Controller-Based Stablecoins

Digital Dollars

Ethereum, a rapidly evolving digital economy, is in the nascent stages of a sustained economic upswing, currently underpinning tens of thousands of applications whilst safeguarding $350 billion in assets, and handles $2 trillion in annual transactions, with an extraordinary rate of expansion. The potential of Ethereum to serve as the cornerstone of the global economy is clear to discerning observers. However, a significant obstacle exists - Ethereum's dollarisation. The dollar, being under the control of the Federal Reserve, casts a pall over the aspiration of a self-governing monetary system.

The industry has taken cognisance of this issue. A fresh wave of initiatives is emerging with the goal of creating stablecoins that are entirely independent of fiat currencies. These pioneering projects offer Ethereum's monetary system a unique opportunity to achieve stability and simultaneously eliminate fiat’s reliance. By doing this, they would not only extricate Ethereum's monetary system from the influence of nation-state controlled central banks, but also usher in a new era of truly trust-minimised stablecoins, perfectly suited for use across the breadth of Ethereum's economy.

The dollarisation of Ethereum is hardly unexpected. Many burgeoning economies resort to dollarisation due to monetary instability. Ether, being volatile and likely to remain so for the foreseeable future, continues to draw speculation, much like Bitcoin. This volatility hampers its effectiveness as a currency and restricts its capacity to drive substantial economic activity beyond speculation.

Fortunately, the programmability of Ethereum has facilitated the incorporation of USD stability into its economy via stablecoins.

This stability has enabled Ethereum to draw more capital into its economy and stimulate economic growth. Stablecoins have played a pivotal role in the flourishing DeFi ecosystem of Ethereum. In practical terms, stablecoin protocols resemble currency boards more than central banks with all their monetary policy decisions subordinate to maintaining a fixed exchange rate targets with the dollar. This not only exposes Ethereum's monetary system to the Federal Reserve, which is indifferent to the needs of the Ethereum economy, but also introduces regulatory risk that could potentially destabilise the foundations of DeFi. If the recently proposed STABLECOIN Act is any indication of what's in store for dollar-pegged stablecoins, all stablecoin issuers pegged at $1 may eventually be regulated as banks. This would compel them to acquire banking licenses and maintain reserves with the Fed. While the STABLECOIN Act was merely a proposal, it underscores the fact that engaging with the dollar invites intervention from the US government.

However, stablecoin designs involves a complex problem known as The Stablecoin Trilemma - a concept that suggests stablecoins must make trade-offs among three key attributes: peg security, capital efficiency, and decentralisation.

1. ⛑️ Peg Stability: The ability to maintain its peg to a stable asset, usually the US Dollar. A stablecoin with high peg security will reliably maintain its value relative to the asset it's pegged to, even in volatile market conditions.
2. 💵 Capital Efficiency: The amount of capital required to create a unit of the stablecoin. A highly capital-efficient stablecoin would require less than or equal to $1 of capital to create $1 worth of tokens.
3. 🛜 Decentralisation: The degree to which the control and governance of the stablecoin are distributed among a network of participants. A fully decentralised stablecoin would be governed by a community of users and would not rely on a central entity to maintain its value or operations.

Different types of stablecoins offer different combinations of these attributes. Fiat-backed stablecoins, for example, offer capital efficiency and price stability but lack in decentralisation. Crypto-backed stablecoins combine decentralisation and price stability but fall short in capital efficiency.

🔑 But how would a self-sufficient Ethereum monetary system, powered by stablecoins not tied to any fiat currency, function in reality? The process begins with Ethereum's native asset, ETH.

ETH is a decent form of money and its quality is expected to improve over time. It possesses scarcity, verifiability, fungibility, divisibility, portability, and with the advent of Ethereum 2.0 and EIP-1559, it can be deflationary at times. However, it falls short as a currency since its volatility makes it unsuitable for many financial activities that require price stability. To tackle this stability issue, a self-sufficient Ethereum monetary system could issue a currency backed by ETH and stabilise it algorithmically through incentives. This is the fundamental concept behind the new generation of non-pegged stablecoins. These stablecoins derive their value from their underlying collateral (primarily ETH), much like how the dollar did during the gold standard era! Introducing, Flatcoins.

Flatcoins

Flatcoins are an emerging token economics concept where the token of interest, as a store of value, would adjust its valuation over time to track changes in inflation. The stated goal would be to conserve the purchasing power of its token holders and/or a specific group of interest (such as platform users). A simple example of a Flatcoin would be the fictional “i-DAI”: an Inflation Corrected DAI. The i-DAI would have its peg attached to a reference time, and its price would be adjusted in real-time in response to changes in inflation, such that the purchasing power for i-DAI holders is conserved.

The design of flatcoins is a unique proposition and contains several challenges that need to be solved, both in isolation and simultaneously. Specifically, the core challenges are around accurately sensing inflation and creating appropriate incentives. Inflation, like many concepts in economics, operates within the paradigm of complex adaptive systems. This means there are an enormous number of dynamic interactions of different factors and variables, including unpredictable human behaviour impacting both the causes and effects of inflation.

However, a promising approach towards building Flatcoins is by reusing some of the most successful stablecoins currently in deployment: the ones that are based on the notion of using controllers as a way to sense price changes and reshuffle participant incentives so that the held token value tends to track a reference value. These are Controller-Based Stablecoins (CBS), a class of tokens of which RAI is a deployed example.

