Is anti-inflation stablecoin a real issue?

Examining the Significance of Anti-Inflation Stablecoins A Valid Concern?

Journalist Jessy from LianGuai

Last year, Vitalik mentioned in an interview that the anti-inflation stablecoin (Flatcoin) would be one of the biggest “opportunities” in the cryptocurrency field yet to be realized. In 2021, the idea of an anti-inflation stablecoin was first proposed by Coinbase’s Chief Technology Officer, Balaji Srinivasan.

As the name suggests, an anti-inflation stablecoin is a stablecoin that can resist inflation. Unlike traditional fiat-backed or mainstream virtual currency stablecoins that are pegged to the US dollar and maintain a constant value, an anti-inflation stablecoin is anchored to the prices of a basket of specific goods. This means that even when the prices of goods rise, the currency in people’s hands still retains the same purchasing power as before the price increase. In simple terms, according to this concept, if an anti-inflation stablecoin can be used to buy a cup of coffee now, it should still be able to buy a cup of coffee ten years later.

From a theoretical standpoint, creating an anti-inflation stablecoin seems plausible. However, the most important function of traditional currency is to serve as a measure of value for the exchange of goods. When a currency is constantly tied to the price of goods, it no longer serves as a measure of value for the goods, and its own value is determined by the price of the goods. At this point, it is no longer a traditional currency, so how big is the market for such a “currency,” and is it practical?

• From Trade to Triumph How an Exploit Turned a Trader’s $280K into a $1.9M Windfall with Multichain Bridge
• PayPal Dances with the SEC: A Stablecoin Saga
• Research Report Introduction to Aztec Account Abstraction

More importantly, is it stable and secure in its design mechanism? And fundamentally, does its design logic truly allow a token system to operate in a healthy manner and achieve self-sustainability?

Is an anti-inflation stablecoin necessary?

In economics, there is a basic rule: when the government creates an excessive amount of currency, prices rise. This is when inflation occurs. For a country’s economic development, if inflation is within a reasonable range, it can actually serve as a lubricant for economic growth, as low inflation rates can stimulate consumption. However, rapid inflation increases business costs, slows down economic growth, and leads to unemployment.

For the general public, inflation is not welcomed, especially when it becomes hyperinflation. People have to bear additional costs to deal with the impact of inflation on the economy and personal life. In most cases, wage growth cannot keep up with the depreciation of currency caused by inflation.

In addition, most people do not have financial knowledge or the necessary skills to combat inflation. They can only watch helplessly as their currency depreciates and purchasing power decreases. The privileged few who possess financial knowledge take advantage of inflationary monetary policies to exploit the majority.

Current practices regarding inflation-stable coins in the market are tied to the inflation rates of the United States. Prior to the pandemic, the U.S. experienced a roughly ten-year period of low inflation. During and after the pandemic, however, prices remained consistently high.

Fighting inflation is a necessity for the general public. In the traditional financial system, people combat inflation by investing in real estate, securities, stocks, precious metals, and other products.

In 2008, Satoshi Nakamoto created Bitcoin. At that time, there was a global financial crisis, excessive money supply, and devaluation of sovereign currency credit. Bitcoin, as a representative of virtual currency, was born with the mission to challenge the mainstream “financial system.” Throughout history, including Bitcoin and other virtual currencies, they have indeed become tools to combat inflation.

Thus, a new financial system based on blockchain technology began to emerge. Although virtual currencies like Bitcoin have the ability to combat inflation, their prices fluctuate greatly. Stablecoins were created as a response to the high volatility of virtual currencies. These stablecoins are anchored to real-world fiat currencies or mainstream virtual currencies. They can also maintain price stability through algorithms. Currently, stablecoins have a wide range of applications, serving as a medium of exchange in virtual currency transactions. In DeFi, they can be used for collateralized loans or providing liquidity. In the real world, stablecoins also play a role in scenarios such as international trade.

The emergence of inflation-stable coins aims to achieve both the function of combating inflation and serving as a medium of value storage and exchange, just like stablecoins.

According to the concept of inflation-stable coins, we can understand that they will be popular during periods of inflation. However, during periods of deflation or price decreases, inflation-stable coins may not be as appealing as fiat currencies.

