Hello,
I have been reading James Gleick’s The Information. It explores how humanity came around to organising different forms of information like the languages we speak, dictionaries and the modern-day web. I am at the part in history where Charles Babbage just invented the mechanical computer and people are still wrapping their heads around what it does. There used to be an odd problem at the time. “Computers” were human beings who used to do low wage, menial tasks to calculate large figures from mechanical devices that filled a room. It used to be hard to cross-check for its validity because the system was prone to human error. So they had multiple individuals doing the same calculation and sending it to a quality analyst who used to verify if both responses were similar. This communication used to happen through letters so nobody knew who was checking for what. Even before the internet was ever a thing - the need to verify claims and do quality checks on systems others relied on was a problem. Today’s issue of my newsletter explores how this applies to our concept of money and sheds light on approaches some startups have been taking to solve for it.

The Problem

In regions struck with high inflation, gradual dollarisation has been the norm. It is how citizens reject regional monetary policy and align with a more stable economy without shifting borders. Startups and technologies are becoming the new agents of change. Like the IMF and world-bank once used to be. Consider Zelle. It is frequently used in Venezuela. Since engaging in trade through regional currencies exposes individuals to hyperinflation (due to dropping value), people often prefer making and taking payments in dollars. The following excerpt from a recent Coindesk article explains how Zelle is used.

”Although Zelle is meant for U.S. usage only, Venezuelans have repurposed the network as a way to make dollar payments among each other. Large Venezuelan supermarket chains including Excelsior Gama, Automercados Plaza’s, Unicasa and Central Madeirense have enabled Zelle as a form of payment. Cafes and restaurants accept it. So do taxis.”

The American government recently acknowledged the use of technology as a means of dollaris-ing external economies through a collaboration with stablecoin service provider Circle. The plan is to use USDC to allow citizens of Venezuela to have access to the dollar without relying on traditional banking rails. Over half a million users are anticipated to be depending on this form of the dollar. 

While this looks incredibly interesting, it needs to be noted that - 

1. USDC can blacklist almost anyone holding dollars through them. This puts those relying on the service of USDC at the mercy of those running the service.

2. The system could lead to the creation of a surveillance economy. Since stablecoin transfers are essentially trace-able on-chain, we could have governments being able to make a network of financial transactions and using it against individuals in the future. It could affect the economic sovereignty of a nation.

While bank deposit based stablecoins have been rapidly capturing market share, the risk they pose to the average individual may not be entirely clear. In many cases, they are not too far from Paypal but with a blockchain slapped on it. On the other side of this equation are projects like MakerDAO which use cryptocurrencies to issue stablecoins. The challenge with them is that the highly volatile nature of cryptocurrencies could translate to many of these “stablecoins” going way off-peg. Those using stablecoins today have a trade-off between absolute centralisation or volatile pegs. Several projects have been looking at alternative approaches to solve them. We explore what they do below.

Indexing the US Dollar

Indices enable individuals to hold multiple assets so that if a single asset collapses, the others can cushion the fall. When it comes to stable-currencies, this would mean having a single dollar-asset that in turn, is backed by multiple stablecoins. The IMF has been using an instrument called special drawing rights to maintain a unit of account that takes into account a basket of currencies from member nations since the 1970s. 

DeFi Dollar helps individuals maintain a stable unit of value called the DUSD. It is minted (generated) by providing a mix of USDC, DAI, Tether or TUSD to a smart contract. These DUSD tokens are then provided to an automated-market maker pool called curve to enable anyone to come in with a single asset (like DAI, USDT or even Ethereum) and get the indexed dollar variant in their wallets. The system uses a mix of incentives for generating indexed stablecoins and maintaining its peg. At its core, there are three constituents.

1. People who mint the DUSD. These could be an exchange, hedge-fund or active market-participant that happens to be holding exposure to a multiple stablecoins and are looking to generate yield on them. These individuals provide this mix of stablecoins to the DUSD smart contract and in return are rewarded in DeFi Dollar DAO tokens for doing this. Individuals providing DUSD take the risk of any of the constituent tokens falling in value. They are incentivised via platform fees and tokens from the DAO.
   

2. Those buying DUSD. These could be the average individual that wants a stable unit of value to reduce the risk that comes from exposure to a single stablecoin. There are roughly about ~$11 million in DUSD issued held in ~350+ wallets. An indication that the average person using DUSD is likely comfortable transacting in the hundreds of thousands of dollars
   

3. Owners of the network. Since DUSD is structured to be a decentralised entity, its fees and platform economics are determined by a vote based consensus. Ownership in this context is determined by who holds how many of the DeFi Dollar DAO tokens.

   

DeFi Dollar’s operations are essentially doing what Robinhood did to equities trading. Instead of charging individuals for making a trade, they are offering incentives in the form of native tokens and underlying fees that are generated from curve. This reduces the cost of capital acquisition for the network and in turn, creates cashflow with a fraction of the operational expenses a typical fintech venture would take. The network itself is valuable so long as individuals are looking to park capital in an index of stablecoins. With a current supply of over $25 billion in different stablecoins, I doubt that it will be difficult for them. You can read more about their interest-bearing stablecoin instrument here and the re-balancing economics used in the project here. 

