1) Overview of Stablecoin Industry in 2021
1.1) Limitations on the Growth of the Stablecoin Industry
1.2) Algorithmic Stablecoins
2) UST-LUNA: A Two-Token Seigniorage Shares System
2.1) Historical Two-Token Seigniorage Models
2.2) How UST Maintains Peg
2.3) Growth Focused Fiscal Policy
3) BEAN: A Credit-Based System
3.1 How BEAN Maintains Peg
3.2 Historical Fiat Debt
3.3 Beanstalk Debt
3.4 Organic Demand via STALK/SEED
1.0 Overview of Stablecoin Industry in 2021
DeFi has seen a massive amount of growth in TVL, recently surpassing 250b TVL as of the end of 2021. As DeFi continues to mature, participants continue to look for more ways to earn high, volatility-risk free yields and arbitrage opportunities resulting in higher capital efficiency within the ecosystem. These drivers have resulted in extraordinary demand for multi-chain stablecoins. In the past year, stablecoin supply grew over 500% from 29b to 150b per The Block. This stat does not even include many of the popular stablecoins like DAI, FEI, and FRAX, which amount to an additional ~$25b more to the stablecoin market.
Most notable has been the explosive demand for UST, the stablecoin native to the Korean blockchain Terra. Terra founder Do Kwon says rising demand for UST is the main factor behind a 65% increase in the price of Terra’s LUNA token over the past couple of weeks due to the UST seigniorage mechanic. Seigniorage is the profit the protocol makes from issuing new UST by burning LUNA. A combination of high yield opportunities and a growth driven fiscal policy have been driving demand for UST, causing UST supply to skyrocket. The growth driven fiscal policies have attracted dozens of new projects and are expected to launch in the first quarter of 2022 after completing their audits. In December 2021, UST surpassed DAI, becoming the fourth largest stablecoin behind USDC, USDT, and BUSD.
BEAN, a decentralized credit-based stablecoin on Ethereum builds on top of the Empty Set Dollar (ESD), which used an algorithmic, elastic supply and debt servicing model to maintain peg. ESD However unlike ESD, BEAN has so far proven its antifragility by managing to maintain peg while growing the BEAN supply from an initial 100 BEAN minted to ~42m BEANs in supply as of the end of December 2021 and surviving the same bank run scenario that lead demise of ESD, showing robustness in the past 5 months since inception at the beginning of August 2021.
As multi-chain liquidity infrastructure continues to grow in 2022, cross chain liquidity for stablecoins will become even more important, continuing to drive the macroeconomic trend for more stablecoins. Decentralized stablecoins will be even more sought after as regulatory pressure continues to increase on the largest centralized stablecoins.
1.1 Limitations on the Growth of the Stablecoin Industry
Regulators all over the world in areas such as the USA and the EU have started to scrutinize how the stablecoin industry will be regulated. This has curtailed growth on centralized stablecoins such as USDC and USDT, which require regulatory blessings in order to continue expanding their fiat collateral positions, putting a cap to the maximum supply of centralized stablecoins.
As a result there has been a shift in demand from centralized stablecoins to a variety of decentralized stablecoins. The largest decentralized collateralized stablecoins are DAI, FEI, FRAX, LUSD, and MIM ranging from overcollateralization to partial collateralization. The major benefit of being a collateralized stablecoin is confidence to maintain peg. Users have confidence in the peg of collateralized coins because they are backed by other assets and in the case that the peg starts a death spiral, the collateralization will create a hard floor for the death spiral if demand starts to become extremely negative during periods of high volatility. In the case of overcollateralized stablecoins such as DAI and LUSD, the probability of a death spiral is essentially non-existent as liquidations occur on the overcollateralized assets to prevent those stablecoins from falling too far off peg. The supply elasticity of these coins are thus also limited by the amount of their collateralized backings, which is the main inhibiting growth factor for continued adoption. For example DAI will only reach 100b supply if ETH backing DAI is much higher than 100b due to the overcollateralization requirements.
1.2 Algorithmic Stablecoins
Algorithmic stablecoins have monetary policies that are controlled by smart contracts, which makes the supply of the stablecoin elastic and leads to greater capital efficiency. The idea of using algorithms to create an elastic supply model for a token was mentioned as early as 2009 by Satoshi Nakamoto. In order to completely solve the supply inelasticity of collateralized stablecoins, there have been a number of algorithmic stablecoins that have attempted to maintain the peg without any collateral.
The past few years have seen many experimentations in algorithmic stablecoin design by experimental projects such as Basis, Ample, and Empty Set Dollar, all of which were never able to maintain peg. Within each of these projects, economic incentive design flaws were discovered within months after launch. Once a death spiral started in a period of high volatility, the economic design flaws all but ensured that these algo stablecoins would not be able to regain peg.
