, but the volatility affects the unit amount rather than the price. This validates the old adage that financial risk rarely decreases; it is more about shifting elsewhere.

Is the effectiveness of transferring price volatility to unit amounts valid? The answer is perhaps. But we must consider the three functions of reliable currency:

1. Unit of account (UoA). "One candy costs 1 AMPL."

2. Medium of exchange (MoE). "Sure, I’m happy to accept AMPL for candy."

3. Store of value (SoV). "I want to store AMPL in a cold wallet for ten years before buying candy."

We note that before 1971, the U.S. used gold to regulate the supply of base currency dollars, but gold was inconvenient for value exchange; the unit of account was based on dollars rather than gold itself. The infrastructure of cryptocurrency wallets and exchanges continues to evolve and merge, making asset exchanges increasingly frictionless, with exchange costs tending toward zero, ultimately making exchange costs negligible for users.

This unbinds the characteristics of reliable currency. Compared to fixed-supply assets, elastic supply assets are more useful as units of account, while assets with deep liquidity pools may become the best medium of exchange. If AMPL can achieve a stable target state, it could represent the optimal unit of account, as the target price will rise with fiat currency inflation.

Among the three functions of reliable currency, the store of value characteristic is the hardest to predict for early experimental assets. Due to volatility affecting unit amounts rather than prices, the price of candy may still be 1 AMPL in ten years, but you might open your wallet to find 0.01 AMPL or 500 AMPL. Therefore, a worthwhile approach to consider is not to keep your AMPL in a cold wallet but to purchase AMPL futures contracts, transferring the risk to investors willing to bear market value fluctuations.

To prove the store of value characteristic, AMPL needs to achieve stability, with long-term prices remaining within the balanced price range, only deviating occasionally due to genuine changes in demand (not speculation). For example, if a popular app adds AMPL as a payment currency, it would drive AMPL demand. Theoretically, prices would exceed the price range based on demand changes, increasing supply to meet market demand, and then returning to a new balance.

A stable state cannot be achieved through massive speculative trading but must be realized through integrating non-speculative uses of AMPL. Additionally, there are psychological factors; AMPL will only reach a stable state when the market believes it has reached that state.

The characteristics of a stable state are continuous buying support below the target price and continuous selling pressure above the target price, with prices remaining within the balanced range. Long-term holders of AMPL believe that the stable state will ultimately be achieved and that it will reach a high network value.

Although AMPL is still in its early stages, it has been operating as expected:

• Elastic supply. Over the past year, the supply of AMPL has continued to expand and contract.

• Low volatility. Aside from extremely low demand from September to October 2019 and extremely high demand in July 2020, the price of AMPL has consistently fluctuated between 0.5 USD and 1.5 USD. While there are still slight deviations from the balanced range, the price is relatively stable compared to fixed-supply assets.

• Decoupling correlation. Gauntlet's conclusion in the August 2020 report found that, based on market capitalization, AMPL's historical returns were uncorrelated with BTC and ETH over different time periods. We will closely monitor the correlation with other assets and the growth of Ampleforth's network value. Importantly, AMPL (as a currency unit) must achieve a stable state as a base currency, accompanied by Ampleforth (the system) reaching a credible midpoint. In the coming years, its decentralization will be reflected in several characteristics, such as protocol changes, oracle pricing, and ongoing project development.

Some projects strive for gradual decentralization by building community governance processes to address these challenges. For others, over time, the reliability of the protocol relies more on eliminating human control. The Ampleforth team recently announced the removal of the protocol's "emergency pause" functions (setRebasePaused and setTokenPaused) from the protocol's smart contracts. As the system evolves, the team has been committed to minimizing human governance from the start.

As everyone knows, all other types of currency, such as shells, stones, gold, and fiat currency, rely on market confidence for their longevity. The question is whether Ampleforth has created a credible economic product and whether, over time, the credibility of AMPL as a commodity currency will be accepted and utilized in the economy.

To complicate matters, the ultimate form of currency in the future may not simply be a traditional reliable currency structure (unit of account, medium of exchange, store of value) mapped onto the blockchain. In the new world we are exploring today, assets can be digitally "packaged" and programmed, allowing us to exchange, price, and store value with minimal friction and transaction costs. The monetary functions we rely on may ultimately undergo unbinding and re-bundling, presenting themselves in forms we cannot currently comprehend.

Welcome to this currency experiment.