OKEx Research | parsing algorithm: stable currency and human nature

OKEx Research: Algorithm vs. Humanity -- Analyzing Algorithmic Stablecoins

Original source: OKEx Research

encryptioncurrencyThe most amazing thing about the field is its constant innovation, and the algorithms that started to emerge at the beginning of the New YearStable currency", is undoubtedly the most ambitious and imaginative monetary innovation experiment at present -- an attempt to abandon the traditional manipulation, and strive to achieve the stability of money by the algorithm itself.

It can be said that the attempt to develop algorithmic stablecoins is a contest between algorithms and humanity. The algorithm pursues absolute rationality, presenting preset rules in the form of code, and its operation logic is not affected by the environment. Human nature, often in the "animal spirits" of greed and fear, triggered the market boom and crash.

However, this leads to a common paradox of the current algorithmic stablecoin: in the early stage, in order to expand the market scale, the algorithmic stablecoin must make use of the greed of human nature to issue more stablecoins, but this is at the cost of unstable price; When the size of the stablecoin market is large enough, the stability of the currency value is improved, but people leave the market one after another due to the lack of profit, resulting in the contraction of the market size.

From the first generation of algorithmic stablecoins AMPL last summer to the second generation of algorithmic stablecoins Basis Cash and ESD, we can observe that algorithmic stablecoins struggle and tear repeatedly in the "market size - price stability" paradox.

The first generation of algorithmic stablecoin --  Single Currency System (AMPL)

Although algorithmic stablecoins started appearing on the market as early as 2018, it wasn't until the summer of 2020 that algorithmic stablecoins really caught the limelight.

In terms of algorithm principle, AMPL is nothing special. Its theoretical basis is the simplest and most important supply and demand model in economics: there is no upper limit on the total amount of AMPL; When the price of AMPL rises above $1.06, AMPL circulation will be increased to lower the market price. When the price of AMPL drops below $0.96, the amount of AMPL in circulation will be reduced to raise the market price, thus keeping the price of AMPL near $1.

There is a joke that if you teach a parrot to say "supply" and "demand", it can become an economist. This is a joke, but it also illustrates the importance of supply and demand analysis in economics. When analyzing AMPL, many people like to use two phrases from supply and demand analysis:

• "The price of the stablecoin rises, leading to the supply of the stablecoin rises"

  
  

• "The supply of stablecoin increases, resulting in the price of stablecoin falling"

  
  

In the first sentence, it seems that there is no problem, because it is also true in reality. When the price of goods rises, businesses will be more motivated to produce more goods. When there is too much supply of goods on the market, the price will fall. So a lot of people like to explain it that wayAMPLHow it works:

AMPLThe price went up.AMPLSupply is rising.AMPLFalling prices

In this way,AMPLWe have achieved price stability, but in the real worldAMPLBut it fluctuates wildly.The reason is that this reasoning, which seems to be logically consistent, is flawed.The key here is that the word "supply" in the first sentence and the word "supply" in the second sentence are two different concepts.

In the first sentence, "when the price rises, the supply rises", where "supply" refers to "quantity supplied", that is, given that other conditions remain unchanged, the higher the price is, the more commodities the producer provides. Seen from the supply and demand diagram, the quantity supplied is a point. In the second sentence, when supply goes up, price goes up. At any given price, the producer is willing to supply more goods. Therefore, the full statement of the above two sentences should be:

• Price of stablecoin goes up → supply of stablecoin goes up (point on curve moves up)

  
  

• The supply of stablecoin goes up (curve moves to the right) → the price of stablecoin goes down

  
  

In distinguishing between the "supply" and "supply", we can find that the first generation algorithm for stable currency of the so-called "elasticity of supply", is just a misunderstanding - AMPL is still a completely inelastic supply of money (a vertical curve, resulting in greater price volatility), only depend on the price of the parameters, has carried on the adjustment, to supply its realistic logic is:

• AMPLDemand rises (curve shifts to the right) → price rises → AMPLSupply rises (the curve shifts to the right under algorithm manipulation) → AMPLFalling prices

  
  

• AMPLDemand drops (curve shifts to the left) → price drops → AMPLSupply drops (curve shifts to the right under algorithm manipulation) → AMPLThe increase in the price

  
  

For speculators, this is an excellent opportunity to manipulate the market using algorithms: early stablecoin circulation is low, and it is easy to inject capital to drive up the price at low cost (the demand curve shifts to the right, pushing up the price), resulting in additional issuance of stablecoin, which is distributed to the currency holders. When the price reaches a certain level, the currency holders sell the additional stablecoin and make a huge profit.