Both UST and BEAN offer distinct algorithmic designs based on economics first principles that aim to overtake USDC, USDT, and BUSD. UST is based on a seigniorage shares system that uses LUNA to absorb price volatility. BEAN absorbs price volatility using a credit-based model to expand/contract BEAN supply.
2.0 UST-LUNA: A Two-Token Seigniorage Shares System
The Terra Protocol ecosystem uses an algorithmic monetary supply and a growth-oriented algorithmic fiscal policy based on a two token seigniorage shares system. Arbitrage participation and profit generation between miners and users creates greater capital efficiency for the ecosystem. Miners are attracted to the ecosystem via stable long-term profits via transactional demand and users are attracted to the ecosystem to speculate on a decentralized algorithmic stablecoin.
2.1 Historical Two-Token Seigniorage Models
Historically an early example of a two-token seigniorage shares system was the USD and GOLD. After WW2, the Bretton Woods agreement created an international currency exchange centered around the trading pair USD:GOLD which started at an initial exchange rate of $35 USD per ounce of GOLD. This system propelled the USD to international currency reserve status and allowed the U.S. to collect international seigniorage from the rest of the world economy.
However the inelastic supply nature of GOLD resulted in a lot of currency supply problems for USD primarily due to the USD:GOLD pair. The 20th century is marked by periods of significant inflationary and deflationary. In 1971, President Richard Nixon finally shut down the Bretton Woods agreement, which formally marked the transition to a credit based economy.
Not coincidentally western petrol production started peaking in the late 1960s, causing substantial petrol shortages in countries such as the USA, Canada, and Western Europe. As a result these countries formed petrol supply dependencies with the petrol rich Middle East. The relationship between the U.S. and Saudi Arabia goes all the way back to WW2, when President Franklin Roosevelt declared Saudi oil a U.S. security interest shortly after Saudi Arabia was found to have vast quantities of OIL.
There have been an estimated 200k tonnes of GOLD extracted, or ~1.16t USD at a 1kg = 58k USD exchange rate. In comparison, an estimated ~2.18t USD worth of OIL was consumed in 2018 alone. As OIL became highly sought after as a resource in the 1970s, the U.S. and Saudi Arabia cemented the petrodollar system, agreeing that the U.S. would buy OIL from Saudi Arabia in exchange for USD, thus formalizing the USD:OIL trading pair and eventually leading up to the replacement of USD with U.S. treasury bonds as the world’s reserve currency.
2.2 How UST Maintains Peg
Similar to USD:OIL, UST benefits from UST:LUNA liquidity and this forms the basis of UST peg mechanism. UST supply is controlled algorithmically with supply expansion fueled through seigniorage and supply contraction through LUNA liquidity to absorb the volatility.
Miners play a foundational role in the stability of UST and are a requirement for security and stability of the Terra Protocol ecosystem. Miners are rewarded by a variable transaction fee and a variable Seigniorage fee. These fees are adjusted algorithmically over time based on market conditions (Terra Whitepaper, 2.5).
In order to contract UST supply, users can swap UST for LUNA, which shifts the short-term volatility impacts to the miners by reducing their mining power, which is represented as staked LUNA (Terra Whitepaper, 2.4). When UST supply needs to expand, the protocol mints new Terra in exchange for LUNA, burning a portion of LUNA which increases mining power, and also collects seigniorage for the treasury.
2.3 Growth Focused Fiscal Policy
Seigniorage fees collected by the Terra Protocol treasury are redistributed back to the community by paying funds to dapps that use their funds efficiently to increase economic activity in the ecosystem (Terra Whitepaper, 3.0). Funds allocated to dapps are algorithmically determined by a weighting function. This gives LUNA validators limited power. Validators only have the authority to determine whether a dapp is making sufficient progress, but has no control over funding allocation amounts.
One of the main difficulties for UST adoption on popular chains such as Ethereum, Matic, Avalanche, and Fantom has been the fact that UST is not an ERC20 token. Terra uses a smart contract platform built with Rust just like Solana. However since the future is multi chain, in order for UST to thrive in 2022, UST must develop a major presence as a cross chain stablecoin. Initially deploying 3m of LUNA for UST incentives across major layer one blockchains, the Terra community has continued to make strides and prioritize getting more UST liquidity to other chains.
By having a transparent and equal opportunity funding program and a multi-chain decentralized stablecoin, Terra provides a compelling reason for dapps to join the Terra ecosystem. Similar to the relationship between USA-Saudi Arabia and turning the dollar into a petrodollar in the 1970s, the ultimate success of Terra depends on bringing dapps to the ecosystem and continuing to make UST more widespread.
