Decentralized Stablecoins: A Critical component of the cryptocurrency ecosystem 3/3

Part 3: Other stablecoins

In our previous article, we discussed stablecoins pegged to the US dollar and issued through over-collateralization of crypto assets. This article delves deeper into other types of stablecoins, including Synthetix’s sUSD, Reflexer Finance’s RAI, and Frax Finance.

1. Synthetix sUSD

Synthetix is a decentralized synthetic asset issuance protocol built on Ethereum and Optimism. These synthetic assets are collateralized by Synthetix tokens (SNX). SNX, when locked in contracts, allows for the issuance of synthetic assets (Synths). This collective collateral model enables users to directly convert between various synthetic assets, eliminating the need for a counterparty and effectively addressing liquidity and slippage issues in DEXs.

Synthetix currently supports synthetic fiat currencies, cryptocurrencies (long and short positions), and commodities. The system distributes trading fees generated in Kwenta platform (Previous named Synthetix Exchange, which user can trade Synths) proportionally to users staking SNX and issuing synthetic assets, thus incentivizing the holding and locking of SNX. The value of SNX derives from the rights to use the Synthetix platform and the trading fees generated by its synthetic assets.

sUSD Minting Mechanism

sUSD tokens are pegged to the US dollar. Users mint sUSD by staking SNX, the underlying asset of Synthetix. The minted sUSD represents a liability for both the user and the system. To unlock their SNX, users must repay this debt by destroying sUSD, with the staked SNX being locked for seven days. If the collateralization ratio falls below 145.00%, it must be increased to 400.00%, or the user faces penalties.

In Synthetix, staking SNX only mints sUSD. To trade other assets (like sETH, sBTC, etc.), users must purchase them in the synthetic asset pool using sUSD.

The pegging mechanism of sUSD primarily relies on market arbitrage opportunities and supply-demand dynamics. When the price of sUSD is above one dollar, arbitrageurs can collateralize SNX on the platform to borrow sUSD, then sell the sUSD for dollars or other stablecoins in external exchanges. Such arbitrage actions increase the demand and supply of sUSD, driving its price back to the one-dollar peg. And vice visa.

SNX Incentives

SNX holders are encouraged to hold SNX and mint Synths in several ways:

• Trading Rewards: Whenever someone exchanges one Synth for another on Kwenta, a transaction fee is generated and stored in a fee pool. SNX stakers can claim a proportional amount from this pool as a trading reward every week. The fee ranges between 10–100 bps (0.1%-1%, though usually around 0.3%).
• Token Rewards: The protocol’s inflation policy generates SNX holding rewards. From March 2019 to August 2023, the total supply of SNX increased from 100,000,000 to 260,263,816, with a weekly inflation decay rate of 1.25% starting December 2019. From September 2023, a permanent terminal inflation of 2.5% per annum was set. These new SNX tokens are distributed weekly, proportionally to SNX stakers with a collateralization ratio not less than the target threshold.

Key Roles in Synthetix

SNX stakers create debt when they mint Synths. This debt can increase or decrease independently of its original minting value, depending on the exchange rates and supply of Synths in the network. For example, if 100% of the Synths in the system are synthetic Bitcoin (sBTC), and the price of sBTC halves, then the system’s debt will halve, and so will each staker’s debt. This means that all SNX stakers become counterparties to all trades on Kwenta; they bear the risk of the entire system’s debt. They can choose to hedge externally to mitigate this risk. All stakers, by assuming this risk, enable trading on Synthetix, thus earning a share of the system’s trading rewards.

It should be explained that the sUSD obtained by users through staking SNX is not a personal debt but a collective debt, which is a major difference between Synthetix and other lending protocols. In other words, the sUSD minted through over-collateralization is proportionally added to the pool’s total debt. Even if users do not take any action, the debt they need to repay can increase or decrease depending on the actions of the counterparties in the pool.

To better understand this mechanism, let’s take an example.

• Step 1: Tom and Jerry each initially invest $50,000, making the network’s total debt $100,000. Tom and Jerry each bear 50% of it.
• Step 2: Tom buys sBTC with his $50,000, while Jerry continues to hold sUSD.
• Step 3: The price of BTC rises by 50%, meaning Tom’s holding value becomes $75,000, with a $25,000 profit that increases the network’s total debt to $125,000.
• Step 4: Tom and Jerry still each bear 50% of the network’s total debt, i.e., $62,500 each.

When Tom’s sBTC value is subtracted from his debt, he profits $12,500; even though Jerry’s position value is $50,000, his debt has increased by $12,500, resulting in a $12,500 loss. This behavior, although Jerry took no action, Tom’s actions raised the network’s total debt to $125,000, increasing Jerry’s exposure and resulting in a $12,500 loss.

As sUSD primarily serves as a basic stablecoin within the Synthetix ecosystem, its circulation is not large, totaling around 60 million. However, the overall TVL of the system is very high, with $880 million worth of SNX staked within the ecosystem, equivalent to 60% of SNX’s issued volume. The overall collateralization ratio is about 500%, indicating relative stability in the ecosystem.

