Stabilizing the Crypto Space: Introducing Low Volatility ETH （ETHL) and USDL

Why We Are Bullish on Low Volatility ETH

The core attraction of cryptocurrencies like Ethereum lies in their potential for high returns, but that comes with equally high volatility. While ETH has rewarded long-term investors, its price instability has deterred many from holding the asset for extended periods. This scenario creates a demand for a stable yet lucrative investment tool, thus highlighting the need for a low-volatility ETH. Such an asset can serve as a foundation for a decentralized monetary system that moves beyond traditional USD-pegged stablecoins and provides stability coupled with a potential for appreciation.

Low volatility ETH (or ETHL) holds massive appeal as a financial asset for several reasons. Unlike traditional USD-pegged stablecoins, ETHL is free from the impacts of global fiat monetary systems, ensuring it’s not subject to the economic policies of any single nation. This autonomy adds a layer of risk mitigation against the ongoing inflation and depreciation of the U.S. dollar. Moreover, given ETH’s strong performance and adoption rates, ETHL could potentially offer stronger purchasing power compared to the U.S. dollar in the long run.

f(x) Protocol’s Approach to Low Volatility ETH and its Limitations

AladdinDao’s f(x) protocol offered one such solution by minting low-volatility fETH and a zero-cost leveraged long asset, xETH. However, it comes with some constraints. The system creates a dependent relationship between fETH and xETH, affecting the development of fETH itself. During market uptrends, fETH becomes less attractive than holding native ETH or xETH, while in downtrends, the upper limit of fETH becomes restricted due to the overall collateral ratio (CR).

An In-Depth Look into f(x) Protocol

• fETH: a low volatile ETH asset that has price movements at 1/10th the price movements of native ETH (Beta of 0.1)
• xETH: a zero-cost leveraged long ETH position that absorbs the volatility of ETH price movements to stabilize fETH
• Both fETH and xETH can be redeemed back to ETH at any time based on their price at the redemption, with some fees charged.

Basic Example to Illustrate Mechanics

For the sake of illustration, let’s assume the protocol has $2000 worth of reserve ETH (with ETH’s spot price at $2000, equating to 1 ETH in reserve). Additionally, $1200 worth of fETH is minted and $800 worth of xETH is minted. With the value of fETH at $1 and xETH at $10, this results in 1200 fETH tokens and 80 xETH tokens.

It’s crucial to understand the equation:

Number of ETH * ETH Price = Number of fETH * fETH Price + Number of xETH * xETH Price

If ETH’s price surges 10% to $2200, fETH’s value would rise by 1% to $1.01. Now, based on the above equation, the total value of xETH would be $988 (2200–1.01 * 1200), and each xETH would be priced at $12.35 (988 / 80), marking a 48.75% increase!

Variable Effective Leverage

The effective leverage rate of xETH tokens fluctuates as xETH and fETH are minted and redeemed in accordance with their relative supply. A higher supply of xETH relative to fETH lowers the effective leverage rate of xETH, as the excess volatility of fETH is distributed across more tokens. Conversely, a larger supply of fETH focuses volatility on fewer xETH tokens, thereby increasing their effective leverage rate.

Design Flaws

The f(x) protocol faces issues primarily due to its design, posing challenges during unilateral ETH uptrends or downtrends. The relationship between fETH and xETH is interdependent; xETH’s leverage relies on the amount of fETH, and vice versa. This dynamic can lead to certain incongruities:

• During Upward Cycles: Holding fETH becomes less attractive compared to ETH or xETH.
• During Downward Cycles: The overall CR restricts the upper limit of fETH, thereby inhibiting the expansion of an ecosystem reliant on fETH.

Collateral Ratio (CR)

A vital parameter known as the Collateral Ratio (CR) is defined as:

CR = ( Number of eth * Price of eth ) / ( Number of fETH * Price of fETH)

The CR changes whenever new fETH or xETH is minted or their prices are adjusted. CR gauges the protocol’s overall health. If the CR falls below 130%, the system enters a stability mode, applying specific rules to regain a CR of 130%.

