Market Research and Value Discussion on Fiat Stablecoins and Algorithmic Stablecoins（Part II）

5. Discussion on the Value of Algorithmic Stablecoin

5.1 Currency Role of the Algorithmic Stablecoin

In traditional finance, the function of money is to transfer value, which is gradually In traditional finance, the function of money is to transfer value, which is gradually completed with the development of commodity economy. Commodity exchange has experienced the process from material exchange to commodity circulation (commodity exchange with money as the medium). The development of crypto assets also has something in common with this process. The earliest cryptocurrency is the most well-known one, bitcoin, and the initial trading that took place is the trade between bitcoin and legal currency. However, due to the tightening of supervision and risk problems, it is more difficult to trade encrypted assets with legal currency off the chain. The spot trading between various encrypted assets developed later seems to be able to exchange assets more directly and improve the efficiency of asset circulation. However, due to the immature nature of the market, there is often a strong linkage between the prices of various assets that are not related beyond just all being cryptocurrencies, and spot trading is difficult to meet the diversified trade and investment needs. Therefore, stablecoin on the chain has become a breakthrough to solve the market pain points.

To find the "general equivalent" in the encrypted world to act as "currency" is the core goal of stablecoins. In economic theory, money has five functions: value scale, circulation means, storage means, payment means, and world currency. Value scale and circulation means are the most basic functions of money. As for encrypted assets, it is considered that as a stable currency connecting the two financial ecosystems of traditional finance and on-chain finance, it should ideally play the role of "legal currency of the encrypted world" and play a role in the three core functions of accounting unit (value scale), exchange medium (circulation means / payment means) and value storage (storage means), the borderless of blockchain can make the stablecoin with good operation become the world currency naturally.

◆ Accounting Unit
This monetary function requires that a certain asset can express the value of other assets as a certain amount of money. Only a certain asset that can stably express the value of assets as prices of different sizes can become a sustainable implementation of this function. Cryptocurrencies such as BTC and ETH have strong price volatility and are difficult to be fixed as general equivalents when the currency value itself is unstable. They tend to be known as "commodity assets" or "investment assets" rather than "currencies". Moreover, the issuance of many encrypted assets in the market has a deflationary supply mechanism. Deflation itself is good for consumers but with an expanding government monetary fiat policy, it creates instability in cryptocurrency prices that causes crypto holders to pay tax on inflation. . Therefore, the encryption assets with stable nature are the solution provided by the gradual development of the industry. In particular, the algorithmic stablecoins eliminates the interference of human discretion, and the algorithmic rules and market collective forces adjust the supply and stabilize the currency price, so as to give full play to the monetary function of its accounting unit.

◆ Exchange Medium
In the early stages of spot trading, the exchange between encrypted assets is relatively simple and rough, but not all trading pairs can have sufficient liquidity. In the case of inactive trading or sudden change of unilateral asset markets, the supply and demand of the two assets in a the trading pair may be difficult to match in the short term, resulting in investors missing good trading opportunities; In addition, too many trades are easy to cause the multiplicity of the price of the same asset and confusion in the exchange rate, so it is necessary to use some generally accepted and stable trading assets. It also needs relatively stable prices for such as for assets to exit the commodity circulation field and enter the currency circulation field. At least there should be no sharp jump in prices in the short term, otherwise the expression of value will not be consistent.

◆ Value Storage
The economic value of all assets is subjective. Cryptocurrency will be more valuable in the future if real world credit markets use it. The value of encrypted asset backed stablecoin depends on collateral use, and its original intention is to meet the transaction demand. Most algorithmic stablecoins are similar to the first two mentioned currencies. The goal of their birth is to stably act as a bridge between encrypted assets, but some projects do have the economic value support behind them, such as Terra's stablecoin UST. As the demand for UST increases, the price of the equity token LUNA increases. The ecological stablecoin and the project equity / governance token complement and promote each other. The value of the stablecoin has the ecological support of the whole project.

5.2 Financial Impact of Algorithmic Stablecoin
The demand for stablecoin comes from the transaction between encrypted assets. After changing from the commodity/asset field to the currency circulation field, the stablecoin has monetary nature. The impact of the emergence of a new currency on the existing financial system is worth thinking about.