RAI

RAI is a groundbreaking financial innovation designed to serve as a low volatility reflex index for DeFi. It uses an on-chain Proportional-Integral-Derivative (PID) controller to react to various market pressures and maintain a stable market price within a small margin of the system's target, known as the redemption price. Unlike other algorithmic stablecoins, RAI allows its exchange rate to float on secondary markets, which enables a unique mechanism design with negative interest rates.

The PID controller is a feedback control mechanism widely used in various industries for its robustness and simplicity. It consists of three main components: the proportional, integral, and derivative terms, each contributing to the overall control action in different ways.

1. ⚖️ Proportional term: The difference between the desired system state (the redemption price) and the observed state (the market price). The proportional term aims to reduce the current error.
2. 🧮 Integral term: It aims to eliminate the residual steady-state error that occurs when the proportional control action is not sufficient to drive the error to zero.
3. 🔬 Derivative term: It provides a prediction of future error trends and helps to dampen the system, reducing overshoot and instability.

The PID controller's goal is to minimise the steady-state error, which is the difference between the market price and the redemption price. The controller adjusts the redemption rate to calibrate the redemption price around an arbitrary number, effectively responding to ongoing market pressures during the revaluing process. If the market price is greater than the redemption price, the redemption rate is negative, and vice versa. This dynamic adjustment helps to maintain the stability of RAI, even in volatile market conditions.

Notwithstanding, the world of stablecoins is finally witnessing a new wave of innovation with the advent of PID-controlled stablecoins!

1. ⛅️ HAI - HAI, a new addition to PID-controlled stablecoins, introduces unique characteristics that set it apart. It broadens its collateral base beyond ETH and RAI to include Ethereum LSTs like stETH and rETH, as well as tokens like OP and UNI. This diversity enhances stability and offers users more flexibility. Unlike RAI, HAI is expected to have more long-term governance, allowing for key decisions such as adding or removing collateral types. This adaptability ensures HAI can respond to the evolving DeFi landscape. It also employs a Proportional-Integral (PI) controller to set the redemption rate, allowing dynamic pricing adjustments to maintain stability. Finally, HAI will launch with an initial price of $1 USD, aligning it more closely with traditional stablecoins and making it more intuitive for users. This pricing strategy aligns HAI more closely with traditional stablecoins, making it more intuitive for users who are accustomed to stablecoins pegged to the US dollar.
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2. 〶 TAI - TAI is also a new entrant in the realm of PID-controlled stablecoins, offering a Proportional-Integral (PI) controller to dynamically adjust the redemption rate, ensuring stability. Similar to HAI, it expands the collateral base by not only accepting ETH and RAI but also established LSTs like stETH and rETH. This diversified collateral base enhances stability and offers users more flexibility. TAI's governance will play a crucial role in adding or removing collateral types, ensuring the protocol's adaptability to the evolving DeFi landscape. TAI also introduces lower liquidation penalties, reducing the risk for collateralised debt positions. It will use the same general liquidation mechanism as RAI and DAI but will charge a much lower penalty when a position is liquidated. Finally, TAI adopts a "fair launch" style of token distribution, with the majority of the system token, RATE, given to users of the protocol, ensuring maximum credible neutrality.
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3. 💡 LED -  The Liquid Energy Dollar introduces a unique approach to maintaining stability with LED designed to be stable relative to energy prices, making it an energy-stable currency. The rationale behind LED is that energy is fundamental to everything we consume, and when energy prices rise, so does our cost of living. Therefore, an energy-stable currency can keep our buying power stable relative to the things we care about. This approach provides a powerful alternative to fiat currencies, whose buying power can be eroded by inflation. LED's stability is maintained through a decentralised global energy index that uses the Bitcoin network. Bitcoin miners consume energy to secure the network and earn block rewards. The relationship between the cost of energy (miner costs) and the revenue from block rewards (miner revenue) is fairly constant over time. By knowing this relationship, the current Bitcoin difficulty, and block rewards, LED can reliably derive the energy prices that miners are paying.
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4. 🧾 RICO - The Rico Reflex Bond System is an innovative player in the financial technology landscape, offering a unique synthetic asset known as a reflex bond. This reflex bond dynamically adjusts its par price in response to market conditions, ensuring stability and adaptability. Similar to the HAI and TAI systems, it expands the collateral base by not only accepting a specific type of collateral but also has a subsystem, known as the rule subsystem, that is responsible for adding new Collateralised Debt Position (CDP) types and managing their parameters. This diversified collateral base enhances stability and offers users more flexibility. The rule subsystem will play a crucial role in adding or removing collateral types, ensuring the protocol's adaptability to the evolving financial landscape. The Rico system also introduces a unique liquidation and profit/loss mechanism, known as the vow. It handles the liquidation of unsafe CDPs and manages the system's profits and losses. Finally, the Rico system includes a risk-share token, RISK, which represents the present value of future interest from all RICO loans, minus bad debt bailouts. All profits and losses are immediately realised via RISK buy/burn or mint/sell.

As we explore the landscape of Controller-Based Stablecoins, it's clear that we're standing on the precipice of a thrilling new era in DeFi. The innovative use of control theory in stablecoins like RAI, HAI, TAI, LED and RICO is not just a technical evolution, but a fundamental shift in how we perceive and interact with digital currencies.

These developments hint at the potential emergence of a Controlled-Peg Summer narrative, where the focus shifts from traditional dollar-pegged stablecoins to these more dynamic, adaptive, and resilient alternatives. The journey ahead is filled with possibilities, and the excitement in the space is palpable. As we continue to innovate and push the boundaries of what's possible, one thing is certain: the future of stablecoins, and indeed the broader cryptoeconomy, has never looked brighter!