Writing

Solving the Stablecoin Trilemma

September 02, 2021 | 7 minute read

Today I’m excited to announce that Multicoin Capital has led a $3M seed round in UXD Protocol with participation from Alameda Research, Defiance Capital, CMS Holdings, Solana Foundation, Mercurial Finance, Solana founders Anatoly Yakovenko and Raj Gokal, and Saber founder Dylan Macalinao.

UXD is a new stablecoin that is 1) capital efficient, 2) decentralized, and 3) stable.

Three years ago we published an essay on stablecoins. In it, we wrote:

“Stablecoins are one of the highest convexity opportunities in crypto. They aim to become global, fiat-free, digital cash, so the total addressable market (TAM) is simply that of all the money in the world: ~$90T. The opportunity for stablecoins is, intrinsically, the largest possible TAM.”

Since then, stablecoins have been booming. Over the last 12 months, stablecoins have grown from $17 billion to $116 billion today. They have found clear product-market fit in the form of acting as a base asset in crypto trading pairs, and are increasingly being used for cross-border payments, remittances, e-commerce, and more.

Stablecoin Supply Source: The Block

We contend that there are three features that a cryptocurrency needs in order to become global digital cash:

  1. Price stable — Unlike BTC, tokens that are actually intended to be treated as cash equivalents need to have stable purchasing power
  2. Capital Efficient — Having to lock up more than $1 of collateral to create $1 of stablecoins is inefficient and leads to stablecoin supply constraints
  3. Decentralized — i.e., the collateral is not held by a single entity, such as is the case with Tether and the Centre Consortium

None of the current stablecoins in the market embody all three of these features.

The problem with USDC and USDT is that they are centralized.

The problem with MakerDAO/DAI is that DAI is neither decentralized, nor stable. And on top of that, it’s capital inefficient. DAI has only been within 50 basis points of its $1.00 “peg” for 62% of its life. And it’s not decentralized because more than 65% of the collateral backing it is centralized fiat-backed stablecoins and WBTC (this percentage has been growing, and is likely to continue to grow).

In order for DAI to scale, MakerDAO was forced to sacrifice decentralization. Today, DAI is effectively acting as wUSDC, and this is becoming more true over time as an increasing percentage of collateral is centralized fiat-backed stablecoins.

Maker Assets Source: Dune Analytics - @SebVentures

Most crypto projects start centralized and slowly decentralize; Maker is moving in the opposite direction. The need for growth forced MakerDAO to sacrifice its most important feature: censorship resistance (which in this case is a function of decentralized collateral).

The problem with Basis and other un-collateralized or under-collateralized “algo stablecoins,” like Empty Set Dollar or Ampleforth, is that these systems are reflexive and fragile. These algo stablecoins do not do a good job of holding their peg.

ESD Price Source: Coingecko

If people don’t believe algo stablecoins will work, they will collapse. The repeated failure of so many algo-coins over the last year further reinforces this. It seems very improbable that any uncollateralized algo stablecoin will be able to muster enough collective social belief to hold its peg in the face of volatility, and to be able to survive Soros attacks.

Luna has created a stablecoin called UST which has a market cap of ~$2.5B. Users create UST by burning $1 of LUNA at the market price at the time of creation and users redeem 1 UST for $1 worth of LUNA at the market price at the time of redemption. This is an extremely reflexive system. While the demand for UST is growing it drives demand to buy and burn LUNA at ever high LUNA prices. However, when the demand for UST is falling it drives users to redeem their UST to mint and sell LUNA at ever lower prices.

The design of UST is scalable and decentralized but the reflexivity poses existential risk. If the price of LUNA falls it can drive a “run on the bank” as users rush to redeem their UST for $1 of LUNA and sell that LUNA. As the selling pressure drives the price lower, more LUNA needs to be printed per UST redeemed and LUNA’s supply can be hyperinflated. Given the extremely volatile nature of crypto capital markets, we believe that the existential risk in UST makes it unsuitable for the majority of stablecoin use cases.

How Does UXD Work?

