Building decentralized stablecoins is hard: it implies taking volatile (or not) crypto-currencies as collateral and issuing something which has a stable value on top of it. The goal of most decentralized designs is then all about one thing: absorbing and distributing the volatility risk of the collateral to be always able to propose to stable token holders collateral in value superior or equal to what they own in stable tokens.

In this series of articles, we explored some widespread approaches to cope with this volatility risk. We went over algorithmic/under-collateralized designs where one option to absorb risk consists in having a volatile supply (like Ampleforth does), or where another choice is to rely to a secondary volatility token (often a governance token) which price is used to absorb the risk in case of a collateral price decrease or a bank run event (like FRAX).

We also dived into over-collateralized protocols like Maker where the volatility risk is taken by collateralized debt position (CDP) owners who risk to loose money in liquidations if the value of the collateral they brought falls too low.

While having CDPs and vaults like Maker really fragments the volatility risk, the counterpart with these designs is that it’s hard to build really stable tokens with it as there are no direct arbitrage opportunities with such protocols when prices deviate from peg. Some promising new designs like Liquity are however emerging and start to remedy this issue.

One idea to absorb the volatility risk is to sell it through derivatives contracts like perpetual futures to people who are looking for volatility. These people tokens with it as there are no direct arbitrage opportunities with such protocols when prices deviate from peg. Some promising new designs like Liquity are however emerging and start to remedy this issue.

One idea to absorb the volatility risk is to sell it through derivatives contracts like perpetual futures to people who are looking for volatility. These people take on this volatility on behalf of the protocol, getting rewarded in case of collateral price increase and incurring losses when collateral price decreases.

This idea is far from being new in crypto. Back in 2017, Variabl came up with it but was never launched on mainnet. Since then and even though derivatives have been battle tested in crypto with exchanges like Bitmex, and on DeFi protocols like PERP Protocol, there have been very few projects leveraging these products to build stablecoins.

Before going into more details, it is important to understand how derivatives can help a protocol hedge against collateral volatility. The idea is quite simple:

• In case of a collateral price decrease, the protocol is protected by traders’ positions as it can capture their losses to cover for the decrease in collateral value. The counterpart to this is that in case of a collateral price increase, the protocol transfers its surplus to the hedging traders as a profit for them.

Below, we illustrate an example of how a protocol which collateral is hedged by a derivative product called a perpetual future resists to a collateral price drop.

Perpetual Futures

Pika Protocol is using a design similar to that of the example for their stablecoin.

In few words, the Pika Protocol is a decentralized non-linear inverse perpetual swap exchange: it is a marketplace between people who own long perpetual positions and people with short positions like what can be found on Bitmex: when the underlying price increases short traders have to give collateral to long traders and when price decreases longs have to pay shorts.

The protocol involves some funding rate equivalent to be paid at position opening or close to incentivize either long or short holders to close their positions when needed and make sure that the market remains balanced.

To get a stablecoin with Pika, you then simply need to open a 1x short position: the value of this position always remains equal to one dollar. In case of collateral depreciation, the long positions losses are used to back the token.

The UXD Protocol is also based on this same idea of a perpetual swap exchange. In this case, a portion of the funding rates paid by the long holders go to an insurance fund to be distributed as a form of funding payment to long holders when there are not enough stable/short holders. This is a way to avoid having stable holders paying funding rates.

Options

Perpetual futures is not the only type of financial products used to maintain a stable asset value in reserves. Lien Finance uses other types of financial products involving a specific maturity and an expiry time.

In more details, someone giving 1 ETH worth 2000$ to the Lien protocol gets two tokens: one token representing a 2x leveraged token and one token which value is supposed to remain stable called a Solid Bond Token (SBT) and pegged to let’s say 1000 USD. At expiry of the tokens if the USD market price of ETH is P, the SBT holder has the right to max(1000/P,1) ETH and the long token holder has the right to max(1–1000/P,0) ETH. In most situations at maturity, unless the ETH price decreases by more than 50%, the owner of the SBT token gets back their full value. If price decreases by more than 50%, the owner only receives a portion of what she brought.

SBTs can then be used to issue stablecoins (called iDOL in this system). This means that the protocol’s stablecoins are backed by SBTs with different maturity dates.

Purely derivatives backed protocols are supposed to work almost perfectly on paper: value of the reserves backing the stablecoins stays the same regardless of the price increase or decrease in collateral. Stablecoins can therefore most of the time be issued or burnt in a capital efficient manner at a 1:1 rate for collateral meaning that they can arbitraged and hence easily keep their peg.

