Economic Analysis & Observation on Secondary Financial Instruments in Algo Stable Coins

Algo Stablecoin.

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TLDR below. This is not financial advice.

In our recent research on algo stablecoins, we found some imperfections in some of their mechanisms — namely economic misalignment and failure of coupons. In this episode, we analyse and discuss the impact of such failures.

Economic misalignment

Economic misalignment is when a participant faces a decision that might benefit one class of agent at the expense of others. It is important to spot these and resolve them in the design of the protocol.

It is not uncommon to have a zero sum game. In such a game, favouring one party means penalising other agents. We have realised that there is a reallocation of risk from some agents to other agents in many algo stablecoin protocols.

You can see that when this happens, there is a clear transfer of risk from agents with the coupon model. This happens when:

• the price moves

• you can make a governance decision

• you have to wait to buy a coupon

• you want to have a target price in mind to sell those assets

You can argue that "this is common in any trade". Yes, you are right. But here, the risk is massive because sometimes these models do not allow for the coupons to be redeemed unless the price goes above one for a specific amount of time. This risk was maybe mis-priced by those agents with asymmetric information, so this is what we mean by economic misalignment and risk that is transferred from agent to agent.

You could also see it as an asymmetry of opportunities (rather than information). This was very clear at the launch of those protocols where some agents were really able to amass a lot of tokens very early on and so were able to influence the decision later on to benefit themselves. This is especially for the protocols that have open and extreme governance. We see this happening with ESD and DSD, where the early whales left the system amassing millions in profits.

Takeaway here: A very important factor to consider is who those protocols give the voting power to, and how early they give that power, and who are the large token holders that are basically hoarding tokens.

Coupon Failures: Incentives VS Stability

The issue here was that incentives were not really designed to improve stability, which was quite a surprise for us. When we were doing the analysis, we realised that the decisions of some mechanisms were not oriented and focused on insuring and assuring stability — quite the opposite. They sometimes created more volatility. That is interesting because a stablecoin needs to be stable in the first place but some mechanisms were focusing on incentivising volatility.

Good and Bad solutions

The movement of the market or the risk of price movement is the sort of negative effect that falls on agents. This is extremely important for stablecoins because all we want is for them to have zero volatility or have a minimum price.

Inflating the supply with coupons and tokens that are not valuable (e.g. the ESD and DSD coupon models) is unsustainable and creates more volatility in the long run. However, if the underlying coupon supply can accrue value, that is a different situation. An example of this is LUNA.

LUNA is required to approve transactions on the Terra blockchain which actually brings value to the system. It is a mechanism where you are helping the model and helping stability through the adoption of the system itself. This is a good boost for the demand of the secondary token LUNA and reduces the problem of a negative feedback loop, which is the main failure of the pure coupon model.

Watch the video here:

Conclusion

We have touched on an aspect of secondary financial instruments (coupons, bonds, and all those newly devised financial instruments). We asked ourselves if these are a good deal and the answer, unfortunately, is no, because rational agents will not involve themselves with these secondary tokens if they really understand the risk that they run. Now, the protocols have a following of new participants or new users and the excitement that comes with that, but we really need much much more solidity. With ESDs or DSDs the incentives of purchasing coupons have been deviating away from when the mechanism is mostly needed, which is under contraction.

TLDR: Coupons, so far, are not a good deal.