However, whenAMPLWhen there is a certain amount of liquidity in the market, it becomes more expensive for speculative funds to drive up prices. To this end, speculative funds began to sell their stablecoin and withdraw from the project, resulting in a drop in demand (a shift to the left of the demand curve), with the result thatAMPLThe price of... began to fall. When prices fall, the supply curve, driven by the algorithm, starts to shift to the right, which causes prices to fall further and pushes more money out of the market, creating a "death spiral" until demand stabilizes.

The above phenomenon can be seen from the price and supply of AMPL in the chart below. In June, speculative capital poured in, constantly pushing up the price of AMPL, making AMPL issue more and more. By July, the price of AMPL had been pushed up to nearly $4, and the cost of continuing to pull was too high. Speculators began to exit and sell their AMPL, causing the price to break through $1, and then the supply of AMPL began to fall rapidly.

AMPLAs the originator of algorithmic stablecoin, due to its own design defects, speculation prevails and the price of stablecoin is extremely unstable. From this point of view,APMLIt is not a successful algorithm stablecoin project. In the game between the algorithm and human nature, the algorithm completely becomes the slave of human nature and becomes a tool for speculators to harvest the market. However, its pioneering significance is still worthy of recognition.

The second generation of algorithmic stablecoin --  Multi-currency system (Basis Cash)

Compared with the stablecoin of the first generation algorithm, in order to increase the stability of the system, the stablecoin has only one currencyBasis CashandESDIs represented by the second generation of algorithm stablecoins increase the richness in the system.

In order toBasis CashFor example,There are three main roles in the algorithm: stablecoinsBAC (Basis Cash),BAB (Basis Bond),BAS (Basis Share), according to the official propaganda, the three tokens correspond to US dollars, bonds and stocks. Its stabilization mechanism is as follows:

• whenBACThe price is lower than1The user can use the dollarBACSubscribe for bonds at a low price  BAB(BAB The price  = BAC The square of the price), so as to reduceBACAnd increase the circulationBACThe price of

  
  

• When the price of BAC is higher than $1, users can exchange BAC with BAB; If it is still necessary to issue additional BAC after the end of buyback BAB, the additional issue will be distributed to the holders of BAS as dividends. Increase the circulation of BAC in the above ways to reduce the price of BAC.

  
  

In terms of currency issuance,Basis CashThe main design of the three liquidity pools:

The first is the stablecoin pool, which users can deposit at the beginning of the projectDAI (MCD),yCRV,USDT,sUSD and  USDCGo to the relevant contract pool and get new onesBACAs a benefit, the pool is now closed;

The second isBasis Share 1 Pool, the user needs to UniswapV2 the  DAI-BACThe pool provides liquidity, accessLPThe token is then deposited1The pool can be enjoyedBASEarnings. By design,1The pool will allocate the totals  750000 & have spentgoldBAS;

Finally,Basis Share 2 The pool to which the user will go  Uniswap V2 the  DAI-BASThe pool provides liquidity, accessLPThe token is then deposited2The pool can be enjoyedBASEarnings. By design,1The pool will allocate the totals  250000 & have spentgoldBAS;

As can be seen from the above,Basis CashThe stablecoin design mechanism mimics the central bank's open market operations (Open market operations) : When there is excess capital in the market, the central bank sells bonds to withdraw money from the market; When the market is starved of money, the central bank buys bonds and releases money into the market. This is alsoBasis CashWhat the authorities have been preaching---Create a "decentralised Fed".

However, from a practical point of view, the price of BAC fluctuated sharply after listing, but did not show the characteristics of stability. At present, the price of BAC has fallen below the 0.60 mark -- that is, there is a 40% negative premium, but the price still does not show the trend of recovery. Why did Basis Cash, the so-called "decentralized Fed", not end up with stable price control? For Basis Cash has learnt only the facade and the skin of modern central banking, but not the essence. This is embodied in the nature and currency of Basis BondpolicyTool design.

(1) What is Basis Bond?

Officially,Basis CashIssued by theBasis Bond(BAB)It's a bond.In fact,BABIt's not a bond (Bond), but a perpetual rise-Type in a call option(up-and-in-call).

It's important to understand that,Bonds are issued to creditors with a promise to pay back the principal and interest on a specified date, regardless of the price of the subject matter---Even in the futureBACThe price is always lower1The dollar, also does not affect the repayment of the debt payment. So when the central bank issues central bank bills in the market, there'sinvestmentThose who are willing to buy, and successfully withdraw funds from the market.

