For stablecoins, "maintaining yield in bear markets and increasing leverage in bull markets" may be the correct path for stablecoin protocols.
Author: Kylo@Foresight Ventures
Tips:
The combination of heterogeneous chains and stablecoin protocols easily creates Ponzi magic;
MakerDAO's bull-bear strategy switch is achieved by transferring revenue sources from on-chain to off-chain;
AAVE's next strategy is to increase GHO yield through Aura;
In the future, a large number of crvUSD cannon fodder will continue to be born based on the curve and convex ecosystems;
Abracadabra has pointed out a specific direction for the development of stablecoin protocols in bull markets.
Web 3 Stablecoins
There is always an ideal of a decentralized central bank in Web3, which can operate independently of all fiat systems and rely entirely on various on-chain assets to implement a complete logic of central bank currency issuance. This utopian ideal has inspired countless developers, who have designed a series of stablecoin systems. However, regardless of whether their original intention is noble, most stablecoin protocols inevitably end up being labeled as "Ponzi" and "over-leveraged" from a mathematical perspective. When the tide recedes, all the magic of stablecoins is stripped of its shame, and assets and liquidity flow away, leaving only the bare mechanism framework. In the end, only stablecoins with sufficient and robust collateralization can survive.
Perhaps we can consider what stablecoins mean for the Web3 industry? Setting aside the utopian ideal and considering the specific significance of stablecoins, they can construct sufficiently elegant Ponzi systems; they can also serve as a new asset issuance method to bring ample liquidity to the chain; and they can also act as leverage to increase a large amount of available liquidity for on-chain users.
In summary, the allure of stablecoins for the Web3 industry lies in the essence of Ponzi, leverage, and liquidity. The main purpose of this article is to elaborate on the clever tricks of some stablecoin protocols, mainly including some Ponzi designs and the stablecoin operation modes of MakerDAO, AAVE, Curve Finance, and Abracadabra. In fact, there are also some stablecoin designs based on arbitrage principles, such as Luna-UST, Ethena Labs, etc., which we will specifically elaborate on in the next article.
Constructing a Ponzi Reasonably with Collateralized Stablecoins
When we create a brand new asset and endow it with value through other real assets, in a sense, this new asset also gains value. This means that the value of the created asset needs to be confirmed through an anchor. Taking stablecoins as an example, the value anchoring of various junk stablecoins is achieved through stablecoin trading pairs. The role of this stablecoin trading pair is not to truly endow various junk stablecoins with value, but only to endow them with their current face value. Real value refers to the steel value, while face value is only the paper value, which can be directly influenced by oracles or marginal value.
To better understand the meanings of "new asset pricing," "value anchor," and "the real value and face value of stablecoins," we can understand them through heterogeneous chain stablecoins. Any heterogeneous chain is essentially similar to a fiat system, and stablecoins within this ecosystem can be minted by collateralizing with the native token of the heterogeneous chain. In theory, the native token of this heterogeneous chain has a price in off-chain CEX, so within the ecosystem, it can be used as collateral to mint a large amount of native stablecoins, and then a portion of stablecoins such as USDC can be transferred into the ecosystem through the cross-chain bridge, paired with the native stablecoin, endowing the native stablecoin with a face value, and USDC becomes the value anchor for the native stablecoin, anchoring its value at 1. However, this anchored value is essentially a face value, not the real value of the stablecoin. Since the amount of real assets brought in by USDC through cross-chain is far less than the amount of native stablecoins minted, the native stablecoin cannot achieve a full backing by USDC.
However, the Ponzi aspect of the financial system often lies in the confusion between real value and face value. The total valuation of assets in the financial market is determined by face value, and face value determines the marginal price of transactions. This means that in the transmission of the financial system, by using a small amount of assets with real value as the value anchor, the face value of new assets can be maintained, thereby affecting the marginal price of transactions and expanding the nominal total assets of the financial market.