In my opinion, fighting inflation is a necessity. However, for users, they may not necessarily need to hold inflation-stable coins to meet this demand. Even in the world of cryptocurrency, it seems that investing in Bitcoin on a regular basis is a better choice for combating inflation than holding inflation-stable coins.

Since there are better choices for inflation resistance, can anti-inflation stablecoins surpass existing stablecoins in terms of security, efficiency, and other aspects when used as a medium of exchange?

The current situation and problems in the stablecoin market

We can categorize the current stablecoin market into two major types: stablecoins collateralized by real-world assets or on-chain assets, and stablecoins that maintain stability through algorithms.

However, both types of stablecoins have unresolved problems. Fully collateralized stablecoins are either centralized or have custody risks, or they suffer from excessive on-chain collateralization issues.

Pure algorithmic stablecoins such as Basis, Empty Set Dollar, and Seigniorage Shares provide a trustless and scalable model that embodies the early vision of Bitcoin as a decentralized and stable currency. However, their current shortcomings are their difficulty to launch and extreme volatility. This erodes users’ confidence in them and leads to an inevitable death spiral.

Therefore, algorithmic stablecoins are viewed as an experiment rather than a substitute for collateralized stablecoins. From this perspective, although USDT is criticized by users for being centralized and opaque, its position remains unchallenged. The simple logic of pegging 1U to one US dollar, and the fact that the pegged dollar is trusted due to its status as a global currency, still convinces those immersed in the traditional financial world.

So, how can anti-inflation stablecoins share the market dominated by USDT?

In my opinion, the first priority is to ensure that when the inflation rate stabilizes, the stablecoin can safely maintain its price stability, so that it can function as a currency and serve as a medium of exchange.

Another important point is whether the stablecoin’s mechanism can truly adjust its price based on the inflation rate, especially when rapid inflation occurs.

Now let’s focus on how the main anti-inflation stablecoins are designed:

What projects are working on anti-inflation stablecoins?

The self-proclaimed earliest anti-inflation stablecoin is Nuon issued by Laguna Labs. In the stablecoin landscape of the DeFi protocol Frax Finance, there is also the presence of FPI, an anti-inflation stablecoin. Collypto, another anti-inflation stablecoin, is backed by real estate and commodities, aiming to maintain the purchasing power of anti-inflation stablecoins in the real world. In addition, there are projects such as Spot and LendrUSD that are also working on anti-inflation stablecoins.

The LianGuai journalist primarily analyzed the anti-inflation stablecoin projects, Nuon and Frax Finance’s FPI, as well as the anti-inflation stablecoin launched by the Ampleforth team.

Nuon

An anti-inflation stablecoin developed by Laguna Labs. Currently, Nuon can be minted on its official website, with a total TVL of $184,000.

In order to achieve stability in the face of inflation, Nuon relies on the Truflation oracle, which the project claims tracks the price changes of 10 million goods and generates daily inflation estimates that are consistent with those of the Federal Reserve. Based on these changes in inflation, the value of Nuon tokens is adjusted once a day.

Specifically, Nuon’s price is loosely pegged to the current value of a basket of goods priced at $1, including a wide range of physical goods as well as services considered essential in modern society, such as food, daily necessities, entertainment, tobacco, alcohol, clothing, housing, transportation, utilities, health, communication, education, and more. Each category is further divided into subcategories and includes multiple data sources.

According to the whitepaper: The Nuon protocol itself uses over-collateralization and arbitrage to maintain the peg.

After reading the project’s whitepaper, the LianGuai journalist discovered that the method used to maintain stability is roughly as follows: when the price of Nuon rises above the peg, the liquidation ratio of all collateral assets in the Nuon protocol will decrease. This increases the capital efficiency of Nuon minting and strongly incentivizes users to mint more Nuon and sell them on the market. As the supply of Nuon increases, its price naturally decreases until it returns to the peg. Conversely, when the price of Nuon falls below the peg, the liquidation ratio of all collateral assets in the Nuon protocol will increase. Arbitrageurs will accelerate the re-pegging process, and the increase in the liquidation ratio will also increase the liquidation risk for participants in the Nuon protocol. This motivates users to increase collateral or burn Nuon to maintain a safe collateral ratio.