So whatBasis Bond(BAB)Is rising- What about a call option? Because only when the underlying assetBACThe price of... has risen to1The system only allows investors to exercise their purchasesBACThe rights of which the benefits=The currentBACPrice & have spent- & have spentbuyBABwhenBACPrice squared. For example, an investor inBACfor0.9US dollars, with0.81Buy one at the cost of the dollarBAB; whenBACPrice rise to1.5US dollar, triggers the option to exercise the condition if the investor exercises and receives oneBAC, then the revenue is  1.5 -- 0.81 = 0.69The dollar; And if theBACThe price has been lower1Dollar, then will not be able to startBasis BondThe exercise condition of, in this case, for the investorBasis BondJust a piece of "waste paper".

Can say,Basis BondThe exotic nature of options, which leads toBasis Bash"Open market operations" fail and investors buyBasis Bond, its confidence is not based onBondThe repayment of the principal and interest itself at maturity is a betBACThe price will come back1Above the dollar, you're betting the market is rightBACThe confidence of the bet isBACIn the future.

It's like being inBTCAs prices fell, some leading analysts told investors to leverage up and buy nowBTC, its logic is: as long as everyone buysBTCIs going to decreaseBTCOf the current, and then raiseBTCThe price, then can obtain a handsome profit. How many investors are willing to foot the bill? I believe the market has the answer. 

(2)Basis CashIs it a proper "decentralized Fed"?

Genuine open market operations require the central bank to have both the tools to release liquidity and the tools to withdraw it. In terms of the types of open market operations, the current open market operations mainly include repurchase transactions; Cash bond transactions and central bank bills are as follows:

althoughBasis CashCalled a "decentralized central bank", it mimics only the instrument of central-bank notes, which can only be issuedBasis Bond(BAB) to withdraw liquidity, but in the face of market liquidity constraints (BAC > 1 And there are not enough tools to pump liquidity into the market.So this has to come back toAMPLThe old way: inject liquidity by directly controlling the stablecoin supply.

althoughBasis CashThere are all kinds of shortcomings, but compared toAMPLStill a big step forward, especially in curbing the urge to issue more stablecoins. forAMPLAs a result of the single currency system,AMPLHolders of the stablecoin themselves can reap dividends from the additional issuance of the stablecoin, leading to a boom in speculation; And the use of multiple currenciesBasis Cash, in the stablecoin issue first repurchaseBasis Cash"And then they will be distributedBasis ShareHolder; On the other hand,  Basis CashContinuously in addition to issue, two aspects of the combined effect of factors, inhibit speculative funds toBasis CashExcessive impact.

The third generation algorithm stablecoin---Semi-mortgage (FRAX)

In the current market, the representative of the semi-secured algorithm stablecoin isFRAX, different from the first and second generation of algorithmic stablecoins,FRAXBoth the casting and the destruction are based on two kinds of wealth---Traditional stablecoinUSDCAnd system finance."FXS", that is,

Among them, the F  Is the quantity of newly cast FRAX, X is the quantity of FXs, is the price of FXs in US dollars,Y is the quantity of traditional stable currency USDC, is the price of USDC in US dollars, and R is the mortgage rate

Mortgage ratesRAdjust it according to the system algorithm: when it starts running,FRAXThe mortgage rate is100% , adjust every hour (according to the number of blocks), the first1 Within hours, cast a  FRAXYou need to  1 The traditional stablecoin of the US dollar is used as collateral. Every hour since then:

• ifPUSD > 1 USD In this adjustment, the mortgage rate will be lowered  0.25%.

  
  

• ifPUSD < 1 USD In this adjustment, the mortgage rate will be increased  0.25%.

  
  

In order to ensure that the actual mortgage rate is equal to the rate set by the algorithm,FRAXAlso designed the "buyback (Buybacks) and remortgage (Recollateralization) mechanism ". The first is the remortgage mechanism. When the algorithm increases the system mortgage rate, in order to make the actual mortgage rate equal to the system mortgage rate, the amount of the system must be increasedUSDCThe number,FRAXAn incentive is set: Anyone can add it to the systemUSDCAnd in exchange for moreFXS; For example, a user can add value to the system1The dollarUSDCIn exchange for value1.2The dollarFSX. The "repurchase mechanism" allows users to use the system at any time when the mortgage rate is loweredFXSTo the system in exchange for equal valueUSDC, so there are no incentives in a buy-back mechanism.

"Repo (Buybacks) and remortgage (RecollateralizationThe existence of ") mechanism "ensures that users can mint or redeem stablecoins at any time according to the mortgage rate given by the algorithmFRAX, preventing it from appearingUSDCLack of collateral. In this case, the arbitrage mechanism guaranteesFRAXPrice stability:

• when  1 FRAX < The $1When, the arbitrageurs will buy  FRAXAnd in order to  FRAX To redeem  USDC and  FXSAnd through the sale  FXS Make a profit. right  FRAX The purchase demand will letFRAXPrices have gone up.