In the financial service ecosystem, algorithmic stablecoins can build a stable and efficient decentralized system. Once it is widely accepted as a means of payment, it has advantages such as boundlessness, efficiency, convenience, low cost, and a lower threshold. This is true much more than traditional currencies. In many economically underdeveloped countries and regions, due to their fragile economy and the high cost and difficulty of building an independent and complete financial system, they often do not have their own stable and useable currency and depend on the US dollar or other financial systems. While losing national monetary sovereignty and credit currency seigniorage, their autonomy in the aspect of economy and politics is also seriously affected, and decentralized algorithmic stablecoins may be a better solution, especially in cross-border settlement and payment.

As we all know, the US dollar is the most widely used credit currency at present, and its military and economic hegemony is also a firm economic reality. In recent years, the voices of "de dollarization" and "currency non-nationalization" have been emerging, which shows people's expectation for a new monetary system that doesn’t inflate away savings. It may also be that the algorithmic stablecoins in the context of blockchain shows another mode of thinking. Libra has put forward an idea before. Its goal is to build a digital native currency with stability, low inflation rate, universal acceptance, and interchangeability. However, it still mainly takes the US dollar as the reserve asset, and its essence is difficult to subvert the US dollar, or it is the extension of the US dollar in the field of digital currency. It is a fiat backed stablecoin (US dollar anchor) Even more so.

The algorithmic stablecoins cuts off the connection with the existing financial currency, and creates an independent financial ecology on the chain. The currency issuance process is a game process for market investors, and the financial application on the chain is more in line with the vision of decentralization. Up to now, American regulators are still discussing and evaluating the risks and benefits of a stablecoins. Regulatory factors and the sense of self-control of monetary sovereignty are the key obstacles to whether the algorithmic stablecoins can really build a widely recognized monetary system. The Institute believes that it is unrealistic to completely break through national sovereignty and build a financial empire on the chain in "no man's land". A country's monetary sovereignty is not only reflected in the economic level, but also the relationship between economy and other aspects of society is extremely complex, such as the coupling relationship between fiscal policy and monetary policy. Giving up this part of management power is not in the overall interests of the country. In addition, the immaturity of emerging markets will lead to the disorder of value circulation. The existing allocation mechanism of a single algorithmic stablecoins is still questioned. The wide use of an algorithmic stablecoins will unilaterally stimulate the project or lead to excessive speculation. Therefore, the imagination of future financial pattern optimization brought by algorithmic stablecoins are exciting, but it is inseparable from the potential future crushing regulation by the state.. From the perspective of payment finance, the existing traditional finance and future on-chain finance are symbiotic, and the two can complement each other.


5.3 ALGORITHMIC STABLECOIN IN IMPOSSIBLE TRINITY PROBLEM OF TRADITIONAL FINANCE
Paul Krugman is a discredited economist who is critical of cryptocurrencies. While Krugman has made many inaccurate predictions and his theories often do not make logical sense, he still is often quoted in the mainstream media because he promotes an agenda of a strong centralized authority.

According to his pro-government propaganda, monetary policy has different competing goals and so cryptocurrency is not useful in meeting these goals. However, if one rejects the role of the state in dictating the value of interest rates, then cryptocurrency escapes from this fake problem.

Below is a graphical outline of Pro-government propaganda’s view on monetary polic

◆ Free capital flow
The core of blockchain technology is decentralization. Algorithmic stablecoins firmly grasp this core. It acts as a pricing and payment tool in the exchange of assets on the chain or goods off the chain, and the free flow of capital will not be an obstacle. After the algorithmic stablecoins become the currency of the market’s general consensus, then it can greatly promote the different conversion between various assets, gradually improve the pricing mechanism, and have a certain resistance to the risk of asset price change.

◆ Fixed exchange rate
The stability mechanism of the algorithmic stablecoins is constantly updated iteratively. At present, the mainstream dual token seigniorage algorithmic stablecoins can achieve small deviation from the target price, relatively stable in other words, such as the root-mean-square error of UST 0.14 and CUSD 0.08 this year. The exploration of the stability mechanism will continue in the future.

