Weaknesses of Algorithmic Stablecoins

Hello, Pollo family.

Finally, Pollo Basic Income will open tomorrow.

Algorithmic stablecoins on BSC were overheated until the first half of March.

Because of its stability, which is different from yield farming, many people thought it was a good all-around deposit destination. However, since late March, we have had a good opportunity to see that it is not necessarily magic.

Weaknesses of Algorithmic Stablecoins

I feel that there is a growing concern about the structure of algorithmic stablecoins themselves.

For those of you who have invested or are planning to invest in Pollo Basic Income or other algorithmic stablecoins, I am writing this article in the hope that you will find some hope while also being realistic.

In this article, I will use bDollar as an example, which is likely to have the most participants.

Basic Knowledge

Basis was the first to design an algorithmic stablecoin using three different types of tokens with different roles. Its breakthrough was welcomed by the public and it raised $133 million in its ICO. Among the investors are GV (formerly Google Ventures) and Bain Capital Ventures.

Algorithmic Stablecoins are largely based on game theory. Therefore, there must be a certain number of participants and a certain number of profit takers.

If everyone takes a ‘take profit’ action, the price of the coin will fall far below $1, and the game will not work.

If everyone does not take profits, the price of the coin will be much higher than $1 and no one will have made a profit, and the game will not work too.

And if the TWAP per epoch continues to exceed $1.01 and the expansion of BDOs continues, the number of BDOs issued will eventually become too large to contain.

As a matter of fact, bDollar has also issued 720,000 new BDOs in epoch 319 ($72 million in $1 terms).

In other words, instead of an inexhaustible expansion, if a contractionary state is not created accordingly, there is a risk that all but the initial participants will become losers.

While many algorithmic stablecoins are below $1, MIDAS was the first to return to $1. This is probably due to the fact that the number of newly issued MDOs was around 100,000.

How well do the participants understand the premise of this mechanism? This is the starting point.

If everyone believes in it, the price will hold; if everyone is scared of it, the price will not hold.

It may sound fishy, but the reason why so many types of algorithmic stablecoins such as BDO, MDO, MSD, BTD, etc. are sold all at once has a lot to do with the influence of “market atmosphere. This is a phenomenon that could happen again and again in the future.

Think about it dispassionately. Originally, Project A and Project B should have been distinguished from each other, but this time they were not.

The anxiety triggered by bDollar’s collapse against the dollar led to the question, “Will that project also fail?”, “Isn’t this system going to fail?” As a result, other projects also fell below the $1 mark.

Since the bDollar started on January 1, and the price has fallen below $1 on a scale that no one has experienced before, it is understandable that people are worried.

On the other hand, if a kind of optimism prevails that the supply of BDO will resume even if it stops, the return to the dollar will be quicker even if the price falls below $1 again in the future.

The above is not a random statement, but is something that can be fully explained from an economic perspective. I will explain it concretely.

An example of a bunk run

Have you ever heard of a “bank run”?

It is a series of events that occur when customers pull out their deposits after hearing untrue rumors that their bank may go bankrupt, resulting in the bank falling into a “crisis of bankruptcy.

A bank run is a classic example of a rumor coming true.

Cases of bank runs have been reported all over the world.

You may have heard of Northern Rock in the UK, Toyokawa Shinkin Bank in Japan, and East Asia Bank in Hong Kong.

There are many small banks that are less strong than the big banks, but have been in business for decades, even over 100 years, as long as they are functioning properly.

However, if customer deposits, the source of funds for business activities, are withdrawn, no matter how good the bank’s financial condition is, it will not be able to operate.

In many cases, the central bank intervenes to calm the situation (i.e., to provide reassurance that the bank will not go under).

The same can be said for the current turmoil.

It is true that bDollar has not stopped expanding and has issued more than 700,000 BDOs in epoch 319. It makes sense that bDollar’s users thought that it would be impossible for them to continue their project if the number of BDOs increased by 700,000 every 6 hours.

(I don’t know what the management was thinking, but they must have wanted to do a contraction somewhere. Maybe that was now.

But the anxiety spread to other projects. This is where the “bank run” began.

Even though other algorithmic stablecoins have the same structure, large and small, the overextension of BDO is a problem specific to bDollar and should not be directly related to other projects.

Some users noticed this, which is why MIDAS was the first to return to $1, followed by Monstar.

In the real world, the central bank (the boss) would intervene and declare safety under companies like MIDAS and Monster.

But in the DeFi industry, there is no central bank yet.

Just as in the real world, it would be nice if DeFi projects could be connected to each other in the same way that banks are connected to each other, and if there is an emergency, they could be connected to each other, but such an intermediary function will not be available until DeFi is more mature.

What we can do now is to help each other and help ourselves, both on the project side and the user side.

One way to do this is for the project side to continue to communicate with users by continuously communicating the mechanism of the algorithmic stablecoin. One way is for the project to continue to communicate with users, and for users to continue to understand the mechanism and spread it to their peers.

Reproduction experiment of bank run

Here are some experiments.

(Bulletin №49 (2019) Results and theoretical reexamination of the “bunk run” experiment 15–26, 27–44, 45–53) https://www.eco.nihon-u.ac.jp/research/economic/publication/annals49/

In order to recreate the bank run, an experiment was conducted in which subjects were given the choice of withdrawing or not withdrawing their balance from a fictitious bank.

