TL;DR: Existing ESD model has significant flaws, which I discuss below. I am calling interested developers to work on an overhauled model that I have devised, but if there is not enough interest in the next few days, I will consider merging my model with an existing project.
It has been an interesting few weeks in the Seigniorage field, to say the least.
Around the same time that new ESD and DSD forks were popping up like wildflowers, both ESD and DSD entered into their most significant contraction cycle. Both projects have been in contraction before; however, that was following a moderate expansion cycle with much smaller volume. This is therefore where the real test begins. After a sustained period of hype and insane yields (~3% every 8 hours for ESD and ~10% every 2 hours for DSD through much of their most recent expansion cycle), it remains to be seen whether the coupon mechanics are capable of bringing the price back to peg once the inevitable dump into contraction began.
It was also not surprising to find that newer forks had varying degrees of success, with some dying out completely and others that held on having a generally shorter expansion cycle with a deeper contraction dump.
We are now at a stage where effectively all ESD-based projects are in contraction unless it is a new project that is still in bootstrap. ESD and DSD coupons are also poised for their first batch of expiry. Each of these projects has a 30-day expiry window for coupons, and they entered into contraction with DSD in the lead by several days.
Although this is not the focus of this article, it is worth mentioning that at the time of writing, Basis Cash and its forks are also generally in a similar state of deep contraction cycle. The only algorithmic stablecoins that have managed to find and hold peg so far appears to be ones that are at least partially backed by collateral, such as FRAX and SHARE.
Will algorithmic stablecoins recover? What is the issue here?
The foremost and most significant issue lies in coupons (and bonds).
Let’s take a deeper look at the theory and reality behind the coupon system.
Coupon Theory
For those not quite familiar with it, in a contraction cycle, you can choose to burn tokens in exchange for coupons. The coupons can be redeemed for the tokens 1:1 in an expansion cycle. To incentivse the purchase of coupons (and therefore the burning of token supply), a coupon premium is applied, which allows you to gain an additional percentage in coupons when burning tokens. This premium increases the longer that a contraction cycle lasts, up to a predetermined maximum (usually somewhere around 50% for most ESD projects, although many projects are now scrambling to rework the coupon model).
So, supply is burned in exchange for coupons, coupon buyers get additional tokens only in expansion, and coupons expire in 30 days with risk of 100% capital loss, so there is a timeframe within which a push back to the peg is expected to occur. Seems elegant and ingenious, right?
Well, until reality hits anyway.
I will go through some major problems with this coupon mechanism.
Problem 1 — the illusion of a contraction
On the surface, coupons burn existing token supply, which causes a contraction. But the problem is that coupons also represent a promise to reward the coupon buyer more tokens than they have burnt. Therefore, coupons are actually a mechanism to defer an expansion. That is, unless the coupon expires, in which case the supply is truly reduced.
This creates a rather undesirable dichotomy. The expiry of coupons is technically a good thing for the ecosystem in contraction because supply is reduced without incurring debt that needs to be repaid in expansion. However, the expiry of coupons inevitably leads to a drop in public confidence as to the token’s ability to return to peg. After all, if coupon purchasers facing 100% loss could not bring the price back to peg, then what would?
More astute readers might point out that coupons do have the effect of locking up supply. However, consider the psychology behind the mechanism. Coupons may prevent further dumping in contraction as people gamble for expansion instead of selling. However, this relates only to existing holders. It may reduce the severity of a contraction cycle, but it does little to truly encourage price to climb back to peg. Any increase in token price will still depend on a wave of new interest, without which locking up supply will achieve very little. What’s more, new buyers in contraction cycles are generally either swing traders who will not coupon, or holders looking for expansion gains and would not have sold at below peg in any case, even without the coupon system existing. This means that the coupon system has little real value to the ecosystem during a contraction.
Problem 2 — risk / reward ratio
This brings me to the second problem with coupons. Purchasing coupons is a a bet that gives you a maximum of ~50% gain where the downside is 100% capital loss. That, frankly, gives a terrible R/R ratio. Those that take the bet generally trust that the system will work to bring the token back to peg, meaning that they thought the risk of actual 100% loss will be low. But if there is one thing that you should have learned by now in crypto, it is that nothing is certain.
Problem 3 — the hidden sell pressure
There’s one concept that many seem to have difficulty in grasping. For any rational investor, a near-certain profit of 100% is more attractive than an uncertain profit of 500%. And the invisible hand of the market is surprisingly rational — even crypto apes can only hold it back for so long.
People talk about expansion FOMO as if it is a certainty. Indeed, if seigniorage yields are so juicy above peg, why on earth would FOMO not take off when the token manages to return to peg from contraction?
Think back to the two problems that I already outlined. Once TWAP is above peg, the coupon buyers will get first dibs on the rewards. After a prolonged contraction cycle, this debt is likely to be at maximum (usually 45% for most ESD projects). That’s an expansion of 45% of the supply that will go to coupon holders before anyone else will receive expansion rewards. Now, given the terrible R/R of coupons, if there has been an extended contraction cycle, the coupon holders would be breathing a sigh of relief towards the end, and counting themselves lucky that they didn’t lose 100% of their invested capital. Sure, greed can always kick in and the coupon holders may DAO or LP their rewards for expansion rewards. However, a significant portion of the redeemed coupons will likely be cashed out. This creates sell pressure right at the beginning of the new expansion cycle.