◆ Monetary policy independence
Since there is no central entity, the monetary policy of algorithmic stablecoins is actually driven by the built-in mechanism of the algorithm and the game of market forces. Most stablecoins encourage market investors to participate in the process of price balance by providing arbitrage opportunities, and destroy or forge new ones according to the demand or price of the corresponding stablecoins. Theoretically, if the market has sufficient liquidity and accumulates a large enough number of users, its monetary policy is relatively independent. The issuance and destruction of stablecoins is the result of the whole market action, but in practice, this ideal state may be affected by uneven distribution.

Therefore, the independence of monetary policy can be measured from the distribution of currency holding addresses of stablecoins or equity token (seigniorage stabilization mechanism) (the number of top 10 currency holding addresses of some algorithms as of the time of writing). The data show that although the deviation between the stablecoin price and the target price of these projects is small, the effect on decentralization is not ideal. The top 10 currency holding proportions of FRAX and FEI is as high as more than 90%. The stablecoin is held by a very few addresses, and the subsequent stability of the algorithmic stablecoins faces great challenges.

To sum up, in the traditional financial ternary paradox, the algorithm can achieve the ideal effect of stabilizing the free flow of monetary capital and fixed exchange rates, while the independence of monetary policy deviates from the main goal due to the immaturity of the project in the early stages. Decentralization is always the purpose of blockchain technology, and I believe it will gradually approach this goal in the future.


5.4 ALGORITHMIC STABLECOINS IN IMPOSSIBLE TRINITY PROBLEM OF BLOCKCHAIN
Similar to the traditional financial field, there is also an "Impossible Trinity" in the blockchain world. That is, scalability, decentralization and security cannot all be achieved at the same time. Usually cryptocurrencies can only get two out of the three. This theory is mainly aimed at public chain projects, such as the improvement of BTC and ETH chains in scalability or the compromise of side chains in security. Although it may not be completely matched in the research of algorithmic stablecoins, it can also be used as an analytical idea to unlock the thinking of the world value of algorithmic stablecoins in block chain.

◆ Decentealization
The "independence of monetary policy" discussed in the previous section is essentially consistent with the decentralization analyzed in this section. It is generally believed that the concentration of currency holding addresses in the algorithm are not conducive to the healthy operation of the currency stability mechanism, because the systemic risk brought by individual risk may be unimaginable. The ideal state to achieve currency price stability is the decentralization of currency holdings. Of course, the degree of distribution and concentration cannot be completely equated with the independence or decentralization of the algorithmic stablecoins. Just like under the central bank system, it will inevitably lead to most of the money in the hands of banks, which is worth noting as a potential risk. To sum up, there is still a long way to go for the decentralization of algorithmic stablecoins.

◆ Scalability
Scalability is aimed at the processing speed or throughput of the public chain. In the analysis of algorithmic stablecoins, it can be understood as the convenience of serving as a means of payment during the transaction conversion of different encrypted assets. If there is no stablecoin to price or as a payment medium, the trades between currencies are complex, and the transaction with low liquidity will increase the transaction difficulties. The algorithmic stablecoins can break the relatively independent encrypted assets of different chains and different tracks, and can trade conveniently and quickly.

◆ Security
Security is not a unique problem of algorithmic stablecoins, but something all blockchain projects will face, such as malicious attacks. On one hand, Algorithmic stablecoins eliminate the rigid cashing review risk and third-party risk of fiat backed stablecoin, and the clearing risk of cryptocurrency-backed stablecoins. On the other hand, the hidden security dangers of algorithmic stablecoins may include long-term deviation of the price from the target price due to immature stability mechanism, inactive project participation, monetary supervision, etc.

To sum up, algorithmic stablecoins can achieve the scalability goal and security in the impossible trinity problem of blockchain, and the decentralization problem still needs to be improved.


