This is Part 3 in a four part series in which we will explore the market for stablecoin issuers, its trend towards fragmentation and how unification can develop to improve mass adoption.
Part 1 dispels the idea that stablecoins are a winner take all model and explain why there is a market gap that will be filled by an Aggregator-Distributor (AD).
Part 2 describes CENTRE, an attempt to create a centralized Aggregator-Distributor (CAD) and how its emergence mirrors the history of credit card companies.
Part 3 will describe CementDAO as a Decentralized Aggregator-Distributor (DAD) and its advantages over the centralized model.
Part 4 will explore the role of issuers in a fragmented market, and how they can carve out defensible, profitable market niches, despite producing a commodity product.
Our previous post mapped the similarities between the proliferation of credit cards in the 1920s and the recent explosion of stablecoins into the crypto markets. This week, we’ll analyze the decentralized model of distribution and aggregation (dA/D) and discuss its advantages over the centralized model.
The Visa of Stablecoins and Why it Doesn’t Work
Just as the innovation of credit cards spawned an influx of issuers, the recent introduction of stablecoins has triggered an explosion of new entrants to the fiat-tied crypto market. In almost no time at all, the competitive pool has grown to over 220 different projects, all issuing coins tied to a traditional currency like the USD.
In response, Coinbase and Circle, two well-established brands in the cryptocurrency industry, decided to follow the example of companies like Visa. Much as their predecessor consolidated the many credit card alternatives under a single banner, the two hope to become the Central Aggregator (cAGG) of what is now a deeply fragmented market.
But is that the best course of action? It may work for credit cards, which carry no implication or possibility for decentralization. But blockchain, and its derivative tokens, are explicitly built with that end goal in mind. Clearly, filtering every stablecoin through a centrally-controlled gatekeeper isn’t the most congruent solution. But the alternative, a distributor/aggregator that maintains the decentralized ethos of the technology its supporting, provides a far better path forward. To build such a mechanism requires solutions to four problems:
First: liquidity and inter-coin operability. In addition to providing a pool of liquidity sufficiently deep to support critical trade volumes, the solution must provide seamless interchangeability between the included coins.
In a similar vein, the second problem addresses user perception. Users must be issuer-ambivalent, with all treated as equally viable sources of a cohesive end product. Differentiation within the system fragments the product and corrupts the result.
Third, and standing in most stark contrast with the solution proposed by Coinbase and Circle, is the necessity of a decentralized governance model. The community of participants must have distributed control over the governance of the aggregator, which expands to choice of included coins.
Finally, the system must also decentralize its risk management processes. If a particular issuer becomes unviable in the long-term, the risk management solution must provide protections against large-scale losses or total collapse.
The First Problem: Liquidity Pools and Fungibility
The first project to successfully address the need for liquidity in a decentralized model was Bancor. Using smart contracts, they designed continuous liquidity pools, which provided users with an automated market maker and consistently available operating liquidity.
The MIXR draws on similar operating principles to create an ecosystem tailored to the complexities of stablecoin aggregation. Rather than focusing on coin-to-coin conversion, the MIXR's liquidity pool provides a mechanism for multi-token interoperability.
The CementDAO solution also utilizes smart contracts, but in a structure more tailored to the unique parameters of the problem. The protocol instead allows a large sample of coins into the system, all able to trade with the others. The smart contracts, via a specially-designed weighting mechanism, simultaneously ensure that all are kept in balance with all other stablecoins in the MIXR. This allows for guaranteed interchangeability between a huge variety of stablecoins, reducing instances of incompatible transactions and enabling additional use cases.
As an example, imagine an arbitrage trader looking to profit on a Bitcoin price disparity. In this case, the price of Bitcoin is higher in Gemini at one exchange than it is on the Kraken exchange. The next step would be to buy where it’s cheap, and sell where it’s high, which in this case is Kraken. But Kraken only accepts Tether deposits, leaving the trader unable to complete the transaction. With the MIXR, he could push his Gemini in to the pool and quickly transform them into Tether, which would then work with Kraken and enable the arbitrage trade. By providing the necessary liquidity and interchangeability between coins, the MIXR model allows for previously-hindered trade possibilities and market forces.
