Stablecoins are one of the most important aspects in all of crypto. All major trading pairs on CEXs and DEXs alike are denominated in stablecoins. Volumes of stablecoins often exceed BTC volumes and ETH volumes. Stables are by far the most borrowed assets on decentralized money markets (27x more USDC is borrowed on Aave than ETH). Yearn’s most popular yield vaults are stablecoin vaults. Perpetual exchange protocols, which offer the most popular derivatives, are almost always collateralized against stablecoins.
Stablecoins are the foundation of nearly all that is DeFi.
However, not all stablecoins are alike. Tradeoffs exist for all stablecoin implementations. Each stablecoin exists along a spectrum of decentralization, stability, and efficiency. Together, these aspects formulate the stablecoin trilemma which plagues stablecoin designs as optimization along one aspect usually leads to degradation in another. The stablecoin trilemma can be defined as:
Decentralization: How dependent is the stablecoin on centralized systems?
Stability: Does the stablecoin remain at its peg without large variances, especially during times of market volatility when stable assets become high in demand?
Efficiency: How much capital is required to secure the stablecoin? More capital required, the less efficient and vice versa.
Stablecoin implementations largely fall into three categories: Fiat, Collateral Debt Position (CDP), or Algorithmic (algo). Fiat stablecoins are backed by corresponding fiat dollars (or other currency) in a traditional, centralized entity. For example, USDC is issued/burned by corresponding TradFi banks who are responsible for maintaining cash and cash equivalents in custody to back issued stablecoins. Collateral Debt Position stables are issued by decentralized protocols that accept collateral and issue debt in the form of a stablecoin. Collateral backing CDP is often greater than the amount of stablecoin debt issued in order to protect the protocol from fluctuations in the collateral token price. All in all, CDP stablecoins are backed by individual user deposited collateral. Algorithmic stablecoins have the widest spectrum of implementations with various algo stablecoins having noticeably different properties. However, each algorithmic stablecoin leans on a combination of game theoretic and mechanistic systems to ensure stability of the token.
Since fiat-backed stablecoins require a trusted centralized partner and collateral debt position tokens require overcollateralization due to the volatile assets accepted as collateral, algo stablecoins present the best opportunity for DeFi to solve the stablecoin trilemma with a scalable, decentralized, and efficiently scalable stablecoin. And decentralized markets are echoing this sentiment. Demand for stablecoins which can solve the trilemma and ensure long-term viability have skyrocketed over the previous year.
In Q4, the Algo stablecoin market cap grew 260%, significantly outpacing fiat and CDP-based stablecoins which expanded market caps by 18% and 87% respectively. At this pace, algo stablecoins are set to pass collateralized debt stables as the second largest category of stablecoins in Q1 2022. However, there is a significant differential between the supply of fiat stablecoins and algo stablecoins. Fiat stablecoin market capitalization is roughly 10x more than both collateral debt and algo stablecoins. This value gap is the market opportunity for algo stables as the more efficient scalability properties play out over the next year.
Current leading algo stablecoins include UST, FRAX, and FEI. Each employs a mechanism of redemptions which alongside supply and demand forces work to keep the stablecoin price pegged. UST, for example, works by minting/burning Luna in exchange for UST so that when the UST stablecoin begins to trade over the peg, Luna can be burned and exchanged for UST at a 1:1 dollar ratio (which is at the peg, but below the current price) to be sold into the market for a small profit. Creation of more UST in this scenario pushes the UST price closer to peg via supply and demand forces. This mechanism ensures that UST always has a market for $1. Luna in this scenario absorbs the supply and demand volatility that plagues stablecoins.