In the heterogeneous chain ecosystem, the typical scenario is that a large amount of native tokens are collateralized to mint a large amount of collateralized stablecoins, which are only used within the ecosystem to form LP trading pairs with the native token. A small amount of USDC is brought into the ecosystem through the cross-chain bridge, serving as the value anchor, endowing the native collateralized stablecoin with a face value of 1. Since the primary use of a large amount of native collateralized stablecoins within the ecosystem is to form LP, this leads to a large demand for the native token, driving up its price. It is worth noting that at this point, the price of the native token is actually determined by the face value of the native collateralized stablecoin, which is 1. CEX captures the on-chain price through oracles, resulting in a nominal price difference between CEX and on-chain. Arbitrageurs often buy the native token with real assets (USDC) on CEX and sell it on-chain to complete arbitrage. Unbeknownst to them, when arbitrageurs buy the native token on CEX, they passively become a part of this Ponzi scheme: as liquidity providers, they expand the exit liquidity of the native token…
The above play with heterogeneous chain stablecoins is just one of the basic plays of a large number of Ponzi structures in TradFi or DeFi. The well-known Luna-UST structure is essentially based on this logic. The face value of UST is anchored by Curve 4pool and the market value of Luna, while the ecosystem's LUNA is supported by the face value of UST; in addition, this logic can also explain the exchange rate issue between the US dollar and RMB, as well as the manipulation of the BTC trading pair by the upbit exchange, the specific details of which we can elaborate on later.
MakerDAO
When MakerDAO was established, it did not have complex designs such as PSM and D3M, but started with a simple CDP collateral model. Users collateralize ETH and generate DAI at a certain collateralization ratio. At this point, users can choose to exchange DAI for ETH and then repeat the above process for loop lending. Many users are engaged in loop lending, which means they are selling DAI, so DAI often remained slightly unanchored before the DeFi summer. MakerDAO addressed the issue of unanchored DAI through the transfer payment, namely DSR. When users mint DAI, they need to pay a certain interest rate, which is paid to DSR depositors through transfer payments. Therefore, MakerDAO can adjust the supply of DAI in the entire market by adjusting the deposit interest rate of DSR, thereby maintaining the anchoring of DAI.
MakerDAO introduced PSM after the DeFi summer. Due to the influx of funds, the yields from DeFi farming became very exaggerated, and the commonly used assets for DeFi farming included DAI. Therefore, the demand for DAI generated a premium for DAI. To solve the premium problem of DAI and maintain the stability of DAI's price, MakerDAO introduced PSM. Users can use assets accepted by PSM, such as USDC, USDP, and other stablecoins, to exchange for DAI at a 1:1 exchange rate. The introduction of this mechanism greatly enhanced the stability of DAI's price. However, later, as the USDC in PSM constituted the majority of DAI collateral, this also laid the foundation for the subsequent unanchoring of USDC.
D3M (Direct DAI Deposit Module) is a collaboration between MakerDAO, AAVE, and Compound regarding the deposit interest rate of DAI. Since the interest rate determination curve of AAVE and Compound is directly related to the utilization rate of the deposit pool, this means that the asset lending rates may experience spikes at certain times. To maintain the stability of DAI borrowing rates, MakerDAO introduced D3M, which provides AAVE and Compound with some emergency minting quotas to limit the borrowing rates of DAI within a certain range. The introduction of this model has to some extent undermined the market competitiveness of on-chain fixed-rate lending products. In addition, the introduction of Morpho Labs has also captured another angle of the fixed-rate lending market. Currently, there is still space for long-tail asset lending in this race. The collaboration between MakerDAO, AAVE, and Compound on D3M may be canceled in the future as Spark Protocol gradually matures.