2. Reflexer Finance RAI

“I am focusing on RAI rather than DAI because RAI better exemplifies the pure ideal type of a collateralized automated stablecoin，backed by ETH only。DAI is a hybrid system backed by both centralized and decentralized collateral，which is a reasonable choice for their products but it does make analysis trickier”-Vitalik Buterin

Reflexer’s RAI is a stable asset priced in USD but not pegged to it, solely backed by ETH, with a local interest rate calculated by an on-chain PI controller to correspond to complex market states, pushing RAI’s market price towards the redemption price.

Basic Mechanism

RAI differs from other stablecoins in that it does not have a fixed peg to 1 USD. Instead, it actively updates its peg (i.e., the redemption price) to adjust market price deviations from the redemption price. RAI uses an on-chain PI controller to set the rate of change of its redemption price, i.e., the redemption rate, expressed as an annualized interest rate. The sensitivity of the redemption rate to market price deviations is determined by the controller’s PI parameters, aiming to adjust these parameters to maintain RAI’s price stability autonomously in the face of various situations and potential shocks.

The PI controller consists of two terms: Proportional (P) and Integral (I). The P term is based only on the current error, so it immediately resets the redemption rate to 0% when the error disappears. The error is defined as the difference between the RAI redemption price (also called “target price”) and the RAI market price. The I term accumulates error over time, increasing the redemption rate as the duration of the error persists, not just the size of the error (unlike the P term, which has no time component). The final redemption rate set by the controller is calculated by adding the rates determined by the P and I terms.

The controller has two terms because the P and I terms operate on different time scales, allowing the controller to detect and respond to sudden and long-term disturbances. The P term is more important for responding to sudden shocks, as it can quickly elevate when RAI detects a price shock and rapidly reset when the price shock disappears. The I term is more important for correcting long-term price deviations, as it will slowly rise, becoming increasingly strong as long as the error persists, and then slowly reset over time. The I term maintains the redemption rate at any value that makes the error zero. In practice, the I term is seeking the average long-term redemption rate that will keep the error at zero.

RAI’s Monetary Policy

RAI’s long-term price trajectory is determined by the leverage demand for ETH. If SAFE (similar to vaults) users deleverage and/or RAI users go long, RAI tends to appreciate; if SAFE users leverage up and/or RAI users go short, it tends to depreciate.

To understand RAI’s behavior better, we need to analyze its monetary policy, comprising four elements:

• Redemption Price: This is the price at which the protocol wants RAI to trade in the secondary market (e.g., on Uniswap). SAFE users use the redemption price to mint RAI with ETH. It’s also used for global settlement, allowing SAFE and RAI users to redeem collateral from the system. The redemption price is almost always floating, not targeting any specific peg.
• Market Price: This is the trading price of RAI in the secondary market (on exchanges).
• Redemption Rate: This is the rate of devaluation or revaluation of RAI. The process of devaluing/revaluing RAI involves changing the redemption price through the redemption rate.
• Global Settlement: This includes closing the protocol, allowing SAFE and RAI users to redeem collateral from the system. Settlement uses the redemption price (not market price) to calculate how much collateral each user can redeem.

When RAI’s market price > redemption price for a sustained period, the redemption rate becomes negative.

When RAI’s market price < redemption price for a sustained period, the redemption rate becomes positive.

When RAI’s market price = redemption price for a sustained period, the redemption rate stabilizes at a state (possibly not zero).

For example, if RAI’s current market price is 2.826 and the redemption price is 2.8234, the total redemption rate from the P and I components would be negative (-4.332%), causing the market price to converge continuously towards the redemption price, allowing RAI holders to short their tokens at this time.

RAI’s Historical Price Trend

In the image above, the orange line represents the ETH price and the bar line represents the RAI price. Based on RAI’s historical performance, despite significant fluctuations in ETH’s price, RAI has been notably stable. Its unique feature of not being pegged to the dollar, and its design of the stability mechanism, seem quite reasonable so far.

RAI’s challenge lies in finding suitable use cases; its overall circulation is only about 1.7M, and TVL is just over $26 million+. It may find certain applicable scenarios in hedging, arbitrage, and as a low-volatility store of value, possibly when ETH’s market value reaches a higher level and enough institutional-level users enter the crypto industry. The user cases for RAI could include:

• Portfolio Diversification: RAI offers a mitigating risk against ETH price movements.
• DeFi Collateral: RAI can serve as a supplement or alternative collateral in DeFi protocols as it can dampen Ethereum’s price volatility, giving users more time to react to market changes.
• DAO Reserve Asset: DAOs can hold RAI on their balance sheets and gain exposure to ETH’s risk without being affected by its full market volatility.

3. Frax Finance

The early version of the Frax protocol introduced a decentralized stablecoin that is partially backed by cryptocurrency collateral and partially algorithmically.