3.0 BEAN: A Credit-Based System
BEAN is a decentralized, credit-based stablecoin designed from the economic theory of credit and debt. BEAN is not backed by collateral, does not have a negative carry rate, and has an elastic supply. Using economic incentives, Beanstalk creates an ecosystem with layers of arbitrage opportunities that maximize capital efficiency and strengthen the peg. Users can currently deposit LP, stake BEAN, or provide credit to Beanstalk. Beanstalk plans to grow in Q1 2022 by making STALK, SEED, and PODS liquid assets denominated in BEAN, unleashing more arbitrage opportunities, capital allocation strategies, and driving ecosystem demand. STALK, the governance token is accumulated by depositing assets into the Silo. When BEAN is above peg, Stalk owners receive 50% of BEAN minted from the time weighted average price (TWAP) BEAN-excess shortage in the BEAN:ETH LP. The remaining 50% goes to Beanstalk creditors in the Field, making pods 1:1 for BEAN once Pods become harvestable. In addition to STALK, Siloers also obtain SEED, which grow STALK every hour, called a Season, at the rate of .0001 STALK per SEED.
3.1 How BEAN Maintains Peg
Beanstalk takes inspiration from Empty Set Dollar (ESD), but with more robust economic incentives to maintain the peg. ESD ultimately death spiraled and collapsed, never regaining peg due to inefficiencies around the supply increases over peg and burning mechanism below peg. ESD failed because the supply was TOO elastic.
In the initial bootstrap phase, ESD started with a deterministic supply schedule. Although fixing the initial supply schedule sounds reasonable from an execution point of view, this does not provide the necessary elasticity to adapt to ever changing market conditions and all but guarantee a starting supply inefficiency. Since the oversupply happened while ESD was above peg, there were no immediate warning signs at the time. The debt schedule for burning ESD was also fixed based on the debt level of the protocol at the time of burning when ESD went below peg. Unfortunately, it did not factor in ESD price or demand for debt, and created a sub optimal economic incentive structure. As the debt level increased with more ESD being burned by creditors, this created higher rates of returns for future creditors thus disincentivizing efficient burning mechanisms.
In Beanstalk’s initial bootstrap phase, 100 BEANs were initially minted by Beanstalk at the beginning of deployment. Beanstalk increases the supply by the TWAP supply shortage of BEAN in the liquidity pool over that Season rather than relying on the ESD price * total supply formula, eliminating one of the supply surplus inefficiencies that ESD had. When below peg, Beanstalk incentivizes issuing debt via creditors Sowing in the Field. Creditors can Sow BEAN in the Field in exchange for pods based on the amount of soil available in the Field. Pods function similarly to non-callable bonds but with no expiry date. Pods are harvestable on a FIFO basis. The FIFO redemption schedule makes the BEAN burn mechanism efficient because any time the interest rate is sufficiently high such that a creditor wants to Sow, they are incentivized to Sow as fast as possible in order to be as close to the front of the line as possible, which fixes the other supply inefficiency that ESD had.
Pods become harvestable when BEAN price > 1. Harvestable pods can be exchanged 1:1 for BEAN. Creditors are incentivized to Sow in the Field by the Weather. Weather is the variable interest rate on Beanstalk debt, adapting to market conditions to stay attractive to creditors. Weather is influenced by how close Beanstalk is to ideal equilibrium and debt levels (Beanstalk Whitepaper, 8.4.7). This is a reactive process designed to adjust dynamically to market conditions. Soil supply functions as a soft debt ceiling for Beanstalk and increases/decreases with respect to the TWAP supply delta of the liquidity in BEAN:ETH and the Soil Rate (Beanstalk Whitepaper, 8.3).
3.2 Historical Fiat Debt
Up until World War I (WW1), the gold standard was widely accepted by governments all over the world. However when the monetary supply needed to change very quickly, the system was constrained as a result of being a collateralized system. When WW1 broke out, the USA and many European countries suspended the gold standard in order to rapidly increase their monetary supply to pay for military expenditures. In 1933, a period of high deflation, the gold standard was suspended again during the height of the great depression. In 1971, a period of high inflation, the U.S. permanently retired the gold standard. This marked the final transformation of the USD from a collateralized fiat currency backed by gold into a credit based currency, backed by the full faith and credit of the U.S. government.
In the past 50 years since 1971, global debt has continued to trend upward, surging to all time highs past 225t USD, or 256% of global GDP shortly after the global Covid-19 pandemic started with the U.S. debt being ~29t and GDP to debt ratio being ~128% as of December 2021. The U.S. Fed M1 money supply consists of the most liquid forms of money, namely currency, demand deposits, and other liquid deposits. As of October 2021, M1 is about ~20t. The USD monetary base, which is circulating currency and federal and institutional reserve balances is ~6.3t. This puts the debt/supply ratio of USD at ~460%.