During the bull-bear cycle transition, MakerDAO made several adjustments to the direction of DAI products, including:
• Further reducing the types of collateral for DAI, retaining only core currencies such as ETH, wBTC, stETH, etc.• Setting the collateralizable share of GUNI to 0• When U.S. bond rates rise, promptly converting the stablecoin assets in PSM into RWA business through Coinbase and specific trust companies
The last two adjustments actually reflect their bull-bear strategy: obtaining revenue from on-chain activities during a bull market and obtaining revenue from off-chain activities during a bear market. GUNI is a DAI-USDC automatic yield strategy LP introduced by gelato in the previous bull market cycle. MakerDAO once supported the minting of DAI using this LP as collateral. The proposal to use GUNI as collateral for minting DAI faced widespread community discussion, with opposition mainly focused on the risk of using DAI derivatives as collateral for minting DAI, while supporters argued that the minted DAI would be locked in a Uniswap LP trading pair with USDC and would not have any impact on the circulating supply of DAI. After GUNI was integrated into MakerDAO, its asset management scale reached several billion dollars, benefiting directly from MakerDAO and Arrakis Finance. However, with MakerDAO canceling GUNI as collateral, Arrakia Finance faced a significant loss of TVL. The decline of Arrakis Finance also reflects the fate of most DeFi protocols in the end…
During a bull market cycle, on-chain trading is extremely frequent, and GUNI can capture a large amount of trading fees from DAI-USDC. But when U.S. bond yields slowly rise and on-chain activity becomes calm, GUNI cannot generate a large amount of fee revenue. At this point, in order to generate more revenue, MakerDAO began transitioning to RWA business, exchanging a large amount of stablecoins in PSM for assets related to U.S. bonds. This operation continued to ferment in Q2 2023, creating the RWA track.
AAVE
AAVE is currently moving towards the direction of a Super Dapp, with the social protocol Lens Protocol and lending business already mature, while the stablecoin protocol GHO is the next segment that AAVE is focusing on. The collateral minting for GHO is currently integrated into AAVE's lending business, where unused collateral within AAVE can be used as collateral for minting GHO, and the minting rate will decrease as the individual AAVE collateral amount increases, currently fluctuating between 3.38-4.83%. Since the minting rate and existing yield scenarios for GHO were much lower than DAI or crvUSD, GHO is currently significantly unanchored. Therefore, restoring the anchoring of GHO's price is an important operation for AAVE, and specific methods include:
• Increasing the minting rate of GHO to make it close to the rates of DAI and crvUSD• Expanding the usage scenarios of GHO yield farming as much as possible
These two methods complement each other. Lower minting rates, combined with higher yield farming returns, can expand the minting volume of stablecoins while maintaining anchoring. Therefore, under the premise that AAVE can achieve minting rates lower than the market, increasing GHO yield farming returns is the most favorable strategy for GHO.
To enhance the yield of GHO, AAVE is working with Balancer and Aura Finance. The collaboration between AAVE and Balancer has always been very close, and the introduction of the Boosted Pool is a milestone in their collaboration. Stablecoins deposited in the Balancer boosted pool can earn AAVE deposit interest while also receiving swap fees, greatly improving the efficiency of stablecoin fund rates. The next collaboration between Balancer and AAVE revolves around GHO, where Balancer will serve as the liquidity hub for GHO, and Aura Finance will act as the yield booster for GHO. To achieve this, AAVE has purchased approximately $800k worth of Aura and has deposited a large amount of veBAL from the treasury into Aura Finance to gain more governance rights related to Balancer. Currently, the minting limit for GHO is 35 million, and when the GHO yield boosting mechanism takes off, it is expected that the minting limit for GHO will significantly increase. At the same time, to lower the minting rate, AAVE's collateral amount will gradually increase. This is a great benefit for AAVE, Balancer, and Aura Finance, but the magic may take some time to start.
crvUSD
Although crvUSD is also an over-collateralized stablecoin, it differs from the CDP model and has created a new design concept for many other DeFi protocols. The design inspiration for crvUSD comes from AMM. In AMM, token swaps are achieved by depositing one type of token and withdrawing another type of token according to a certain algorithm. If we deduce through the principle of equivalence, the lending process is essentially similar to AMM. Users need to deposit some collateral and then borrow another asset based on a certain collateralization ratio. This method of implementing lending through the AMM model has been adopted by some protocols, such as timeswap and 0xfluid, a sub-product of Instadapp.
