Here is an example of the impact of inflation on your purchasing power (from a Canadian bank)

Inflation-resistant stablecoins could bring real value to holders: they would help protect from volatility AND from inflation at the same time.For example, if US inflation is 2%, the stablecoin worth $1 a y ago should now be worth $1.02.

Today, we will be looking at:

• a potential centralized design

• decentralized designs and their challenges: 1) oracle, and 2) backing mechanism

• what we think about it at Angle

Let’s dive in 👇

Inflation-resistant stablecoins could work through centralized entities. These would hold different bonds or securities that protect from inflation, like TIPS (treasury inflation protected securities).

This has been suggested on Twitter recently by @zhusu, @davidbelle, and others.

A. In practice, the entity could then redistribute the funds earned from the securities to stablecoins holders through specific mechanisms: sending new tokens, updating supply (rebasing), etc ...

B. This would create a fully backed centralized stablecoin that could be priced as a traditional fiat currency. However, backing an inflation-resistant stablecoin in a centralized way with TIPS or bonds has some disadvantages:

• TIPS are not highly liquid and can be a burden tax-wise,

• bonds would need to be rolled over regularly to new maturities to account for changes in interest rates

• the stablecoin would likely be considered a security under US law

C. Overall, this seem possible but would require heavy costs, overhead, and treasury management to work out in a sustainable and scalable way.

Ideally, this inflation-resistant stablecoin should be decentralized. How would that be possible?

There are at least two unavoidable aspects:

A/ an oracle to pass the inflation data on-chain, and

B/ a mechanism to reverberate it on the stablecoin holders on-chain.

A/ a. Two projects have started implementing that: @fraxfinance with FPI, and @VoltProtocol with VOLT. Both use a @chainlink feed providing the monthly US CPI inflation.

b. However, relying on CPI comes with its share of issues.

c. Another way to get inflation could be to have feeds of prices from inflation-linked and non-inflation linked securities (like German bonds), and build an index based on their price differences in real time.

It would be a way to track inflation much more dynamically, as estimated by the traditional financial markets. However, there is no empirical evidence yet that this would work as a good indicator of inflation.

Now, let’s assume that CPI works fine, or that we could solve this oracle / pricing inflation issue.

B/ What stablecoin protocol mechanisms should be used? How valuable would they be?

a. We recently had a stark example of how seigniorage share models like UST & LUNA are not sustainable, and eventually bound to fail. When two tokens work in tandem and none of them is properly backed ...

...there is a high chance it creates a death spiral. This death spiral is even more likely with a stablecoin stronger than the $. So we can rule out this case for today.

We will now look at two other models: b) backed by reserves, invested to try to beat inflation - the hedge fund model, and c) collateralized debt positions (CDP)

b) The hedge fund model

Protocol reserves are invested to beat inflation and remain over-collateralize.FPI and VOLT rely on this mechanism, coupled with a module allowing users to mint and redeem the CPI stablecoins against FRAX & FEI at oracle value.

Essentially, this transfers the job of finding on-chain yield to a protocol which issues CPI pegged tokens to its users as a counterparty. It could work, as long as the protocol can find higher yield than the CPI.

In case it doesn’t, Frax plans on relying on a seigniorage share mechanism with FPIS as a fallback. We are curious to see how it is going to unroll for FPIS and FPI if it ever comes down to that.

c) The debt-based (or CDP) model

In CDP based protocols (known for being robust) like @MakerDAO DAI, users borrow stablecoins against crypto assets deposited as collateral. But who would borrow a CPI-pegged instead of a USD-pegged stablecoin, an intrinsically stronger asset?

In most cases, borrowers would be better off borrowing a weaker asset, as a stronger one would mean:

• seeing your debt increase without even any borrowing interest rate and have more risk of getting liquidated

• earning less yield or make less profit with the borrowed funds

However, this could be interesting for borrowers if they could find yield on top of these stablecoins, by providing liquidity in high volume pools with tx fees covering for IL + borrowing interest rate for example.

The CDP based model would not allow direct arbitrages to maintain exact peg, but only indirect arbitrages. Tracking inflation over-time and maintaining a soft peg should be enough though to provide strong value to holders.

At Angle, we believe that the CDP mechanism for an inflation-resistant stablecoin could work, even though there are still challenges to resolve, mostly on the oracle front.

Angle upcoming Borrowing module could technically be used to support that. Yet, would there be real demand to borrow inflation-resistant tokens and create supply?

Many challenges remain unsolved to make a solid stablecoin 2.0 bringing real value for holders. But when multiple teams keep pushing the boundaries and experimenting with new ideas, interesting breakthroughs are usually around the corner.

Another aspect sometimes overlooked is that an inflation resistant stablecoin shouldn’t necessarily track inflation per se. Rather, they should try to protect holders purchasing power as much as possible, in a stable way.

Yield assets like @AaveAave aTokens or @iearnfinance yTokens are already first steps towards this. A token acting as a well-balanced ETF between multiple assets could probably fill this role even better, similar to the original vision from @OlympusDAO.

What about you? How do you think the stablecoin 2.0 should look like?