There is however an important caveat to this design: it can only work provided that there are enough people willing to go long on the collateral. As any two-sided marketplace, such protocols need to be balanced. To back a stablecoin by derivatives, more than finding collateral for the stablecoin, you therefore need to find people that are willing to take volatility of the underlying at all times.

For instance, with Lien Finance, if there isn’t anyone to buy the leverage tokens issued, exposure to the volatility of the collateral cannot be reduced.

Generally speaking, stablecoin demand tends to grow in bull markets when more people want to borrow stablecoins to get leveraged, creating attractive interest rates for lending stablecoins. At the end of such periods, the trend is usually that stablecoin supply plateaus.

ETH Price (source: The Block)

Total Stablecoin Supply (source: The Block)

On-Chain Volume of Stablecoins (source: The Block)

With mechanisms like Lien or Pika where there is always a need for a perfect matching between long and stable, in case of decreasing demand for leverage, supply of stablecoin automatically decreases. This makes these mechanisms not perfectly suitable for a fully decentralized finance where stablecoins supply shouldn’t be fully dictated by market conditions.

In the case of the UXD Protocol, the fact that funding payments can be used to incentivize people to open long positions may make the protocol more robust in bear market conditions, but the size of the payments is only capped by the amount of the insurance fund accumulated in bull market and the governance token auction occurring in that case may not be sufficient to handle severe decreases in price drops.

• Derivative-backed stablecoins are decentralized and can be, depending on the design, capital-efficient to issue

• These protocols rely on derivatives like perpetual futures to absorb the volatility of the collateral backing the stablecoins. In case of collateral price decrease, long traders’ losses are used to maintain stable assets value in reserves.

• Provided that there is enough demand for leverage, these protocols can resist potentially any collateral price drop

• The bottleneck for derivative-backed stablecoins is to find enough long traders willing to get leveraged on the price of the collateral with respect to that of the stablecoin

• Such protocols are often designed as two-sided marketplaces between long traders/stable seekers meaning that in case of drop in demand for leverage, stablecoin supply tends to mechanically shrink.

Angle’s design follows this derivatives-backed idea, but tries to move away from necessarily matching shorts with longs. Overall, like most derivatives-backed stablecoins:

• Angle is decentralized and it is capital efficient to issue and burn stablecoins

• Angle insures itself against the volatility of its collateral by issuing perpetual futures to resist collateral price drops

• Angle lets traders (called Hedging Agents) get an on-chain leveraged position in one straightforward transaction

Yet, contrary to these protocols:

• Angle is not conceived as a perfect marketplace between people looking for stability and leverage. Besides having a way to still bring back equilibrium between long and stable holders through transaction fees, Angle also has a mechanism to insure the reserves not covered by long traders by relying on a second type of liquidity providers called Standard Liquidity Providers. Thanks to that, Angle stablecoin supply could continue to grow or stay steady even in difficult market conditions.

• Angle protocol has been designed from scratch to support various types of collaterals and of stablecoins, not limiting itself to an ETH collateral backing a USD stablecoin like it is unfortunately the case for many derivatives-backed protocols

• Angle is not a purely derivatives-backed protocol: in the case for instance of USDC and DAI backing a stable Euro, the protocol could work even with a limited volume of agents getting long on the variation of the Dollar price with respect to the Euro

• Conclusion

  In this series, we tried to give an overview of the different stablecoin protocols designs while making a case for Angle Protocol. This came from our limited knowledge and we may have forgotten interesting protocols. If you know about others that are worth discussing, please do not hesitate to let us know on Twitter or Discord.

  Stablecoins market is in constant expansion, with a total market capitalization of over $110 billion. While centralized tokens like USDT and USDC still dominate the market, we think there is a huge opportunity for decentralized stablecoins to keep growing and innovating in the space and that there will be multiple winners. We are looking forward to a future where multiple decentralized stablecoins emerge and gain traction!

  Legal Disclaimers

  The forward-looking statements in this announcement are subject to numerous assumptions, risks and uncertainties which are subject to change over time. Such assumptions, risks and uncertainties could cause actual results or developments to differ materially from the results and developments anticipated by Angle Labs Inc. Even if our anticipated results and developments are realized, such results and developments may nevertheless fail to achieve any or all of the expected benefits anticipated by this announcement. We reserve the right to change the plans, expectations and intentions stated and implied herein at any time and for any reason or no reason, in our sole and absolute discretion, and we undertake no obligation to update publicly or revise any forward-looking statement, whether as a result of new information, future developments or otherwise.

