Stablecoins have a unique goal of maintaining a stable value in relation to the assets they are pegged to, such as the US dollar or Euro. Unlike other cryptocurrencies like Bitcoin, stability is their priority. However, achieving decentralization, stability, and scalability simultaneously can be challenging for Stablecoins.
During ethCC 2023 in Paris, Robert Lauko, founder and head of research at Liquity, proposed an approach to tackle this stablecoin trilemma.
Lauko highlighted that borrowing-based or CDP-based stablecoins face a scalability problem. The issuance of stablecoins is limited by the demand for loans backed by collateral, which can result in a softer peg and reduced stability. This limitation could potentially lead to liquidity issues, requiring significant incentives to maintain liquid secondary markets.
The founder, Lauko, introduced the “decentralized reserve” approach as a solution to the stablecoin trilemma. The concept involves a protocol-owned reserve backed by a native asset like Ether (ETH). Users can mint and redeem stablecoins at face value, ensuring a stronger peg and enhanced liquidity. However, the protocol takes on the volatility of the reserve asset, which could pose a challenge in hedging against price fluctuations.
Two approaches to the decentralized reserve concept that are often used are recapitalization by inflation and delta-neutral hedging. Recapitalization by inflation requires high collateral ratios and could subsequently pose sustainability challenges. On the other hand, the potential challenge encountered with delta-neutral hedging is decentralization and incorporating futures markets into native protocols.
Given the challenges encountered with the approaches to decentralized reserve, Robert Lauko’s Liquity introduced principal protection and integration of a secondary market.
The principal protection ensures that losses are mitigated, making the position more attractive to users. Alongside this, the integration of a secondary market within the protocol reduces strain and cost while providing a perpetual, liquid environment, the founder stated.
How the Decentralized Reserve Works
When a user opens a hedging position of say 10 ETH, the protocol can increase its value by taking money from the reserve when the Ether price rises. Interestingly, the principal protection mechanism guarantees the user can always retrieve their position size from the system if the Ether price plummets. This makes the position asymmetrically attractive on the upside, the founder said.
Due to the principal protection feature, users are willing to pay a premium in addition to the principal when opening positions. Instead of 10 ETH, they pay 12 or 14 ETH which works more like insurance. The system collects these premiums to finance the protection when required. In most cases, users would prefer to sell their positions on the secondary market rather than claiming principal, further reducing the need for payout.
To prevent a potential bank run or outrageous withdrawal situation caused by numerous users simultaneously claiming their principal, Liquity employs a secondary market mechanism. The system detects if a user fails to sell their position within a specified timeframe and then steps in to subsidize the sale gradually. This targeted approach minimizes the total liability of the system.
Lauko believes that Liquity’s combination of deltronutral hedging, principal protection, and the secondary market offers a promising solution to the stablecoin trilemma.
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