When the number of withdrawals was less than a certain number, the full amount could be withdrawn, and those who did not withdraw would have their deposits increased as interest.

On the other hand, if the number of withdrawals exceeded a certain number, the amount of money withdrawn would decrease and those who did not withdraw would not get their deposits back.

It is interesting to note that the results of the experiment differed when only a “Withdrawal button” was provided, and when both a “Withdrawal button” and “No Withdrawal button” were provided.

To put it simply, the possibility of a bank run was increased when only a “pull out button” was provided. Probably, when other subjects in the same room heard the click sound, the information that “others have already withdrawn” was transmitted, which led to panic behavior, or bank run.

On the other hand, in the experiment with the “withdraw button” and the “do not withdraw button”, there was no bank run at all.

In addition, when we compared banks with low strength and banks with high strength, bank runs were more likely to occur in the banks with low strength.

Based on the results of the above experiments, we can make a hypothesis about bDollar, MIDAS, and Monster.

In place of the clicking sound, there are many triggers that can lead to a “bank run”, such as

  • The price of the coin drops rapidly.

In this visible way, the anxiety triggered by bDollar has spread and eventually led to other projects falling below $1.

In addition, some Scam projects are going to be in a very similar situation as above when they are nearing the end, but please distinguish between that and this story.

Again, even if a project is in good shape, once the same thing happens, the money will be drained and it will be difficult to get back up again. I know that Bolt Dollar (BAT) also had a difficult period with only $10,000 TVL.

This is the knowledge that I want to share with you, and it is the basic premise, the “starting point.”

Without the above starting point, the following measures are meaningless. If you understand any of this, please proceed to the next section.

Presenting the use of bonds

Bond tokens are a means of returning to $1 when the algorithmic staple coin falls below $1.

Bonds are a ‘claim’ for investors and a ‘debt’ for the protocol.

Therefore, the biggest test of Pollo and the Pollo family is the contractionary period, or the period when bonds are issued below $1.

Depending on the source code of each project, there are a number of tricks to get the algorithmic Stablecoin back to $1.

  • Set a premium on the bond to encourage bond purchases (leading to Dollar’s Burn)

On the other hand, bDollar and Monster have created new pools where you can harvest BUSD and MSC using bond tokens.

I’m watching this with great interest as an attempt.

I can understand why some people say, “If we can’t harvest MSCs, it’s not worth it,” or “If you can afford to spit out BUSD, buy back BDO.”

However, if the MSCs that originally existed are being spit out, and if this is the result of figuring out where to take on bonds that are a liability for the operation, I don’t think it’s such a bad move.

They were trying to maximize their performance by trial and error or preparation, I can imagine.

Pollo is also planning to implement Farm LP deposits using bPDO in Pollo Vaults.

Providing a use for bond tokens would also create an incentive for people to take the initiative to burn algorithmic stablecoins to buy bonds. This would also give some users the option of using the bond as a pickaxe instead of exercising it, and possibly encourage them to avoid exchanging the bond for algorithmic stablecoins as much as possible.

Note: Bond tokens are simply tokens that can be purchased when the price of an algorithmic stablecoin is less than $1. BDO can be used to purchase bBDO, and the BDO used to purchase bBDO will be burned.

Build up energy

Without the stability of Algorithmic Stablecoin, the protocol will not survive.

The reason why community funds are able to buy bonds when Algorithmic Stablecoin is in crisis is because they are saving their money until then.

This means that it is essential to make funds when Dollar is somewhat high, to the extent that it does not affect the market.

All algorithmic stablecoins take similar measures, and Pollo Basic Income is no exception.

In particular, the period from the first day of the protocol’s launch to a short period of time is a relatively easy time to build up energy, and the funds earned during this period will undoubtedly become the funds that support the entire community.

The most important issue is to create real demand.

Up to this point, we have been focusing on the mechanism of algorithmic staple coins. From here on, we will get closer to the essence.

First of all, something cannot be created out of nothing.

Apples grow because the roots suck up nutrients from the earth and the leaves receive solar energy. As long as there is a law of conservation of mass, an apple cannot be created from nothing.

The same is true for cryptocurrencies. When a new cryptocurrency is issued, the total amount of value will not increase unless new value is created.

The seigniorage that comes from issuing a new algorithmic stablecoin may appear at first glance to be issuing new value, but it is BUSD and BNB at its source.

If we don’t work on something new with the incoming funds, we are just passing the money around among investors. If we don’t create new value, it will always be a money game, a zero-sum game or a minus-sum game.

New value means, for example, that Pancakeswap invites new projects from outside to do IFOs, or that exchanges get trading fees.

Earning foreign currency with the funds raised is also an effective way.

Auto Farm, lending, and as you can see by following the bDollar contract, a portion of the community fund is automatically transferred to Pancakeswap’s syrup pool, earning a cake and raising the total fund amount.

It is impossible to accomplish a grand plan without creating new value.

Pollo will not shy away from this painful truth, and this is part of the reason why we are developing NFT issuance and Vaults as an experiment.

Fortunately, the DeFi world is experiencing increasing inflows of capital, so we will not miss this tailwind.

We will take measures to double or triple our leverage.

As mentioned above, we will continue to give hints in the “miracle 3 months” and then move on to DAO.

There is a limit to the wisdom that can come from the Pollo Team. However, there is no limit to the collective wisdom of DAO.