UXD Protocol creates fungible, USD-pegged stablecoins, called UXD, by accepting BTC (or other crypto) deposits, and using it as collateral to short an equivalent amount of BTC-USD perpetual swap contracts or dated BTC futures. The long BTC spot is perfectly hedged by the 1x BTC-USD short, so the value of the combined position is always $1.

If the price of the stablecoin deviates from the peg in either direction, arbitrageurs will arbitrage the price back to the peg for a riskless profit. If UXD is under $1, arbitrageurs can return UXD to the protocol to unlock $1 of collateral. If UXD is over $1, arbitrageurs can deposit collateral and create more UXD.

That is the core construction but there are a few other variables to solve for.

Solving For Funding Rates

The first challenge is the funding rate (note that UXD Protocol doesn’t need to manage an oracle at all; the underlying derivatives DEX manages this). When funding is positive (meaning the market is in contango), longs pay shorts. This means that UXD holders can earn interest just by holding UXD. But rather than pay all the funding to stablecoin holders, UXD Protocol accrues a portion of those fees to an insurance fund and a portion to pay governance token holders. Why? Because when the funding rates turn negative (i.e., the market is in backwardation), stablecoin holders would need to pay funding. In UXD Protocol, the insurance fund pays the funding rate when it turns negative. In the event the insurance fund is depleted, UXD governance token holders backstop the risk in the system (in a similar mechanism to how MKR holders backstop risk in MakerDAO).

Looking back on a historical basis, the funding rate has been positive for a majority of BTC’s life. Here is a chart of the integral (sum of cumulative gains and losses from running the basis trade) of FTX’s historical funding rate on the BTC perpetual swap contract starting in May 2019:

FTX Perp funding rate Source: Skew

There is a chance that there is a market regime change in which the funding rate stays negative for an extended period of time. In that scenario, the UXD Protocol remains flexible and can adapt by reversing the stablecoin position by shorting spot and longing the derivatives to collect funding.

Solving For Diverse Collateral and Currencies

The other variable to solve is diversifying collateral types. The construction described above doesn't just work for long BTC spot, short BTC-USD perp. In theory, UXD Protocol is compatible with any (trust-minimized) collateral.

  • Long ETH spot, short ETH-USD perp
  • Long SOL spot, short SOL-USD perp
  • Long SRM spot, short SRM-USD perp
  • etc.

Support for a diverse set of collateral types makes UXD more scalable.

UXD can also extend to support other stablecoins including EUR, YEN, etc. so long as there are liquid futures contracts denominated in that currency (e.g., BTC-EUR perps or futures).

The Solana Stars Are Aligning

We have been looking to fund a delta-neutral stablecoin for the past year and a half, if not more. Kento and the team behind UXD are seasoned traders familiar with running delta-neutral strategies and are deeply ingrained in the Solana ecosystem.

Speaking of the Solana ecosystem, the time to launch UXD could not be better. Solana is experiencing a Cambrian explosion of development and activity. Notably, two projects will serve as major catalysts for UXD’s adoption.

The first is Mango Markets. Mango Markets just completed an impressive $70M funding round. Mango is a decentralised, cross-margin derivatives exchange powered by Serum. Mango Markets recently launched BTC perps, a core component of the UXD system. Mango will be the first of many decentralized perpetual futures markets that UXD can leverage in scale.

The second notable project is Saber, which is the leading cross-chain stablecoin exchange on Solana. Similar to Curve on Ethereum, Saber enables traders to swap effortlessly between different stablecoins. Have USDC but want to get yield-generating UXD? Head to Saber.

Solana DeFi is growing like a rocketship and UXD will help accelerate that growth. We could not be more excited to invest in UXD Protocol and work with them to create the world’s first stablecoin that is decentralized, capital efficient, and stable!

Disclosure: Multicoin has established, maintains and enforces written policies and procedures reasonably designed to identify and effectively manage conflicts of interest related to its investment activities. Multicoin Capital abides by a “No Trade Policy” for the assets listed in this report for 3 days (“No Trade Period”) following its public release. At the time of publication, Multicoin Capital holds positions UXD, MNGO, SOL and SBR.