Editor's Note: This article comes fromFirst class warehouse blockchain research institute (ID: first_vip1), reprinted by Odaily with authorization.
First class warehouse blockchain research institute (ID: first_vip1)
Decentralized stablecoins seem to be contradictory: while their goal is to create non-custodial assets, they can only achieve full stability by adding uncorrelated assets (centralized/custodial assets, such as Maker’s recent addition of USDC as a collateral asset). In fact, this problem is more widespread in synthetic assets and cross-chain assets. We develop an alternative market-based mechanism to enhance the stability of assets in crisis while ensuring the absence of regulation. This creates a buffer that separates those who are willing to swap stablecoins for custodial assets in a crisis (in exchange for continued gains for option buyers) from those who want full decentralization.
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Historical price of ETH: On March 12, 2020 (Black Thursday), the price of Ethereum was almost cut in half, triggering a large-scale liquidation of DeFi and CeFi (chart: OnChainFx).
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On March 12, 2020, COVID-19 caused market panic and ushered in "Black Thursday", the price of cryptocurrency plummeted by about 50% on that day. The ensuing mass liquidation of major cryptocurrency leveraged platforms, including centralized platforms such as exchanges and new decentralized finance (DeFi) platforms that facilitate on-chain over-collateralized lending. On this unusual day, the Maker stablecoin Dai was not spared, falling into a deflationary liquidation spiral. This led to high volatility in “stable” assets and a breakdown in collateral liquidation procedures. Some collateral was liquidated at close to zero prices as network congestion exacerbated market illiquidity. As a result, the system suffered from a collateral shortage, prompting an emergency response by the project, which had to recapitalize by selling new, stock-like tokens.
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During this time, the demand for Dai has increased. It became a riskier, more volatile asset, but traded at a steep premium, with lending rates in the mid-double digits. Leveraged speculators have to buy back Dai to deleverage, which drains Dai liquidity and drives up Dai prices, thereby increasing future liquidation costs (we will discuss some of the causes of market illiquidity in the second half deeper reasons). These speculators are starting to realize that, in this case, they run the risk that $1 of debt forgiveness could carry a huge premium. Ultimately, a new external stable asset must be injected—USDC, a regulatory stablecoin pegged to the U.S. dollar, as a new collateral to stabilize the system.
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Historical lending rates for Dai, note double-digit rates starting March 12, 2020 (chart: LoanScan).
In addition to the panic caused by COVID-19, bitUSD, bitBTC, Steem Dollars, and NuBits also suffered major decoupling events in 2018.
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Stability Results
In this paper, we model the incentives for stablecoin speculators (CDP owners) like Dai to resolve crises like Black Thursday. These speculators determine the supply of stablecoins by optimizing the profitability of leveraged positions combined with expectations of future collateral liquidation costs.
This instability is triggered by several factors: huge underlying price volatility, ETH crash, liquidity issues caused by deleveraging in the crisis (possibly leading to a deflationary deleveraging spiral). In order to liquidate a CDP, speculators need to buy back stablecoins to repay debt. If speculators want to deleverage a lot, whether it is fringe speculators who want to increase leverage and issue new stablecoins, or stablecoin holders who want to sell their stablecoins, they cannot find a balance point, and then speculators end up Both will drive up the price of stablecoins. Essentially, speculators need to pay a premium for deleveraging in this situation, as Black Thursday showed.
The figure above is a visual explanation of the deleveraging spiral. To deleverage, CDP holders need to buy back stablecoins at an increasing price when market liquidity dries up.
These triggers are how things actually work in a cryptocurrency setup. They have proven to be relatively likely events over a long period of time. Therefore, we can neither ignore them nor expect them to change, we must adapt ourselves to them. We can focus on expanding the breadth of the stable region. The size of the stable zone depends on the precise market structure. In idealized (unrealistic) settings, the currency is stable over a large area. Importantly, however, even ideal circumstances can worsen when prices crash. Therefore, there are not many speculators who want to issue stablecoins, because it is related to risk positions that they think are not profitable.
The results of our analysis may be more applicable to data-driven stablecoin risk tools, for example, estimating the probability of breaking the peg and inferring when the barrier is crossed to leave the stable zone. But there is an obvious caveat here: certain numerical results can be highly model-dependent and very sensitive to market structure and the distribution of the underlying assets. Our focus is on dissecting these systems and how to mitigate the crisis.
One Solution: Integrating with Regulatory Assets
The deleveraging effect introduces a fundamental tradeoff in decentralized design. One way to bring stablecoins closer to a "perfect" stable state is to increase the adaptability (elasticity) of demand to supply.
Another way to bring stablecoins closer to "perfect" stability is to add marginal speculators willing to use leverage and issue more stablecoins. Since there are not countless speculators with high expectations for ETH (especially during a long bear market), this needs to rely on holding other collateral assets. Since all decentralized assets are highly correlated, this also relies heavily on holding custodial collateral, such as Maker’s recently added USDC. Of course, it should be noted that regulatory assets also have their own risks, which may not be relevant to those extreme crises. Such as counterparty risk, bank operational risk, asset seizure risk, and the impact of negative interest rates. There may be some substantial diversification potential, however.
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Dai Adds USDC as Collateral
While these measures of integration with custodial assets can enhance stability, this creates greater centralization and takes the system out of the “non-custodial” status. This seems to create a paradox: although the goal is to create non-custodial assets, these assets can only be fully stabilized by adding uncorrelated assets (currently centralized/custodial assets).
Alternative: Non-custodial insurance pools
We propose an alternative: a buffer to dampen deleveraging without direct consolidation of regulatory assets. The role of the buffer is to separate those who are willing to swap stablecoins for custodial assets in a crisis (enabling CDP holders to reap continuous benefits) from those who want to achieve full decentralization.
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Summarize
Expanding into Crypto Assets Beyond Stablecoins
This model/results (and thus proposed solutions) have broader application to synthetic and cross-chain assets and over-collateralized lending agreements that allow borrowing of illiquid and/or inelastic assets, as long as the mechanism is based on leveraged positions and forms The endogenous price of created or borrowed assets. Synthetic assets generally use a similar mechanism, just with different anchor targets. Cross-chain assets that migrate assets from non-smart contract-enabled blockchains (such as Bitcoin) to smart-contract-enabled blockchains (such as Ethereum) also tend to rely on similar mechanisms. In decentralized (or rather rely on on-chain custody) structures like XClaim and tBTC, vault operators lock up ETH collateral in addition to deliverable BTC assets. They are exposed to a leveraged ETH/BTC exchange rate risk and a similar deleveraging risk. Especially in order to reduce risks, they need to repurchase cross-chain assets on Ethereum.
