Digital dollars
We’ve written about stablecoins before - digital coins issued directly on the blockchain and pegged to a real-world currency. Their relentless growth has continued this year with the stablecoin market now 5x from the moment we started this newsletter in the autumn of 2020.
These coins can be issued by traditional centralised companies (Circle, Tether, Paxos etc) or by a decentralised community directly on the blockchain (Maker DAO, Frax etc). Each of these paths has its pros and cons, mainly revolving around transparency and confidence around having sufficient reserves backing the coin. Decentralised coins have full transparency by the virtue of being crypto-native beasts, but it’s harder to codify all possible scenarios protecting coins from bank runs. Centralised coins may be easier to manage given decisions are made within one entity rather than a broader community, but transparency is harder to achieve - while some issuers publish regular audit reports, others provide less granularity into their reserves.
Both models are viable and both models share the same important feature - these stablecoins are pegged to USD. For obvious reasons, it makes perfect sense and allows us to use (almost) the same USD on new digital rails.
As we learned from this newsletter, however, the moment crypto starts to make sense, it innovates further into the new realms.
Smart dollars
Could coins track something else and still be useful? If we are looking for something that is ‘stable’ (i.e. not volatile vs the real world currency of our choosing) and something that could protect us against inflation (i.e. gold / bitcoin), then why not try a coin tracking inflation-adjusted USD?
USD and other real currencies are still the only real major acceptable method of payment but they do depreciate over time. A smart stablecoin which algorithmically tracks USD + inflation sounds like a perfect solution.
This is exactly what some crypto founders went out to achieve. The trick is to define CPI, track it on the blockchain and embed it into the ‘exchange rate’. Some projects are working towards creating their own CPI index (Frax), while some have started by treating the Ethereum token as the inflation index - it currently has the deepest liquidity and broadest acceptance among smart contract enabled tokens.
Reflexler Labs have launched an algo stablecoin which is designed to track demand for ETH leverage (i.e. it should be loosely positively correlated with the price of ETH). The chart below is an insight into a sophisticated mechanism where the Market Price of RAI is a smoothed derivate of ETH price and the protocol supports it my maintaining a redemption price, ensuring the peg to the underlying index.
FLOAT - another algo stablecoin - tracks the value of ETH (the main component of its underlying ‘basket’) in a heavily smoothened way.
These are early attempts towards creating the next generation of stablecoins - the ones with utility and embedded inflation protection. Obviously most people in the world don’t care about the price of ETH but this is merely a starting point aimed at showing us what’s possible.
Complexity and opportunity
Designing and maintaining an algo stablecoin is no easy feat, many have tried and failed:
Maintaining a coin which is supposed to be pegged to something without being 100% collateralised by its underlying is a challenging task. It requires modelling complex logic as well as game theory and market behaviour. Float, for example, runs a sophisticated system of Auctions which serve as incentives for arbitrageurs to step in when the market price of Float is deviating from its ‘fair value’.
When there is a will there is a way and such experiments are what driving crypto and financial technology into the future.
We are fascinated by the potential of this technology and are delighted to welcome you to join us for a webinar chat with the founders of Float. It’s taking place on September 9th and you can register here.
Author is the Managing Partner of Re7 Capital - a stablecoin centric DeFi fund.