3.3 Beanstalk Debt
Since Beanstalk is a credit-based protocol, Beanstalk needs to have competitive rates to incentivize providing credit. Beanstalk generates organic demand for BEAN by attracting creditors to Sow in the Field. Creditors find Beanstalk appealing because Beanstalk offers competitive interest rates and never defaults on debt. Sowing in the Field has been the primary driver for organic demand for BEAN thus far. The Field is arguably the most important element of Beanstalk because Sowing is the only mechanism that burns BEAN supply. Optimal debt level parameters for Beanstalk were initially set between 5-25% of pod debt/BEAN supply (Beanstalk Whitepaper, 12.1). Above 25% and the debt levels are labeled as “excessive”. The direction of the Weather, the interest rate on Beanstalk debt, is influenced by the different classification of debt levels (Beanstalk Whitepaper, 8.4.8). Soil, the amount of debt Beanstalk issues every season, is influenced by the time weighted average shortage of BEAN in the BEAN:ETH pool each Season, the number of Pods harvested (debt repayment), and the weather.
It is worth mentioning that Beanstalk debt levels are currently at all time highs as of December 2021, recently breaching the 1000% level. Beanstalk labels the debt level as excessive when the debt level is over 25%. This results in the direction of more aggressive weather, which has been increasing at 3% a season for an extended period of time through the month of December as 2021 comes to an end. However the aggressive interest rate set by the Weather has been largely successful in continually attracting creditors and increasing organic demand.
One of the reasons for Beanstalk’s excessive debt levels is that the Soil mechanics were adding excessive amounts of soil into the Field, allowing Beanstalk to issue debt when it didn’t necessarily need it. Changes were made in BIP-6 and additional changes are currently proposed in BIP-9 to make the soil mechanics more efficient by adding tighter bounds to the amount of soil being released in the Field.
Since Beanstalk is still relatively new, initially launching in August 2021, it is an open economic question as to what the optimal debt level parameters should be set at and what the best economic policy surrounding Beanstalk debt levels should be or what the significance of the total debt level even is. Although Beanstalk debt is much higher than the initial parameters that were set in August, a priori we do not know effectiveness or overall usefulness of the parameters in determining whether current debt levels are truly optimal for Beanstalk or not. The future is not predictable and thus it is not possible to predict whether the initial parameters would have been optimal from August to December 2021 and whether the initial parameters will still be optimal with respect to where Beanstalk will be in 2022.
The debt level parameters initially set in August are, from a probabilistic perspective, most likely not optimal because economic theory surrounding credit based stablecoins is still being developed. As the Beanstalk ecosystem experiences larger growth cycles and becomes more capital efficient, another open question is to understand how future growth cycles will impact what the optimal debt parameter should be.
3.4 Organic Demand via STALK/SEED
STALK, SEED, and Pods are all set to become tradeable in Q1 2022, all of which will increase organic demand for BEAN as they all become tradable against BEAN. Beanstalk uses STALK as an incentive to create an increasingly higher opportunity cost for leaving the Silo over time. When a user deposits assets into the Silo in the form of staking or LPing, they immediately receive STALK and SEED. BEAN stakers receive 1 STALK and 2 SEED per BEAN deposited and LPers receive 1 STALK and 4 SEED per BEAN-denominated amount deposited, thus incentivizing LPing over staking. Upon withdrawing, users must forfeit SEED, STALK, and STALK grown from SEED in proportion to assets withdrawn from the Silo.
Once STALK and SEED have liquidity, this will create a new utility for the underlying deposits by turning deposits into collateralized positions with no risk of liquidation. STALK can be thought of as an increasing line of credit against the underlying collateral with a variable interest rate in the form of future yield from BEAN supply increases. SEED would be a fixed line of credit with an interest rate of .0001 STALK per season.
If there is a lot of buying pressure for STALK/SEED, users are incentivized to deposit assets into the Silo and sell STALK/SEED while the demand is high and reclaim the STALK/SEED once demand subsides. If there is a lot of sell pressure for STALK/SEED, there is an opportunity to buy STALK/SEED at a discount because the Siloers that sell their STALK/SEED will eventually need to buy them back in order to withdraw their positions in the Silo.
4.0 Conclusion
DeFi will make major technological strides in 2022 towards cross chain liquidity. One of the major benefactors of this trend will be stablecoins, specifically decentralized stablecoins. Innovative decentralized stablecoin models that have elastic supplies will have the most potential to scale and benefit from the expansionary macroeconomic trend towards cross chain liquidity.
P.S. If anyone is curious, the picture is a Hapori from eth.blockart :)