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The Path to the Holy Grail: Solving the Stablecoin Triangle

24-09-17 10:00

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Original source: Pure.cash

This article delves into the major attempts to solve the stablecoin trilemma in the history of cryptocurrency. By analyzing these efforts, the core of the problem is gradually revealed, and innovative solutions are finally led.

The trilemma of stablecoins

Currently, the largest stablecoins are either fiat-backed stablecoins, such as USDT ($117 billion) and USDC ($35 billion), or hybrid stablecoins backed by fiat and crypto assets, such as DAI ($5.3 billion). Stablecoins that are purely collateralized by cryptocurrencies, such as GHO or LUSD, are much smaller, at around $100 million.

As for once-popular algorithmic stablecoins, such as LUNA’s UST, they are still doomed to collapse despite reaching a peak supply of $20 billion in 2022. This article will not discuss such undercollateralized stablecoins in depth because they cannot guarantee a 100% redemption rate. Once confidence collapses, they will fall into a death spiral and fail to achieve the most basic stability goal as a stablecoin.

The stablecoin trilemma refers to the challenge of achieving stability, capital efficiency, and decentralization at the same time. Seeking solutions to the trilemma has been the focus of academic research and practical applications. MakerDAO, with its decentralized stablecoin DAI, implemented the use of collateralized debt positions (CDPs) for the first time on a large scale. After the market turmoil on March 12, 2020[1], MakerDAO introduced centralized stablecoins as collateral, and then gradually increased its holdings of centralized assets, including U.S. Treasuries. As a result, DAI evolved into a hybrid stablecoin backed by both crypto and fiat assets.

The primary reason for MakerDAO’s gradual move toward centralization is the inherent limitations of CDPs, which are manifested in high collateralization ratios and low capital efficiency. Currently, decentralized stablecoins that are still backed by CDPs, such as Aave (GHO) and Liquity (LUSD), are relatively small in scale due to their low capital efficiency.

Delta Neutral Hedging Model

To address the low capital efficiency of CDPs, some have turned to another promising approach: the Delta Neutral Hedging Model. For example, holding ETH spot and simultaneously taking an equal short position in an ETH perpetual contract can achieve a perfect hedge, thereby protecting the underlying asset from ETH price fluctuations. The biggest advantage of this model is that it can achieve the same capital efficiency as fiat-backed stablecoins, where $1 of the stablecoin is backed by $1 of the underlying asset.

UXD is one of the early experiments in this direction[2], which relies on Solana's decentralized perpetual contract Mango Markets for hedging. However, the exchange’s limited open interest (OI), combined with the risk of negative funding rates, severely limited UXD’s scale. In addition, Mango Markets lost $100 million in a hack in 2022, dealing an additional blow to UXD. Since then, UXD has been unable to find a suitable hedging exchange and has chosen to hold USDC directly. UXD’s exploration of a delta-neutral stablecoin ultimately failed.

Angle Protocol takes a different approach to the delta-neutral hedging model, issuing agEUR, a stablecoin pegged to the euro. Unlike UXD, Angle integrates its own perpetual contract product, Hedging Agents. However, Angle’s perpetual contract product was inconsistent with mainstream market demand, which hindered the protocol from expanding its hedging business and ultimately led to the strategy being abandoned.

In 2023, Arthur Hayes, the founder of Bitmex, published an article 《Dust on Crust》[3], proposing a Delta neutral model stablecoin hedged by centralized exchanges, which led to the birth of Ethena. Ethena issued the stablecoin USDe by hedging on centralized exchanges, and quickly reached a supply of more than $3 billion by providing airdrop rewards and high APY. It can be said that Ethena is a large-scale verification of the Delta neutral model, but it does not represent an attempt to solve the stablecoin trilemma. Ethena not only holds centralized stablecoins such as USDT, but also superimposes the risks associated with its own operations and third-party centralized exchanges. As Arthur Hayes mentioned, while Ethena's USDe did successfully get rid of its dependence on the banking system, it introduced a variety of other centralized risks - which raises the question: Is this really safer than relying on banks?

Vitalik’s Assertions

After the LUNA crash, Ethereum founder Vitalik*** published an article titled Two Thought Experiments for Evaluating Automated Stablecoins[4], in which he made an important assertion: “For a collateralized automated stablecoin to be sustainable, it must somehow include the possibility of implementing negative interest rates.” He recently mentioned this statement again in his comments on LUSD[5]. This is indeed a crucial question.