The Second Problem: Issuer Ambivalence
While the above liquidity model solves the need for coin interchangeability, it still leaves a prominent issue for users. There is a huge variety of tokens all tied to the dollar, which invites uncertainty of choice for anyone looking to take advantage of their benefits. Even worse, each token experiences its own slight deviations in price from their supposed anchor. Traded against each other, some end up above the dollar and others below. Intraday volatility in a token designed to minimize that exact characteristic is a market inefficiency that is compounded by the increased risk present in every stablecoin.
In holding only one stablecoin, the user exposes their assets to concentrated risk of loss. If Gemini deemed a transition suspicious, for example, those tokens could be blacklisted and made worthless. If a token fails to maintain or prove full reserves, or if regulators discover a discrepancy in the smart contract, the coin could be shut down entirely.
To combat these serious drawbacks, the CementDAO protocol serves as an abstraction layer between client and issuer, removing proximity and dramatically reducing the risk profile. This layer also provides practical unification, and dampens volatility by means of averaging.
The Third Problem: Decentralized Governance
In addition to identifying the issues of any stablecoin aggregator, our proposed solution must further guarantee the advantages of decentralization. The most obvious target is the governance model of the system, which sets the guidelines for future operation of the product. Rather than allowing a central point of control, a decentralized model gives power of decision-making to its participants. The CementDAO method relies on two principles to do this: Futarchy and minimal governance.
Economist Robin Hanson first proposed Futarchy as a form of government, and advocates for two primary elements in governance. Prediction markets are the policy-generating feature of such a system, which work to determine the policies most likely to impact the community positively. Second is the utilization of elected officials, who set the determining measures of that community’s success. In this system, these elected officials serve as Curation Agents, with responsibilities ranging from setting market parameters to whitelisting participating issuers. In addition to providing geographic independence and non-limited participation, CementDAO uses these tenants to provide equitable distributed governance for users.
Importantly, this system also subscribes to the school of minimal governance, in which only the minimum necessary structures remain in place. This provides a level of operational freedom that would, again, be unattainable in a centralized alternative.
The Fourth Problem: Decentralized Risk Management
In any system that aggregates multiple assets, the primary risk is in the loss or other devaluation of a portfolio coin. If one of the included tokens loses its peg, becomes unreliable, or must otherwise be removed, it presents the entire model with default, or higher state, risk.
The Visa system is once again the inspiration behind the solution posed by Coinbase and Circle. To offset the risk of any one member bank defaulting on the credit they take on for their consumers, Visa requires a collateral pool managed exclusively by the operator (Visa). If that default does happen, the collateral pool provides backup capital to offset the loss. If its insufficient, the participants spread the loss evenly.
CementDAO, on the other hand, introduces a specific token to enable more effective risk management on a distributed basis. This token allows for autonomous users to “own” the risk of the pool, and to profit according to their degree of assumption. The resulting marketplace provides multiple strategies for offset any chance of communal loss to the primary coin. If an issuer defaults or goes out of business, the risk tokens automatically cover the loss to re-stabilize the pool. In exchange for holding such tokens, risk-tolerant users receive financial incentives in the form of fees paid into the pool. By creating a risk marketplace free from central control, the MIXR system provides unparalleled stability for core users as well as an otherwise-untapped means potential profits.
Putting it All Together
An effective decentralized model for stablecoin aggregation and distribution faces substantial obstacles to successful deployment, but all are solved in the CementDAO architecture. The multi-input continuous liquidity pool provides reliable interchangeability between coins, while the weighting measures and unique aggregation structure provide the necessary coin standardisation to make the that pool viable.
As to the challenges of making a complex system decentralized, CementDAO maintains the principles of blockchain implementation by providing a minimalist governance model that shuns central control, instead electing to empower those participating. Finally, the tokenization of inherent default risk simultaneously stabilizes the core market while proving a secondary opportunity for those interested in profiting directly from an assumption of the pool’s risk. By effectively solving each of these problems, CementDAO provides a model of stablecoin aggregation that is far superior to any centralized alternative.