Algorithmically Maintaining A $1 Peg

The challenge with the index approach mentioned above is that risk could be induced in the system from both centralised and decentralised systems. The use of DAI in DeFi Dollar means a MakerDAO liquidation event leaves the network far from a $1 peg. Similarly, if the government takes down USDC or Tether, the network could stand in substantial losses. The race to make a stable store of value that is truly decentralised and out of reach of regional regulators may be one of the biggest problems in the modern world today. This is part of the reason why over $130 million was invested in a project named Basis in 2017. Regulators have since shut it down. Most algorithmic stablecoins run on a simple mechanism. Whenever the price of the token is over $1 (say $1.03), you issue more of the asset to dilute the value of the token. When it is under $1, (eg: 0.$97), you create incentives for market-participants to buy the asset in the market. The demand for the asset, in turn, creates buoyancy for the price and brings it closer to a peg of $1. While multiple projects are taking this approach to create a stable asset, we will be looking at Empty Set Dollar in particular for today.

Empty Set Dollar runs on a few key concepts.

1. The ESD - Empty set dollar is the core asset of the ESD network. It is designed to be maintaining a peg of $1 at all times. It is also used for rewarding individuals on the network for carrying out specific functions explained below.
   

2. Network Debt - Assume ESD goes off a peg of $1 to $0.97. The network’s debt is now $0.03 (because of the deficit from the ideal price point of $1). The amount of debt in the system accumulates over a period of time. The assumption for those holding ESD is that over time, the network will be free of debt as the asset trends towards $1. 
   

3. Epochs - Epochs in ESD are a pre-set amount of time. Typically 8 hours. Oracles use the number of epochs that the price was off the peg to get an estimate of the debt. A Time Weighted Average Price (TWAP) is taken to check if the price of ESD was close to one at the end of each epoch. 
   

4. Coupons - A coupon is a call option on the future price of ESD. When the price of ESD is under $1, individuals are incentivised to burn their Empty set dollars in exchange for coupons. They transfer their ESD’s to a wallet address which issues coupons to them (and reduces ESD supply in the market). These coupons give them the right to receive newly minted ESD’s whenever there is an inflation in the network. Inflation in this context refers to minting more tokens to bring the price of the asset to $1 when it is greater than the preferred peg value.

Note : The flywheel above discounts market supply and demand which is the major contributor for price movements of most assets. I have only flagged how coupon issuance happens during price mentions in the image above.

In effect, every time the price of the token is under $1, people are incentivised to burn their ESD’s in exchange for coupons. The coupon is a bet that the price of the token will return to $1 at some point in time in the future. When the price of the asset is back above $1, the system issues new tokens to inflate and reduce the price of the asset. At that point in time, individuals that purchased the coupons can practice their rights to receive ESD tokens and sell it in the market to make a profit. The coupons and network inflation in essence balance the price of the asset around $1. The challenge here is that the coupons expire within a period of one month. So if the price of the asset does not trend towards $1 within a month, the individual can stand to lose the entirety of the ESD’s that were spent in acquiring the coupon. Part of the reason why the asset is structured this way is to incentivise market-makers or hedge funds to partake in maintaining a peg. If you know for a fact that you can meaningfully push the price of ESD to $1 through in-market purchases, you will buy coupons. If not, you will be speculating on the eventual return to $1. For more details on how ESD works, I highly suggest reading this explainer from Complement Capital

What’s Next

Money is an “idea”. The only real asset that matters for us mortals that are destined to die is time. Money merely allows us to multiply our time through its ability to acquire services or commodities. Philosophy aside, the concept of a “stable asset” is not something that we may ever see in reality. The value of the US dollar keeps fluctuating against other currency baskets and commodities like gold. The on-going, large-scale monetary experiments we see with these blockchain projects is merely an attempt to create an asset that trends closest to a stable value at a global scale. As I was working on this piece, news had leaked of Facebook’s plan to revamp their blockchain project, US regulators were considering releasing regulations for Stablecoins and Visa integrated USDC into their operations. By no means are stablecoins a niche concept that is used by power-users. Its impact and effect will be felt across the internet in the years to come. More importantly, as an increasingly large part of human populace begins making its money in digital forms, the quest to find a stable store of value will only become higher. We are at the earliest stages of finding an answer to this question. There will be many versions of these experiments and it is likely that the market eventually picks one. I am just glad to have a front view seat to this evolution of what we consider money.

I will be exploring changing regulatory and enterprise moods to DeFi, indices and new ways of financing startups in the next week’s issues. So I guess you can expect more e-mails than normal.

Have a pleasant weekend.
Joel

Disclaimer
1. I may have exposure to some of the projects mentioned here through some of the investment vehicles I am associated with.
2. Nothing mentioned here is investment advice. Everything is for educational purposes only.

Random Weekend Reading List

1. Sarah Cooper’s 10,000 Hours
2. Powerlaws in Venture portfolio creation
3. The $2 Billion Mall Rats
4. On remote learning in Indian villages
5. The price of discipline
6. Peter Thiel and the cathedral
7. Being short term nice is long term harmful
8. The big lessons from history
9. Maybe social media isn’t making teens depressed

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