Frax works similarly with regards to the redemption mechanism of Luna, except FRAX is algorithmically collateralized by a floating collateral factor. Collateral factor simply defines how much USD value of collateral backs the stablecoin FRAX. At a collateral factor of 1, there is one dollar for every FRAX in reserves. As the collateral factor drops (by design in order to scale efficiently), less collateral is required per FRAX. Redemptions change by issuing FXS, the protocol’s governance token, alongside collateral (USDC) in line with the current collateral ratio. For example, with a collateral ratio of 0.75, redemptions would net $0.75 sourced from the collateral pools of the protocol and $0.25 worth of minted FXS which in total is $1 for every redeemed FRAX. Frax as a protocol also employs other mechanisms contributing to the stability of the protocol which by and large utilize collateral in market operations such as liquidity provisions, investments, or lending (these modules are referred as AMOs by Frax).
With the release of V2, FEI too deploys a redemption mechanism as the primary stability force for its algo stablecoin. Unlike FRAX, FEI is overcollateralized by its Protocol Controlled Value (PCV) reserves which consist of a variety of assets ranging from stables like DAI to volatile assets like ETH and Ethereum DeFi tokens. PCV serves both to fund 1:1 redemptions of FEI as well as to seed liquidity in trading pools guaranteeing FEI can trade at high volumes. Due to the volatile nature of the PCV collateral, FEI can shift from being overcollateralized to undercollateralized at which point redemptions would be funded with newly minted Tribe. Redemptions enable the supply of FEI to scale at a minimum 1:1 ratio relative to collateral while also enabling a stability mechanism for FEI as market volatility changes supply and demand ratios of collateral and FEI.
Redemptions are the key stability mechanism utilized by current algo stables because each either has a one of or a combination of the following; volatile collateral (FEI), undercollateralized (FRAX), or requires volatility absorption mechanisms via a complementary token (UST). All because of one simple fact, none of these protocols have consistent, guaranteed backing 1:1 of collateral to stablecoins. Why don’t fiat backed stablecoins require sophisticated mechanisms of stability? Because there is faith in 1:1 backing of cash assets to each stablecoin irrespective of market volatility.
So why can’t an algorithmic stablecoin create the same guaranteed backing but without centralized cash backing?
UXD Stablecoin
UXD is a recently launched stablecoin protocol native to Solana. UXD aims to solve the stablecoin trilemma with a unique algorithmic design that is backed 1:1 for stable-like assets instead of relying on redemption methods to absorb volatility.
Each UXD token is backed by a delta-neutral position on a perpetual derivatives exchange.
While sounding complicated, the design is actually rather simple. Users deposit collateral such as SOL to the protocol and receive $1 of UXD in return for every $1 of SOL deposited. The SOL is then deposited to a perpetual exchange protocol (Mango Markets) as collateral and then an opposite short position is taken at the same value of the deposited SOL. So if the price of SOL falls -10%, the deposited SOL collateral would lose -10% of USD value, however, at the same time, the short position would gain +10% of USD value resulting in a net 0% move of UXD’s collateral in USD terms.
Having a net 0% move relative to the underlying asset is the definition of delta-neutral. Effectively, the UXD protocol simulates having stable assets as collateral but with volatile assets enabling it to back each UXD token 1:1 with decentralized assets.
When a user wishes to redeem UXD for collateral, the process flows in reverse. Users burn UXD with the protocol and in return receive the exact USD amount in SOL or the collateral token of their choice. To return the user’s SOL, the protocol closes the SOL short position on the perpetual exchange for the exact dollar amount of UXD burned and the freed up SOL collateral is withdrawn to the UXD protocol at which point it is returned to the user.
As a result, the supply of UXD can scale much faster and much more efficiently than CDP stablecoins since these require more USD value of collateral than stables issued. UXD with its 1:1 stable asset backed position should more closely resemble the stability of fiat-backed stablecoins, but with the added benefit of being decentralized and censorship resistant. This same stability property is an added advantage compared to other algorithmic stables which rely on redemptions and secondary tokens to absorb volatility. Mechanisms like such are highly complex and have in the past broken peg in times of high volatility.