If this assertion is true, then the conclusion Vitalik gives in the article is as follows:

"Negative interest rates can be achieved in two ways:

1. The RAI approach, with a floating target that can decline over time, and declines if the redemption rate is negative.

2. Actually letting the balance decrease over time.

Option (1) has a user experience flaw, namely that the stablecoin no longer clearly tracks "1 dollar". Option (2) has a developer experience flaw, namely that developers are not used to dealing with assets where receiving N coins does not mean you can unconditionally send N coins later. But choosing one of the two seems inevitable - unless you go the MakerDAO route and become a hybrid stablecoin that uses both pure crypto assets and centralized assets such as USDC as collateral. ”

When the price of a stablecoin starts to fluctuate, or the number of stablecoins held by users changes automatically, it is hard to imagine that such a stablecoin will be widely used. Projects that adopt these two strategies have never been able to make significant progress, especially those that follow option (2), which often have a very short life cycle. These stablecoins lack real competitiveness.

In simple terms, "automated stablecoins" can be understood as truly decentralized stablecoins, because truly decentralized stablecoins must essentially operate without human intervention.

Negative Interest Rates

It is highly recommended to read Vitalik's original article, in which he uses an interesting thought experiment to explain why the implementation of negative interest rates is crucial for automated stablecoins. Here, let's revisit the importance of negative interest rates from the perspective of the Delta Neutral Model.

We consider a Delta Neutral stablecoin called dnUSD, which is backed by ETH and corresponding short positions. Obviously, an equal amount of demand for long positions is required to facilitate the opening of short positions. Assume that a certain amount of dnUSD has been issued and some users hold corresponding long positions to bring the system into balance. The potential changes in the system in the future can be simplified into four typical scenarios for analysis:

1. The demand for dnUSD continues to increase, while the demand for long positions remains unchanged. This situation can be solved by restricting the minting of new stablecoins.

2. The demand for dnUSD remains unchanged, but the demand for long positions increases. This can also be solved by restricting users from opening new long positions.

3. The demand for stablecoins decreases, but the demand for long positions remains unchanged. This situation is controllable because the intrinsic value of stablecoins remains stable, and both spot collateral and short positions are intact. Limiting the liquidation of short positions will not result in losses for stablecoin holders, and those who wish to exit can also sell on the spot market.

4. The demand for stablecoins remains unchanged, but the demand for long positions decreases. This poses a challenge because the previous simple approach may no longer be effective-it is not feasible to limit the liquidation of long positions by long users. Therefore, it is necessary to find a way to reduce the supply of dnUSD accordingly. However, since the demand for stablecoins remains unchanged in this case, dnUSD holders lack the incentive to perform redemption or destruction operations unless some form of negative interest rates are introduced.

It seems that negative interest rates are indeed inevitable, but why did Ethena not achieve negative interest rates, but still achieve large-scale supply without any problems? The answer is simple: Ethena is not the kind of automated stablecoin that Vitalik said. Centralized stablecoins have more flexibility: when the demand for long positions decreases, they can simply close their short positions and hold USDT directly.

Excess Demand Model

Is there no other solution? Let's review the fourth scenario in the previous section, where the demand for stablecoins remains unchanged, but the demand for long positions decreases. Now, imagine a perfect perpetual contract product where the demand for long positions always exceeds the supply and never decreases - this solves the problem, doesn't it? This concept forms the basis of the Pure.cash excess demand model.

While it is easy to make bold assumptions, the reality is that no perfect product exists and some degree of compromise is inevitable. In the next section, we will gradually unveil the core mechanism of Pure.cash.

To create sustained excess demand, it is necessary not only to provide a highly competitive product, but also to ensure that demand always exceeds supply. Pure.cash's built-in LongOnly perpetual contract allows users to hold ETH long positions at zero cost, without paying financing fees, and only charging a market average transaction fee of 0.07%. Let's explore the possible results when this product is widely adopted in two scenarios.

Currently, there are two mainstream ways to go long ETH:

1. Through futures contracts: Mainly perpetual contracts. The overall market size of perpetual contracts is about US$10 billion. Historical data shows that the funding rate of perpetual contracts is usually positive for most of the year. Over the past year, the average annualized interest rate paid on Binance ETH long positions has exceeded 11%.

While funding rates on these platforms often turn negative during bear markets, these periods are usually short-lived and highly volatile. Therefore, whether in a bull market where funding rates soar or a bear market where rates turn negative, holding long positions at zero cost is still the best option for most traders. This is because the duration of negative funding rates is unpredictable and may turn positive at any time, which is not conducive to medium- and long-term positions.

2. Lending:There is no accurate market size data at present, but it is estimated to be around $1-2 billion. Users pledge ETH, borrow stablecoins, and buy ETH in the spot market to achieve leveraged longs. The lending market is relatively simple, with an average lending rate of around 8% for stablecoins. Even if there is insufficient lending demand and interest rates fall, they will not fall below zero. In this context, Pure.cash's zero-cost long position is undoubtedly the best choice.

In addition, holding long positions at zero cost is also an ideal hedging tool for arbitrageurs, which can greatly reduce the hedging costs of arbitrageurs or improve capital efficiency. For example, those who engage in spot arbitrage in other futures markets can hold long positions at zero cost instead of spot assets. This can improve capital efficiency without incurring additional costs, thereby significantly increasing their returns.