Why CDP and LUSD Serve as a Blueprint

The Collateralized Debt Position (CDP) model used by Liquity’s LUSD presents a mature solution to these problems. Unlike f(x), which makes fETH minting equivalent to relinquishing ETH holdings, CDP allows investors to mint stablecoins while keeping their ETH as collateral. Liquity’s stability pool and liquidation mechanisms offer a strong foundation to handle volatile situations without affecting the protocol’s solvency.

Advantages of CDP and LUSD Over f(x) Protocol

Individualized Debt Management

CDP is a form of individual debt, enabling users to retain their ETH without surrendering it. In contrast, minting fETH essentially means forfeiting ownership of ETH.

Robust Liquidation Mechanisms

During market downturns, the f(x) protocol may need to incessantly redeem fETH, potentially leading to protocol insolvency. CDP-based models like Liquity’s provide mature liquidation mechanisms. Risks are localized to individual CDPs, safeguarding the protocol’s overall financial health.

Flexible Asset Management

The correlation between fETH and xETH in the f(x) protocol constrains the growth of fETH. This limitation is absent in the CDP model, where new tokens like ETHL or USDL can be minted as dictated by market demand.

Unique Features of LUSD

Innovative Liquidation Mechanism

Liquity’s liquidation mechanism incorporates a stability pool. Users can deposit LUSD into this pool, which activates when liquidation thresholds are reached. The protocol utilizes LUSD from the stability pool to repay debts and recover collateralized ETH. Concurrently, this ETH is distributed to stability pool contributors. This setup essentially allows users to acquire ETH at below-market prices using LUSD, making it a compelling incentive.

Zero-Interest Loans with Protocol-Controlled Fees

LUSD introduces a protocol-controlled fee (commonly referred to as the Borrowing Fee) during the minting or redemption of LUSD. This mechanism enables LUSD to provide loans at an interest rate of 0%, enhancing its attractiveness as a stablecoin.

The Necessity for ETHL and USDL Coexistence

While ETHL offers long-term potential as a crypto-native stablecoin, its short-term adoption rates may be low. The market’s immediate need for a stable coin pegged to the U.S. dollar remains significant. That’s why our protocol will also allow for the minting of a U.S. dollar-pegged stablecoin (USDL), thereby addressing both short-term and long-term use cases.

Our Product Design

Our protocol employs a CDP mechanism for users to deposit stETH/wstETH as collateral and mint ETHL and/or USDL. The protocol employs Stability Pools for ETHL and USDL to handle liquidations, minimizing risks to individual CDPs.

1. Mint: Users can deposit stETH/wstETH as collateral to open a CDP for minting ETHL and/or USDL.

2. Redeem: ETHL or USDL can be redeemed to the same value of stETH/wstETH at any time.

3. Liquidate: A Stability Pool is used for each asset (ETHL and USDL) to handle liquidations effectively.

This model is not tied down by the complex interplay between low and high volatility tokens, thus removing limitations inherent in f(x).

Improving Upon LUSD’s Shortcomings

While LUSD is a robust model, it has its drawbacks:

1. Borrowing Fee: Our protocol incentivizes short-term arbitrage by refunding the mint fee if the CDP is closed within 24 hours.

2. Liquidity: We propose the use of governance tokens to incentivize liquidity pools.

The Vision Moving Forward

Low-volatility ETH has enormous potential to serve as a crypto-native stablecoin, poised to offer resilience against the inflationary tendencies of fiat currencies like the U.S. dollar. While its immediate demand may be limited, integrating it with a USD-pegged stablecoin like USDL creates a comprehensive solution that addresses both immediate and long-term needs. Our CDP-based approach not only leverages existing, mature mechanisms but also offers more flexibility and robustness than previous iterations like f(x). By adopting this hybrid strategy, we are pioneering the next generation of stability and potential growth in the crypto landscape.

This paper offers a blueprint that aims to shape the future of decentralized finance, providing an effective alternative to existing stablecoin mechanisms. With ETHL and USDL, we’re not just adapting to the crypto world’s needs; we’re anticipating them.

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.