Framing the UXD token against the stablecoin trilemma:
Decentralization: UXD utilizes decentralized assets to form stable USD positions (delta-neutral) and the UXD protocol is itself designed as decentralized and its overall decentralization is dependent on the perpetual protocols it leverages.
Stability: Collateral in UXD is traditionally volatile but synthetically stabilized via derivatives, recreating the dependability of fiat backed stablecoins without reliance on centralized providers. Also, the protocol design relies on 1:1 backing guarantee with collateral assets rather than complex redemption mechanisms involving non-collateral assets (FXS and LUNA) which have only had a short history combating volatility.
Efficiency: UXD scales at a rate of $1 UXD for every $1 deposited in collateral which is far more efficient than collateral debt position stables which require more than $1 to mint $1 in stables. While the 1:1 mechanism favors stability, it is less efficient than floating collateral factor stablecoins like FRAX which can have less than $1 in collateral for every $1 in stables. Large enough perpetual markets is the chief constraint on UXD scalability, not collateral.
For the protocol to have long term viability, a revenue source is required to align incentives and fund growth. UXD Protocol doesn’t plan to collect fees from users but rather to absorb cash flows from an integral part of perpetual exchanges – the funding rate. Funding payments on perpetual exchanges arise due to the fact traders on the exchange are trading representations of tokens, not actual tokens. Since there are no actual tokens involved, the market price on the perpetual exchange can deviate from the true market price of the underlying token being traded. To keep prices aligned, a funding payment is introduced which scales relative to the trade imbalance. If the traders on the perp exchange are overweight on the long side (which is often the case in crypto), then the funding payment would be positive where the long traders pay a percentage fee to traders holding short positions. This mechanism incentivizes traders to take the unpopular side of the trade which has the effect of pushing the perpetual exchange price back towards the true market price.
Since funding historically has been positive in crypto markets, that means traders with short positions like UXD Protocol will receive funding payments from traders with long positions. However, this is not always the case and when funding turns negative, UXD Protocol requires a mechanism to pay funding payments without impacting UXD holders. To do so, an insurance fund is employed which was adequately funded ($57M) in the IDO sale of the UXP token.
Overall, like many stablecoin projects, UXD aims to drive real productive use cases for the stablecoin. Productive use cases are largely centered around financial usage as opposed to speculation or a rewards vehicle. For example, debts denominated in a stablecoin drive real usage as borrowers subsequently use the stable in swaps and continue to hold the stable in regard as their debts are denominated in the token. This drives the need for deep money market pools (borrowing) and for liquid AMM pools (swaps). Less productive uses involve staking and farming which drive liquidity but ultimately are unstable, short-term masquerades of adoption. UXD’s stated roadmap is focused on driving long-term health through more productive uses of the stablecoin.
UXD Tokenomics
UXD protocol is governed by the UXP token. UXP was offered in a public IDO ending November 14th that raised over $57M from 3,676 investors. Funds raised in the IDO are directed towards the insurance fund which is responsible for backstopping any negative funding payments incurred on the perpetual exchanges and any protocol exploit. According to the UXD documentation, the insurance fund at its current size would be able to sustain a year’s worth of -11.4% interest on $500M of UXD. Governing the insurance fund is the responsibility of the forthcoming UXP DAO.
In addition to IDO funds, UXD raised a $3M seed round from prominent solana ecosystem investors Multicoin, Alameda Research, Defiance Capital, CMS Holdings, Solana Foundation, Mercurial Finance, Solana Founders Anatoly Yakavenko and Raj Gokal, and Saber DEX founder Dylan Macalinao.
UXP holders will be the sole governing body of the UXD DAO. As such, holders are responsible for stewardship of the insurance fund and participating in governing actions. Potential governing actions could include adding new exchange integrations, adding new collateral types, protocol income management, and general improvements to the protocol.
Revenue for the UXD protocol is derived from two main sources. First and foremost is the positive funding payments as a result of the short position on the perpetual exchange. Funding in crypto has historically been positive meaning UXD, over the long term, can be expected to rely on this revenue stream as the primary source of cash inflows.