Building decentralized stablecoins is hard: it implies taking volatile (or not) crypto-currencies as collateral and issuing something which has a stable value on top of it. The goal of most decentralized designs is then all about one thing: absorbing and distributing the volatility risk of the collateral to be always able to propose to stable token holders collateral in value superior or equal to what they own in stable tokens.

In this series of articles, we explored some widespread approaches to cope with this volatility risk. We went over algorithmic/under-collateralized designs where one option to absorb risk consists in having a volatile supply (like Ampleforth does), or where another choice is to rely to a secondary volatility token (often a governance token) which price is used to absorb the risk in case of a collateral price decrease or a bank run event (like FRAX).

We also dived into over-collateralized protocols like Maker where the volatility risk is taken by collateralized debt position (CDP) owners who risk to loose money in liquidations if the value of the collateral they brought falls too low.

While having CDPs and vaults like Maker really fragments the volatility risk, the counterpart with these designs is that it’s hard to build really stable tokens with it as there are no direct arbitrage opportunities with such protocols when prices deviate from peg. Some promising new designs like Liquity are however emerging and start to remedy this issue.

One idea to absorb the volatility risk is to sell it through derivatives contracts like perpetual futures to people who are looking for volatility. These people tokens with it as there are no direct arbitrage opportunities with such protocols when prices deviate from peg. Some promising new designs like Liquity are however emerging and start to remedy this issue.

One idea to absorb the volatility risk is to sell it through derivatives contracts like perpetual futures to people who are looking for volatility. These people take on this volatility on behalf of the protocol, getting rewarded in case of collateral price increase and incurring losses when collateral price decreases.

This idea is far from being new in crypto. Back in 2017, Variabl came up with it but was never launched on mainnet. Since then and even though derivatives have been battle tested in crypto with exchanges like Bitmex, and on DeFi protocols like PERP Protocol, there have been very few projects leveraging these products to build stablecoins.

Before going into more details, it is important to understand how derivatives can help a protocol hedge against collateral volatility. The idea is quite simple:

• In case of a collateral price decrease, the protocol is protected by traders’ positions as it can capture their losses to cover for the decrease in collateral value. The counterpart to this is that in case of a collateral price increase, the protocol transfers its surplus to the hedging traders as a profit for them.

Below, we illustrate an example of how a protocol which collateral is hedged by a derivative product called a perpetual future resists to a collateral price drop.

Perpetual Futures

Pika Protocol is using a design similar to that of the example for their stablecoin.

In few words, the Pika Protocol is a decentralized non-linear inverse perpetual swap exchange: it is a marketplace between people who own long perpetual positions and people with short positions like what can be found on Bitmex: when the underlying price increases short traders have to give collateral to long traders and when price decreases longs have to pay shorts.

The protocol involves some funding rate equivalent to be paid at position opening or close to incentivize either long or short holders to close their positions when needed and make sure that the market remains balanced.

To get a stablecoin with Pika, you then simply need to open a 1x short position: the value of this position always remains equal to one dollar. In case of collateral depreciation, the long positions losses are used to back the token.

The UXD Protocol is also based on this same idea of a perpetual swap exchange. In this case, a portion of the funding rates paid by the long holders go to an insurance fund to be distributed as a form of funding payment to long holders when there are not enough stable/short holders. This is a way to avoid having stable holders paying funding rates.

Options

Perpetual futures is not the only type of financial products used to maintain a stable asset value in reserves. Lien Finance uses other types of financial products involving a specific maturity and an expiry time.

In more details, someone giving 1 ETH worth 2000$ to the Lien protocol gets two tokens: one token representing a 2x leveraged token and one token which value is supposed to remain stable called a Solid Bond Token (SBT) and pegged to let’s say 1000 USD. At expiry of the tokens if the USD market price of ETH is P, the SBT holder has the right to max(1000/P,1) ETH and the long token holder has the right to max(1–1000/P,0) ETH. In most situations at maturity, unless the ETH price decreases by more than 50%, the owner of the SBT token gets back their full value. If price decreases by more than 50%, the owner only receives a portion of what she brought.

SBTs can then be used to issue stablecoins (called iDOL in this system). This means that the protocol’s stablecoins are backed by SBTs with different maturity dates.

Purely derivatives backed protocols are supposed to work almost perfectly on paper: value of the reserves backing the stablecoins stays the same regardless of the price increase or decrease in collateral. Stablecoins can therefore most of the time be issued or burnt in a capital efficient manner at a 1:1 rate for collateral meaning that they can arbitraged and hence easily keep their peg.