In the crvUSD model, it adopts a gradual liquidation model similar to AMM. The traditional CDP model is characterized by the fact that once the collateral ratio reaches a certain threshold, all collateral will be liquidated at once. The crvUSD model, on the other hand, liquidates collateral gradually as the price of the collateral changes. The LLAMA algorithm of crvUSD determines that the price of the collateral will be slightly lower than the collateral price in Uni V3 when the price of the collateral decreases. In this case, arbitrageurs will use crvUSD to purchase collateral from LLAMA at a lower price and sell it in Uni V3 to profit from arbitrage. Conversely, when the price of the collateral increases, the price of the collateral in LLAMA will be higher than in Uni V3, and arbitrageurs will sell the collateral to LLAMA, receive crvUSD, and use it to buy back assets in Uni V3 to profit from arbitrage.
The advantage of the gradual liquidation in the AMM model is that the asset collateralization ratio can be set sufficiently low. Since the liquidation process occurs gradually as the price of the collateral decreases, this means that there is enough flexibility in the liquidation price. In other words, gradual liquidation involves selling collateral bit by bit, and compared to selling all collateral at the lowest price at once, it results in more assets, allowing for a lower collateralization ratio to be set. If higher capital utilization is the advantage of crvUSD, then the cost is more impermanent loss. If the price of the collateral drops significantly and then rises back to its original price, due to the arbitrage mechanism within the LLAMA algorithm, the value of the user's collateral will decrease, and the reduced portion will be the part arbitrated by external parties.
crvUSD has several tools to maintain the price anchoring of crvUSD:
• Higher minting rates• Rich crvUSD yield scenarios• Automatic minting function of pegkeeper
According to the theory of AAVE GHO, minting rates and yield farming returns are the two major factors determining the scale of stablecoins. From these two perspectives, despite the existence of various "cannon fodder," even though the minting rate of crvUSD is currently at the highest level in the industry, there are still a large number of users minting crvUSD. If there is a desire to further expand the minting scale of crvUSD, it is actually only necessary to lower the minting rate to the industry average.
Currently, crvUSD tends to become unanchored. Due to excessively high yield farming returns, the minting rate of crvUSD is also high. The common practice for DeFi farming users is to mint other stablecoins at a low rate and exchange them for crvUSD to engage in DeFi farming. This arbitrage behavior based on interest rate differentials creates demand for crvUSD in the secondary market, potentially leading to unanchoring. The solution to this upward unanchoring for crvUSD is quite straightforward: directly minting without collateral through pegkeeper and selling it in the relevant liquidity pool of Curve V1. This approach differs from the MakerDAO PSM mechanism in that pegkeeper has almost no financial cost and continues the high capital efficiency characteristic of crvUSD.
crvUSD has gradually built a "cannon fodder ecosystem." Before the theft of Conic Finance, crvUSD had established a three-tier Ponzi structure with Curve, Convex, and Conic, and after forming a 3pool or 4pool with various stablecoins, it could pass the returns to Conic Finance. Through this method, crvUSD accumulated a minting volume of approximately 150 million crvUSD. Prisma Finance was originally intended to be the fourth-tier income after Conic Finance, but due to the damage to the reputation of Conic Finance caused by the theft, Conic Finance withdrew from the crvUSD cannon fodder ecosystem. Therefore, Prisma Finance essentially inherits the role of Conic Finance for crvUSD in terms of functionality, and its valuation logic is similar to that of Conic Finance.
