Yesterday I got caught up with a pending job so I wasn’t able to make it.
That’s why today I decided to bring you a Double Issue with 1000 words on the flippening: UST vs off-chain collateralized stablecoins and novel partial-collateralized stablecoins pioneered by FRAX.
What's happening? UST flipped BUSD by market cap yesterday.
It's time to see who will win: algorithmic stablecoins or off-chain collateralized stablecoins?
UST uses an algorithm to manage UST and LUNA supply, but the model is known in the academic research sector as a dual coin mechanism where a secondary coin absorbs volatility, in this case, LUNA.
On the other side, off-chain collateralized stablecoins like USDT or USDC, took a more traditional approach and decided to be backed by a set of real-life assets into a reserve, still, having to deal with centralization and institutional bad behavior.
Knowing the issue with a dual coin system is to be relayed upon demand, UST decided to take the best from both approaches since they acquired BTC and AVAX reserves used as a backup, something like a hybrid model between off-chain collateral and dual coin mechanism.
It has also been widely noticed the fact that more than 70% of UST supply is currently locked on Anchor Protocol. More now knowing that tomorrow we should hear news about the new NEAR stablecoin, USN, which promised to offer 20% APY.
Are we gonna see a rotation of money LUNA and NEAR? We should, knowing investors are yield-drive individuals.
Looks like Terra has been predicting an event like this, especially since Do Kwon announced the 4pool.
The 4pool is a algorithmic vs off-chain collateralized stablecoin pool over Curve Finance.
UST vs FRAX vs USDT vs USDC.
The 4pool also will give another liquidity avenue for UST thus more price stability. This, as Terra is leading the 30D change regards CVX accumulation according to Delphi Digital report with almost 650K CVX front-running Frax.
Curve Wars? Remember that in Curve Wars, Convex Finance is the protocol, by now, with the most gauge weight thus being the DAO with the most Protocol Owned Liquidity (POL) and power to control CRV pool's emissions.
So how Terra can fight Convex gauge weight's power? By forming alliances with Badger, Redacted, Olympus and Tokemak, adding up almost 60% of total gauge weight power.
The State-of-the-Stablecoin
I think we are gonna face a new era of innovation for stablecoin mechanisms.
Traditional approaches like off-chain collateralized stablecoins bring the centralization issue. Even as USDC tried to make a difference by diversifying its collateral across many banks, they still rely upon a centralized set of institutions.
On-chain collateralized stablecoins might be good as they control further inflationary or deflationary pressure, but, the problem being they rely upon borrowers paying their debt.
What if they don't pay their debt? Liquidations' cascade.
And sure, we still can rely upon MakerDAO holders and open market operations selling MKR tokens to buy back liquidity to pay back borrower's debt but still, we are putting a set of users at risk.
Algorithmic stablecoins had shown to be great.
Rebasing Rebasing algorithmic stablecoins might be more "sus" than other mechanisms as the supply of token holders is directly rebased on demand. This y being driven by an algorithm so it's kind of like a third party management
Dual coins Dual coins mechanisms such as the one used by UST had shown to be great: they solve the borrowers' debt dependency, volatility, and supply unscalability to meet demand, but, they rely upon demand.
Partial-collateral Partially-collateralized stablecoins such as FRAX, being the first example of stablecoins implementing this model, is a mix of the best of fully-collateralized and fully-algorithmic ones. A still new territory explored by Frax Finance.
On Partial-collateral stablecoins, the collateral ratio asked to borrowers is set according to how much liquidity is needed to stabilize FRAX-peg.
So, what's the FXS deal?
You got two tokens: FRAX, the stablecoin, and FXS, the volatility absorber a.k.a. share token.
Might look pretty similar to what UST and LUNA do but here is the catch.
To mint FRAX, users (now borrowers) ask for a loan: Collateral plus FXS tokens.
And as we know, every loaner needs to secure their assets.
How? With LTV.
Collateral ratio a.k.a. LTV is the amount of collateral needed to get a loan.
The lower the LTV, the more risks for lenders as they are willing to lend more money out to borrowers than the money borrowers put down as collateral.
The higher the LTV, the fewer risks for lenders.
For example: If LTV a.k.a. Collateral Ratio value is equal to 50%, for every FRAX asked, the loan will ask for $0.5 of collateral and $0.5 of FXS.
Borrowers can always redeem one FRAX token for $1, always, plus, the collateral.
If FRAX, goes below $1, arbitrageurs are incentivized to buy FRAX at open market and redeem it to Frax Finance for $1 and make a profit. This drives demand higher.
This is where FRAX becomes fully collateralized.
If FRAX goes above $1, arbitrageurs, now borrowers are incentivized to mint FRAX through a loan-> They put a collateral asset plus FXS.
Loaned assets are then sold through open market which will drive the price down.
But, what about FXS demand? When FRAX tokens are minted due to borrowers' loan demand, FXS is burned proportionally driving higher demand due to scarcity.
This means that FXS price will increase as long as there is increasing FRAX demand.
Here is where FRAX becomes fully algorithmic.
To wrap things up:
When FRAX is above $1-> LTV asked to borrowers will decrease gradually-> Less collateral needed for loans-> Borrowers are incentivized to ask for loans-> The more FRAX is minted-> Supply goes up-> FRAX abundance-> Price goes down looking for a fair price according to demand.
When FRAX is below $1-> LTV asked to borrowers will be increased gradually-> More collateral needed for loans-> Borrowers are less incentivized to ask for loans-> The less FRAX is minted-> Supply goes down-> FRAX scarcity-> Price goes up looking for a fair price according to demand.
The mechanisms look good, but what if I tell you that instead of having just one weak point, now we got two?
On one side we have on the downside de-peg risks: the dependency over demand.
If there isn't enough FRAX demand, why borrowers will even try to ask for loaned FRAX?
On the other side, we have the upward de-peg risks: the dependency upon borrowers.
What if borrowers aren't able to pay their debt?
FRAX is still on time to show overtime how well it can maintain a stable price, especially during future black swang events like the 2020 pandemic dump.
It's in the bad times that stablecoins are tested.