There is however an important caveat to this design: it can only work provided that there are enough people willing to go long on the collateral. As any two-sided marketplace, such protocols need to be balanced. To back a stablecoin by derivatives, more than finding collateral for the stablecoin, you therefore need to find people that are willing to take volatility of the underlying at all times.

For instance, with Lien Finance, if there isn’t anyone to buy the leverage tokens issued, exposure to the volatility of the collateral cannot be reduced.

Generally speaking, stablecoin demand tends to grow in bull markets when more people want to borrow stablecoins to get leveraged, creating attractive interest rates for lending stablecoins. At the end of such periods, the trend is usually that stablecoin supply plateaus.

ETH Price (source: The Block)

Total Stablecoin Supply (source: The Block)

On-Chain Volume of Stablecoins (source: The Block)

With mechanisms like Lien or Pika where there is always a need for a perfect matching between long and stable, in case of decreasing demand for leverage, supply of stablecoin automatically decreases. This makes these mechanisms not perfectly suitable for a fully decentralized finance where stablecoins supply shouldn’t be fully dictated by market conditions.

In the case of the UXD Protocol, the fact that funding payments can be used to incentivize people to open long positions may make the protocol more robust in bear market conditions, but the size of the payments is only capped by the amount of the insurance fund accumulated in bull market and the governance token auction occurring in that case may not be sufficient to handle severe decreases in price drops.

• Derivative-backed stablecoins are decentralized and can be, depending on the design, capital-efficient to issue

• These protocols rely on derivatives like perpetual futures to absorb the volatility of the collateral backing the stablecoins. In case of collateral price decrease, long traders’ losses are used to maintain stable assets value in reserves.

• Provided that there is enough demand for leverage, these protocols can resist potentially any collateral price drop

• The bottleneck for derivative-backed stablecoins is to find enough long traders willing to get leveraged on the price of the collateral with respect to that of the stablecoin

• Such protocols are often designed as two-sided marketplaces between long traders/stable seekers meaning that in case of drop in demand for leverage, stablecoin supply tends to mechanically shrink.

Angle’s design follows this derivatives-backed idea, but tries to move away from necessarily matching shorts with longs. Overall, like most derivatives-backed stablecoins:

• Angle is decentralized and it is capital efficient to issue and burn stablecoins

• Angle insures itself against the volatility of its collateral by issuing perpetual futures to resist collateral price drops

• Angle lets traders (called Hedging Agents) get an on-chain leveraged position in one straightforward transaction

Yet, contrary to these protocols:

• Angle is not conceived as a perfect marketplace between people looking for stability and leverage. Besides having a way to still bring back equilibrium between long and stable holders through transaction fees, Angle also has a mechanism to insure the reserves not covered by long traders by relying on a second type of liquidity providers called Standard Liquidity Providers. Thanks to that, Angle stablecoin supply could continue to grow or stay steady even in difficult market conditions.

• Angle protocol has been designed from scratch to support various types of collaterals and of stablecoins, not limiting itself to an ETH collateral backing a USD stablecoin like it is unfortunately the case for many derivatives-backed protocols

• Angle is not a purely derivatives-backed protocol: in the case for instance of USDC and DAI backing a stable Euro, the protocol could work even with a limited volume of agents getting long on the variation of the Dollar price with respect to the Euro

• Conclusion

  In this series, we tried to give an overview of the different stablecoin protocols designs while making a case for Angle Protocol. This came from our limited knowledge and we may have forgotten interesting protocols. If you know about others that are worth discussing, please do not hesitate to let us know on Twitter or Discord.

  Stablecoins market is in constant expansion, with a total market capitalization of over $110 billion. While centralized tokens like USDT and USDC still dominate the market, we think there is a huge opportunity for decentralized stablecoins to keep growing and innovating in the space and that there will be multiple winners. We are looking forward to a future where multiple decentralized stablecoins emerge and gain traction!

  Legal Disclaimers

  The forward-looking statements in this announcement are subject to numerous assumptions, risks and uncertainties which are subject to change over time. Such assumptions, risks and uncertainties could cause actual results or developments to differ materially from the results and developments anticipated by Angle Labs Inc. Even if our anticipated results and developments are realized, such results and developments may nevertheless fail to achieve any or all of the expected benefits anticipated by this announcement. We reserve the right to change the plans, expectations and intentions stated and implied herein at any time and for any reason or no reason, in our sole and absolute discretion, and we undertake no obligation to update publicly or revise any forward-looking statement, whether as a result of new information, future developments or otherwise.