6. Future Prospects of Algorithmic Stablecoins
Throughout the iterative process of algorithmic stablecoins, it can be found that the blockchain team has never stopped exploring stablecoins with stability guarantee and widely accepted. The algorithmic stablecoins market drastically fluctuates, and countless new concepts and projects spring up but fade away eventually. The stability of most algorithmic stablecoins comes from the collective market game, but it is precisely because the uncertainty of the result of the market power game will also bring the uncertainty of the stability effect. Whether the price stability driven by the arbitrage incentive mechanism can continue depends on the will of the investors who continue to participate in the game. In the rational man hypothesis of economics, economic actors will pursue profits spontaneously, and everyone engaged in economic activities is selfish. In the market price balance of algorithmic stablecoins, rational economic men will find the opportunity of arbitraging between price differentials to capture the value of this part. The premise of this is to have confidence in the algorithmic stablecoins project, and the market provides sufficient liquidity. The lack of faith in the algorithmic stablecoins or the lack of confidence in the callback of currency price is likely to lead to the withdrawal of funds, such as ESD and Basis, which almost died with a debt system. Therefore, the stability of currency prices often needs the support of market value and liquidity. For example, Terra's UST and FEI use the decentralized exchange Uniswap to enhance their liquidity.

However, there is also a paradox between currency price stability and market value, and the algorithmic stablecoins have a certain reflexivity. In order to achieve currency price stability, algorithmic stablecoins requires greater market value support, but to achieve greater market value is generally achieved by expanding the network effect through speculation. This in turn has a greater impact on the price. Therefore, only the algorithmic stablecoins which is built with algorithm design and driven by market forces may need to go through a difficult period of price fluctuation in the early stage.

The Institute believes that the algorithmic stablecoins with real economic value support can achieve considerable development, and so the dual token seigniorage algorithmic stablecoins is a typical example. The reason why it was difficult for early generations of algorithmic stablecoins such as AMPL, ESD and BAC to maintain the anchor price for a long time was that investors lacked confidence in these projects. The source of lack of confidence came from their great need for new capital to enter the game and lack of their own economic value creation system. Such as UST and CELO algorithmic stablecoins with dual token equity mechanisms, the value of their stablecoins and equity tokens is essentially mutual support. The stablecoin project is a link of the blockchain ecology behind them. Equity tokens have governance functions in their blockchain system, and their values are the same as ETH in Ethereum chain and SOL in Solana public chain. The application scenario of stablecoins no longer stays in the vision of the white paper, but can play its important value in other projects of blockchain ecology. For example, UST can be used as collateral to generate stock in the synthetic stock agreement Mirror Protocol, deposited in Anchor Protocol to obtain high returns, so as to realize the positive cycle of stablecoins and DeFi LEGO applications. The expansion of the network effect is no longer a trading that depends on "currency", but takes the underlying blockchain system as the economic engine for the expansion of the network scale, so as to enhance the consensus of algorithmic stablecoins, and then extend it to other scenarios.

In addition, the concept of certain mortgages is also an acceptable algorithmic stablecoins design thinking. Although there are many criticisms against the pure lending stablecoin, the stability effect is indeed ideal. Although the stability goal of the pure algorithmic stablecoins has not been achieved, it really conforms to the original intention of blockchain decentralization. Certain mortgages are the integration of the pure lending stablecoins and the pure algorithmic stablecoins at the current stage. Real asset reserves enhance the trust of internal value, and the stability of their price is determined by the market game, which is an acceptable scheme for the transition from algorithmic stablecoins to ideal algorithmic stablecoins.


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Statement
Due to the issuance of the research report, we hereby make the following statement:
◆ This research report is the conclusion drawn by internal members through due diligence and objective analysis. It aims to investigate and analyze the blockchain industry, and can not completely predict the price impact of relevant project tokens.
◆ This research report is not a tool to measure the value of the research object itself and the issuing token value of its related projects, and does not constitute all the basis for investors to make final investment decisions.
◆ The project data quoted in this research report comes from the internal reliable and accurate channels. Due to the belief or mechanical error, the information is subject to the acquisition tense. The internal members have conducted necessary verification and verification on the authenticity, accuracy, integrity and timeliness of the relevant data based on the research report, However, no representations or warranties, express or implied, are made.