In theory, with the help of Curve Finance and the Convex ecosystem, crvUSD can continue to incubate more cannon fodder, a potential that other stablecoins do not inherently possess. The collaboration between AAVE and Balancer is also theoretically aimed at replicating the successful path of Curve Finance and its ecosystem, but there is still a long way to go.
Abracadabra
Abracadabra was born during the bull market period and is a stablecoin protocol specifically designed for leverage. It mainly uses various yield-bearing assets with poor liquidity as collateral to mint various stablecoins and maintains price stability through the MIM-stablecoin secondary pool. Currently, most of the MIM liquidity is built on Curve, and the MIM_spell official maintains the stablecoin pool in two ways:
• Using $spell bribes to vote veCRV for the MIM-stablecoin pool• Additional spell token incentives for the MIM-stablecoin LP pool
In fact, the strategy of Abracadabra at the end of 2021 is likely to be repeated in the next bull market cycle. During a bull market cycle, there is a significant demand for leverage, with users eager to obtain highly liquid stablecoins without sacrificing the yield of their assets and paying a certain interest rate to engage in various leverage operations. The above model has two pain points: how to find popular and large-scale yield-bearing assets and how to maintain the liquidity of newly minted stablecoins.
Abracadabra's strategy at the end of 2021 was to use large-scale assets with broad user demand as collateral and to quickly enable users to leverage through the construction of a secondary liquidity pool. At that time, Yearn Finance's yETH pool was at its peak, with a large TVL. Therefore, Abracadabra opportunistically used yETH as collateral to mint the stablecoin $MIM and enable leverage through the MIM-stablecoin liquidity pool.
Since users use Abracadabra mainly to leverage through MIM-stablecoin, the depth of the secondary liquidity pool is crucial. Abracadabra achieves this by heavily incentivizing MIM-stablecoin LP. The spell used to incentivize the MIM-stablecoin LP and the ecosystem incentives of Abracadabra.
The main reasons why the value of $spell can skyrocket 100 times in a short period are:
• All interest income is used for direct repurchase, creating a large buying pressure• A sufficiently high price of spell can support rich secondary liquidity, allowing the product to continue operating
This means that from the perspective of active and objective market-making, $Spell has the incentive to be pulled up.
Abracadabra is a very classic case in the DeFi ecosystem cycle, and in a sense, this model can "win repeatedly" in a bull market. However, the problem is that the main reason for Abracadabra's rise in the previous cycle was that it happened to take over a large number of yield-bearing assets from Convex Finance and Yearn Finance. After being tested in a bear market, the next bull market cycle may bring new asset categories, weakening the position of Convex and Yearn in the current DeFi space. Therefore, for the Abracadabra team, timely attention to the potential changes in yield-bearing assets in the market and making adjustments to the market direction is the only way to maintain its advantage in the entire chain liquidity.
From the current strategic direction adjustment, Abracadabra still maintains a friendly relationship with Yearn Finance, but is also continuing to explore opportunities with GMX and Kava Chain. Whether it can turn over a new leaf depends on whether MIM can discover more promising market opportunities ahead of the market.
Summary
The design of stablecoin models essentially has no dark side, but when this model becomes a real-money gambling arena, its dark side as a financial game becomes apparent. Excluding its dark side, if we look at stablecoins from the perspective of user leverage and liquidity, they truly meet user needs. The matching of products with user needs is the true side of stablecoin protocols in Web3.
For stablecoins, "maintaining yield in a bear market and increasing leverage in a bull market" may be the correct path for stablecoin protocols. The rise of Lybra Finance in a bear market reflects the logic mentioned above. However, the bear market will not last forever, and adjustments at the protocol level should also keep up with the cycle. With the bear market lasting too long, the DeFi and stablecoin protocols that require a large amount of capital have been dormant for too long. But with the arrival of the bull market cycle, ample liquidity and capital will certainly irrigate the DeFi liquidity, which is currently close to drying up. The gears of history will continue to turn along the original track, and we wait and see…
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