That’s not even the worst of it. The non-linear nature of coupon redemption creates a massive opportunity for smarter traders to swing trade in contraction. This is especially so for tokens like DSD where higher expansion rewards also cause a more significant dump in contraction. DSD bottomed out at somewhere around $0.30 in the most recent contraction. Given the high uptake in coupons and the existence of large coupon whales, it was a good bet that a push back to $1 was going to happen sooner or later. However, instead of couponing, you could simply buy DSD at $0.30 and dump it all as the price approaches $1. This allows you to skip the coupon queue (as coupon holders can’t redeem until TWAP is above $1), and you definitely want to be skipping that queue because you don’t want to compete with coupon holders when taking your profits. By the time you are finished dumping and have taken your ~100% profits, the push to $1 has probably fizzled out, price has likely crashed down again, and you’re free to buy in again and repeat.
This is what we have seen in DSD so far. Its price has touched $1 on numerous occasions in its current contraction cycle, but each time it did so, the price immediately dumped before the TWAP could reach $1. This is not a case of weak hands, and it is certainly not whales suppressing the price in order to accumulate. As I have said on many occasions, smart whales do not coupon.
This means that there are in fact two separate layers of sell pressure, and we have already seen how significant the first layer can be. There is no telling what coupon holders are likely to do if FOMO does manage to push past the “dump at $1” sell wall, as we are in unchartered territory. However, this is even more reason for people, especially coupon buyers, to take profits early. After such a rollercoaster ride, pushing past TWAP = $1 would be like winning a significant bet, and many people will know to take at least some profits after such a win, rather than going all in a second time.
Problem 4 — lack of interest in contraction
This is a bigger problem for newer forks, but is still relevant to even ESD / DSD. With so many similar forks, one option people have is to profit in expansion, dump the token just before contraction, and then move on to a new project that is still in expansion / bootstrap. This strategy does becomes less effective over time as confidence in new projects wanes. Many of them are unlikely to ever return to peg, simply because most participants in bootstrap were never interested in sticking around.
When the dust settles, it’s true that the original projects and several new ones with real innovation will likely see interest again. However, if one project is in contraction while another is in expansion, many people may simply move from the contraction project to the expansion project, given the significant discrepancy between possible rewards in contraction vs expansion.
This creates a vicious cycle since projects in contraction need new interest to climb out of contraction, yet the contraction itself deters new interest when higher expansion gains are available elsewhere, or where the ability of an ESD-based project to climb out of contraction is still unestablished.
Band-aid solutions
As contraction cycles dragged on for numerous ESD-based projects, many of them have been furiously amending the coupon mechanism in an attempt to push out of contraction. These include solutions such as removing the expiry date for coupons and allowing expired coupons to recover the principal investment.
However, alleviating the psychological panic of expired coupons in this way just worsens the supply issue. A price under peg suggests that there is an oversupply of the token. Without coupons expiring, the supply never truly contracts. For the most part, the market understands that supply burned by unexpired coupons is a debt that the protocol needs to repay. Removing this key mechanism means that the project is now entirely reliant on a wave of new interest that is either ignorant of the debt or is willing to bet that there will be enough ignorant new interest to push past the debt into expansion.
Other problems with the ESD model
Coupons are a significant problem for ESD projects in contraction, but they are far from being the only problem.
For example, every project since DSD appears to chase ever-increasing gains in expansion. Shortened epoch lengths are not the issue so much as the yield — when you gain something like 5% every hour compounded, can you really blame people if they dump the price to oblivion in contraction? There would very likely be people still in profit even if they sold their stack for 10x under peg. And of course, the lower the price dumps in contraction, the harder it will be to climb back. This does not instill confidence in a token that is supposed to be a stablecoin.
Another big flaw in the ESD model is the dynamic between DAO and LP. Those of you familar with my past writings will understand the hidden yield of LP and how it actually compounds faster than DAO if played correctly. And since LP is the mechanism through which dumps occur to bring down the price (which is supposed to happen, remember), one must then ask, what is the real purpose of DAO?
Regardless of the theoretical purposes of DAO when ESD was launched, the reality is that DAO is a means of locking up supply to inflate the price in expansion, which in turn allows LP to dump and profit. DAO can only really profit if they exit early while expansion is still in full swing, or if they ride out the contraction and the price of the token actually moves back up significantly towards peg. Yet at the same time, the rules of the game are so designed that if DAO were able to unlock faster than LP, then there will be nearly no interest in LP, which would lead to a collapse of the entire ecosystem. This is less than desirable and far from fair.
Where do we go from here?
We are entering into a new era of seigniorage coins where existing models will be sorely tested. In order to survive, a seignioirage project needs to pay attention to market sentiments and be willing to pivot.
I believe there is a place for some type of coupon / bond system in a seigniorage model, but it is far from sufficient as the sole reward mechanism in a contraction cycle.
I have in fact been designing a completely overhauled model which I believe addresses the problems I outline above and properly incentivises a move back to peg in contraction, without over-incentivising the expansion phase participants.
I have given it a lot of thought, and believe that the best way forward is to implement this model as a new project. This is because the model significantly changes the rules for the participants, which may cause complications in its implementation if it is to be adapted into an existing project.
I have a technical background, but I am not a solidity developer. I have two developers currently interested in assisting, but neither has a lot of time that they are able to commit. Therefore, consider this article a call to interested solidity developers to create something new that is (hopefully) able to stand the test of time. If you are interested, send me a DM on Telegram @DkNinja and we can discuss further.
The seigniorage field moves fast and I believe that speed will be crucial, before all confidence in uncollateralised algorithmic stablecoins is lost. If I do not receive enough interest to form a team in the next few days, then I will consider merging my concepts with an existing project that shows promise. There will be challenges in the implementation, but I believe it can be done with the right amount of care and planning. To that end, if you are an existing project and are interested to discuss, please also feel free to reach out on Telegram.