  
  

• when  1 FRAX > The $1The arbitrageurs are going to go through  USDAC and  FXS Go to the casting  FRAXAnd sell  FRAX While taking profits, selling pressure will promptFRAXPrices go down.

  
  

As you can see from the above, althoughFRAXClaimed to be a "semi-collateralized" algorithmic stablecoin, it is actually a "fully collateralized" algorithmic stablecoin---Users can use it at any time1 FRAXIn return for value1 The dollarUSDCandFRXThe algorithm controls only the mortgage rate and the mortgage rate of the systemFXSThe rate of increase, soFRAXThe price of... is remarkably stable.

Of course,FRAXThe problem is:FXSIt has absolutely no practical value,Arbitrageurs can use it at any time1 FRAXIn return for value1 The dollarUSDCandFXS, which means that the system completely transfers the price fluctuation risk of stablecoin to the systemFXSThe holder of a. After all, the value of1The dollarFXS, can be "the price is0.01The dollar100 FXS", or "The price is  0.001 & have spentThe dollar1000 FXS".

What's more, whereas the first and second generation algorithmic stablecoin market size was dependent on speculation, FRAX eliminates the possibility of speculative attacks -- which means that the FRAX market size is slow to grow. As the chart below shows, Frax hasn't sold more than 26 million units since its launch this year. For this reason, Frax will need to establish its own "debt markets" or other wealth-generating markets in the future to allow it to expand rapidly.

The future of algorithmic stablecoins

Under the modern economic conditions, there are two main channels of money release:

First, money issuing institutions release money by purchasing currency reserves or value anchors (such as gold, foreign exchange and other stores of value) to determine the unit value of the currency and enhance the credibility of the currency.

Second, money released by money issuing institutions through issuing loans to social subjects or purchasing their bonds. Loans and bonds, which represent the future wealth, are out of the current reality of the wealth of the restrictions, the release of money, will be able to ensure the timely supply of money, as well as the total amount of money and the basic corresponding scale of wealth, so as to guarantee the stability of the value of the currency.

Take China as an example2000-2014.Between years, the issue of RMB mainly foreign exchange, the reason is that China's foreign export increase rapidly during this period, the central bank to stabilize the currency RMB exchange rate, will have to purchase large amount of foreign exchange assets, such as the dollar, in turn, put out a lot of RMB, namely the renminbi issue is established on the basis of dollars and other foreign currency assets; Since the2014After the year 2000, China's foreign exchange outstanding funds began to decline year by year. At this time, the issuance of RMB evolved to be dominated by the increase in liabilities of the domestic banking system, that is, the issuance of RMB was built on the basis of debt.

Similarly, the first-generation stablecoins, such as USDT and USDC, are all like this: behind each stablecoin issued, there is 1 dollar of real fiat currency as a reserve (although some non-compliant stablecoins are tricky), so as to maintain the confidence of the stablecoin and ensure the stability of the price of the stablecoin.

Stable currency and the current of all kinds of algorithm exists "the size of the market - price stability" the root cause of the paradox is that algorithm stable currency issuance is not according to the size of the present or future wealth, prone to speculation, and thereby achieve a stable currency expansion, the consequences are extremely unstable currency and sustainability of the project.

Similarly, there is a fallacy in the current market that the expansion of the size of the algorithmic stabletop market must rely on speculation, thus sacrificing the price instability of the algorithmic stabletop. This itself is not deep understanding of the market economy, the expansion of the monetary scale, depends on the growth of social wealth. The wealth brought by speculation is temporary, because it does not create wealth, but only transfers wealth by using market rules, so when the speculative capital is withdrawn, the project will also decline.

Current algorithmic stablecoins generally lack a market for wealth creation. Therefore, if the algorithmic stablecoin wants to be successful in the future, it must establish a "debt market" or "wealth creation market" for the algorithmic stablecoin, which is in the marketDeFiThe domain can be loan agreements, insurance agreements, or other agreements that have practical application value. Based on the current and future wealth scale, the stablecoin can be put into and recovered by the algorithm. This can not only solve the "market size - price stability" paradox, but also create enough "policy tools" for the algorithmic stablecoin to maintain price stability.

Welcome to join the official BlockBeats community:

Telegram Subscription Group: https://t.me/theblockbeats

Telegram Discussion Group: https://t.me/BlockBeats_App

Official Twitter Account: https://twitter.com/BlockBeatsAsia