In short, providing free leverage in a market where costs are usually paid will naturally create a highly competitive product. However, the availability of such a product will inherently be limited by the supply of stablecoins. By further limiting this supply and keeping it below the lower limit of the volatility range of long market demand, it is possible to create a product that is close to the ideal state.

Pure.cash’s Mechanism

Pure.cash also adopts the Delta neutral hedging model, effectively achieving stability and capital efficiency. The remaining challenge is how to achieve decentralization - a topic we will now explore step by step.

It must be acknowledged that the decentralization of Pure.cash would not have been possible without the pioneering efforts and contributions of early projects, the most notable of which are:

1. The perpetual contract AMM model created by GMX (later widely adopted by projects such as Jupiter) laid the theoretical foundation for Pure.cash’s LongOnly perpetual contract AMM model.
2. The Pegged Stability Module (PSM)[6] introduced by MakerDAO, which Pure.cash incorporates into a safeguard mechanism and uses only in extreme cases.

Based on these fundamental innovations, Pure.cash offers a suite of products designed to solve the stablecoin trilemma, while introducing highly competitive perpetual contract products and high-yield assets. These include:

1. Pure USD (PUSD):A scalable, fully decentralized stablecoin.

2. LongOnly:A reverse perpetual contract product with zero funding fees.

3. Pure.cash Liquidity Provider Token (PLP):Provides liquidity for LongOnly and PUSD within its liquidity range and charges 35% of transaction fee income.

Based on the excess demand model, the protocol limits the size of long positions to maintain a state where long demand continues to exceed supply. This is equivalent to a utilization rate of 90% for the PLP pool, which is considered optimal. This makes PLP an excellent yield asset, combining extremely low underlying volatility (ideally 10% of Ethereum's volatility) with a high yield from the ongoing injection of 35% transaction fees.

It is critical to explain how the 35% transaction fee income contributes to PLP's "high yield". Because PLP only covers the difference between long positions (LongOnly) and short positions (PUSD), rather than the entire long position, it achieves significantly higher capital efficiency. This efficiency is expected to be more than three times that of GMX's GLP, making PLP a very profitable asset.

Safeguards in Extreme Situations

Now it is time to address the "inevitable compromise" mentioned earlier. The market environment is complex and unpredictable; even if we manage to maintain excess demand for long positions as mentioned above, black swan events are still inevitable. A sudden market crash may cause long demand to fall rapidly, exceeding the buffer capacity of PLP. If short positions are not reduced accordingly, the protocol may be forced to hold volatile assets, thereby compromising the Delta neutrality target of the stablecoin. However, in order to ensure the user experience of stablecoin holders, we choose not to implement "negative interest rates", so it is necessary to introduce alternative solutions to solve this problem.

Pure.cash solves this problem by introducing a stable fund and an active redemption mechanism. When long demand drops beyond a certain threshold, the stable fund will repurchase PUSD from the market and destroy it, thereby simultaneously reducing short positions to a safe level. If the repurchase action causes the price of PUSD to exceed its peg price, the Stability Fund will purchase USDC, mint PUSD with USDC at a 1:1 ratio through PSM (the stablecoins supported by PSM can be adjusted through the DAO), and then destroy and close the corresponding short positions.

Once the demand for long positions recovers or the supply of PUSD decreases (in this case, the protocol only allows destruction and prohibits the minting of new PUSD, which further reduces the supply of PUSD), the Stability Fund will perform the above operations in the opposite direction: mint PUSD through the protocol, exchange it for USDC at a 1:1 ratio through PSM, and sell USDC on the market.

In essence, PSM is a guarantee of system stability in extreme cases. As balance is gradually restored, the dependence on PSM will drop to zero. In other words, in most cases, Pure.cash will only hold native crypto assets such as ETH. In extreme cases, Pure.cash may temporarily hold USDC as a reserve asset for PUSD. Once the balance is restored, the USDC held will be automatically converted back to ETH. This approach not only solves the potential risk of PUSD decoupling upwards, but also maintains the decentralization of reserve assets.

PUSD Scalability

In the initial stage, Pure.cash chose to deploy on Ethereum and chose ETH as the underlying asset because it was the only option that met the basic requirements at the same time: the ability to deploy smart contracts and a sufficiently high market value. Currently, the market value of ETH is about US$300 billion, and the perpetual contract market size is about US$10 billion. Taking into account the further promotion of long demand by zero-interest long positions and the potential growth of ETH's market value in the future, we estimate that ETH alone can currently support a PUSD supply of US$3-5 billion, and it is possible to expand to more than US$10 billion in the future.

In addition, since the issuance of PUSD is backed by an equal amount of ETH, the greater the supply of PUSD, the greater the demand for ETH. This in turn will push up the price and market capitalization of ETH. As the market capitalization of ETH increases, the likelihood of issuing more PUSD will also increase, forming a positive feedback loop in which the two assets reinforce each other.