Basic Mechanism

Frax Protocol operates a dual-token system, encompassing the stablecoin FRAX and the governance token FXS. The protocol includes a pool contract holding USDC collateral, which can be modified through governance voting to add or remove collateral types. FRAX is pegged to the US dollar, backed partially by collateral, and uses periodic buying and selling of FXS to maintain its market value.

FRAX is minted when collateral and FXS are deposited into the Frax protocol contract. The amount of collateral required to mint one FRAX is determined by the Collateral Ratio (CR). The CR of Frax dictates the proportion between collateral and algorithm required to constitute one dollar’s worth of FRAX.

If the market price of FRAX is above one dollar, the protocol decreases the collateral ratio, thereby reducing the collateral and increasing the required FXS to mint FRAX. This lowers the amount of collateral backing all FRAX. Conversely, if the market price of FRAX is below one dollar, the protocol increases the collateral ratio, allowing FXS redeemers to receive more FXS and less collateral from the system, thereby increasing the proportion of collateral in the FRAX supply and boosting market confidence in FRAX.

Stability Mechanism

One FRAX can always be minted and redeemed for one dollar’s worth of value from the system. This allows arbitrageurs to balance the supply and demand of FRAX in the open market.

If FRAX’s market price is above its target price of one dollar, there’s an arbitrage opportunity to inject one dollar’s worth of value into the system to mint FRAX and sell the minted FRAX tokens in the open market for over one dollar. At any time, to create new FRAX, users must input one dollar’s worth of value into the system. The difference lies in the proportion of collateral and FXS that make up this one dollar’s worth of value. At 100% collateral phase for FRAX, the full value of one dollar inputted into the system to create FRAX is in collateral. As the protocol enters the hybrid phase, a portion of the value entering the system during the minting process becomes FXS (which is then burnt). For instance, at a 98% collateral ratio, minting one FRAX requires 0.98 dollars of collateral and burning 0.02 dollars worth of FXS. At a 97% collateral ratio, it requires 0.97 dollars of collateral and burning 0.03 dollars worth of FXS, and so on.

If FRAX’s market price is below the price range of one dollar, there’s an arbitrage opportunity to buy FRAX tokens cheaply in the open market and exchange them for one dollar’s worth of value in the system. At any time, users can redeem one dollar’s worth of FRAX value from the system. The difference is only in the proportion of collateral and FXS returned to redeemers. At a 100% collateral phase for FRAX, redeeming FRAX returns 100% of the value in collateral. As the protocol enters the hybrid phase, a portion of the value redeemed from the system becomes FXS (minted for the redeemers). For instance, at a 98% collateral ratio, each FRAX can be exchanged for 0.98 dollars of collateral and 0.02 dollars worth of minted FXS. At a 97% collateral ratio, it’s 0.97 dollars of collateral and 0.03 dollars worth of minted FXS.

Frax, as a hybrid stablecoin, primarily addresses the issues of low capital efficiency and liquidation risks in over-collateralized stablecoins like Dai, and the speculative nature over practicality in fully algorithmic stablecoins like Ampleforth. By introducing the concept of the collateral ratio, it effectively balances these two mechanisms.

Development of Frax

Following the collapse of LUNA and UST, pure algorithmic stablecoins and partially collateralized stablecoins not only drew criticism from most of the industry but also attracted regulatory attention. In response, Frax made innovative demands on its V1 partially collateralized algorithmic stablecoin. In this context, Frax v2 pivoted, suspending the concept of “de-collateralization” and introducing the AMO concept, fully utilizing treasury funds for protocol profits. AMO controls treasury asset market operations through pre-defined strategies, distributing treasury assets to various DeFi protocols for additional gains. The Curve AMO currently holds the most funds, where Frax has accumulated a significant amount of CRV and CVX, gradually utilizing its profitability to increase CR. Frax v3 aims to transform Frax into a fully collateralized stablecoin. V3 includes the RWA track, where users deposit FRAX into a contract to earn sFRAX and eventually RWA government bond returns. FRAX Bond was also launched and deployed to Curve, with AMO continuing to run, utilizing accumulated Curve and Convex voting rights for DeFi profits, theoretically yielding higher than most stablecoins on the market. With RWA profits, Frax will continue to increase CR until it’s >=100%, ultimately becoming a fully collateralized stablecoin.

Essentially, Frax has become a yield-generating product. The entire Frax protocol system is vast and complex, but ultimately aims to earn additional profits through Frax, deviating from the value exchange function typically associated with stablecoins.

Conclusion

These stablecoin projects showcase the diversity and innovation in the stablecoin space, with each project striving to solve specific issues and offer new value to users. As these projects evolve, we can anticipate seeing more innovations and applications emerge in the DeFi ecosystem.

SCapital, a visionary crypto-native fund, is championing novel strategies in the DeFi landscape. Beyond mere investment, we actively partake in governance and advisory roles, ensuring continuous value growth.