UXD Protocol’s second form of income is from active management of the insurance fund. Non-essential to business operations, the insurance fund is usually kept idle, only to be used during times of negative funding (shorts traders overweight longs on the perp exchange). For capital efficiency, UXD will explore asset management strategies for the insurance fund. Ultimately though it will be up to the UXP holders to dictate the management of the insurance fund.
Protocol Challenges
Outside of general smart contract risk, there exist a few key challenge areas for a protocol like UXD to not just work, but to scale efficiently to the size a stablecoin protocol needs.
Perpetual Market Size – Currently there is roughly $30M in open interest on Solana Perpetual Exchanges ($17M on Mango across all their L1 token markets and $11M on Drift Protocol). Stablecoin marketcaps require nearly $1B in market cap to be considered successful and to be considered sufficiently liquid for widespread use. In order for UXD to reach significant levels of adoption, the amount of market activity on Solana Perpetual exchanges would need to scale significantly. At the current size of the perp markets, UXD would almost assuredly drive the funding rates negative on the exchanges since it would create an imbalance of positions to the short side. However, this would attract more traders to trade against cheaper fund borrowing rates so there is a self-referential playbook here that can scale both UXD and the perpetual markets on Solana.
Negative Funding Rates – Along the same vein, when funding rates on the perpetual exchange turn negative, it’s on the UXD protocol itself to pay out. Usually, funding rates are positive in crypto due to the much larger demand to be on the long side of assets and in this case UXD protocol would be making additional money via traders paying it funding. However, if UXD scales faster than OI on the exchanges, there exists a real possibility funding could get driven negative and the protocol would be paying. To counteract this probability, sufficient funds are stored in the insurance fund to cover negative funding periods (which have historically not been long in duration). In the unlikely event that the insurance fund is depleted paying funding payments, additional UXP would be auctioned off to replenish the insurance fund. Even in this unlikely event, the insurance fund would not rapidly be depleted via funding payments (no flash crashes, just fairly predictable payments over known periods of time) so UXD holders would nearly always be able to redeem for collateral.
Exchange Exit Liquidity – Related to exchange sizes, there needs to exist enough counterside liquidity for UXD to unwind its short positions. UXD by design puts on short positions every time a user deposits collateral into the protocol, but when the UXD holder wishes to exchange the stablecoin for their collateral, the short position needs to be unwound and the collateral returned. For this to happen, there needs to be liquidity (users or market makers) on the exchange willing to sell tokens to UXD protocol in the size required. This risk is more prevalent in times of market volatility.
Treasury Management – UXD as a protocol is designed not to make money from UXD users but in the way it manages its collateral (positive funding rates) and its insurance fund. As the insurance fund is deployed in asset management strategies, the benefit is clearly the capital appreciation of the fund size. However, on the flip side there is introduced risk that funds are subjected to which needs to be taken into account. Not a great concern as presumably the fund will be deployed in low-risk strategies with the only notable risk being smart contract risk.
UXD Supply and Demand – Every stablecoin is subject to fluctuations in demand which can drive prices off peg. What matters is the ability of the protocol to absorb price volatility via redemption mechanisms to remain at peg or user confidence in the future redemption abilities (fiat stablecoins). UXD offers both avenues but as a growing stablecoin, it’s still subjected to the risk – especially in its early stages when concentrated amounts of UXD can experience more volatility pressure than if the supply of UXD was vast.
Looking Ahead
UXD offers a unique solution to the stablecoin landscape. As Solana continues to build out its DeFi ecosystem, having truly decentralized, native stablecoins will greatly benefit the ecosystem as a whole. Market demand for this type of solution is rapidly increasing, not just on Solana, but across DeFi as projects and users alike look for stable assets without centralization risk and that synergistically benefit the ecosystem. UXD has the potential to propel Solana’s already thriving derivatives market into new territory by catalyzing the cost of trading down and providing sufficient stable liquidity.
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