The team claims that over-collateralization during minting avoids the risk of a death spiral redemption.

According to the whitepaper, the increase in value of Nuon comes from the over-collateralization provided by the collateral providers during minting. They compensate for the inflation-induced rise in Nuon price through rewards in the governance token nuMINT and fees from the protocol treasury.

Although this seems reasonable, in reality, if faced with rapid inflation, such as the price of coffee increasing from $1 to $2. If the initial Nuon could be exchanged for $1, then at this point Nuon could be exchanged for $2. And we will find that even though there is over-collateralization, the collateral and Nuon cannot be exchanged on a one-to-one basis. If a large number of people rush to exchange collateral with Nuon and cannot be redeemed, the project will collapse.

According to the project’s whitepaper, the project itself is designed to compensate for the price increase caused by inflation through governance tokens and protocol treasury fees. However, LianGuai journalists did not find how these governance tokens specifically work on their official website and whitepaper.

FPI

One of the three stablecoins in the Defi protocol Frax Finance.

Similar to nuon, it is pegged to the inflation rate in the United States and is linked to a basket of real-world consumer goods defined by the average value of the U.S. CPI – U. This pegged rate is updated every 30 days, synchronizing with the monthly CPI price data released by the U.S. government. In terms of collateral minting, FPI maintains a 100% collateral ratio.

According to the description of FPI in the Frax Finance whitepaper, the project explicitly states that when the FPI treasury cannot generate enough revenue to maintain the value of each increased FPI due to inflation, new FPIS (governance tokens) may be minted and sold to increase treasury funds.

This is still minting coins out of thin air and selling them to fill the holes in FPI.

Spot

A stablecoin project created by the team behind the first-generation algorithmic stablecoin Ampleforth (AMPL).

Spot’s implementation relies on existing tools in the Ampleforth ecosystem.

First, Spot minting requires the use of existing stablecoin AMPL. After collateralizing AMPL, users receive A-Tranche and Z-Tranche, which are two types of debt certificates, and users then use the A-Tranche debt certificate to mint Spot. In fact, users participating in Mint use AMPL as the principal and receive Spot and Z-Tranche.

As for redemption, Spot represents the redemption right of a basket of on-chain assets, and it redeems the collateral in the collateral pool in proportion to the holdings of Spot. For example, 1% of the total Spot can redeem 1% of the collateral.

First, let’s take a look at AMPL as collateral. As an algorithmic stablecoin, AMPL cannot solve the death spiral. It has no collateral and its price relies on consensus among users. Its mechanism is very simple, using Rebase (a mechanism similar to stock splitting) to collectively change the holding quantity for everyone.

In simpler terms, when AMPL exceeds 1U, it will be increased to push the price back to 1U; when AMPL’s price falls below 1U, it will contract to pull the price back to 1U. The key to the success of this mechanism lies in people’s FOMO (Fear Of Missing Out) sentiment.

However, in actual operation, this stablecoin has its problems. Its volatility is relatively high, which is why the project later stopped calling itself a stablecoin and referred to it as an elastic currency.

Considering this token, which has a relatively low level of consensus, as collateral, LianGuai journalists believe that the collateral for Spot itself is not trustworthy. So, is the anti-inflation stablecoin built on top of it still reliable?

Summary:

Through the three anti-inflation stablecoins mentioned above, we can see that two of them maintain the stability of token prices by first using oracle to track the inflation index and adjust token prices. The second method is through arbitrage by speculators to prevent the price from decoupling. This is consistent with the way algorithmic stablecoins maintain price stability.

Different projects may have some limitation mechanisms in times of extreme financial volatility. For example, people may rush to redeem collateral on a large scale. For example, Spot redeems collateral in the same proportion as the amount of Spot held. However, this collateral itself is another form of algorithmic stablecoin within its entire ecosystem.

All these complex designs seem to make this monetary system function, but in reality, the essence of this system is either still unable to avoid a death spiral, or it creates new tokens to fill the gap, or it simply uses a consensusless token as collateral for inflation stablecoins. From the perspective of LianGuai Journalist, this is still a predicament of parasitic relationship. We cannot expect to create consensus among people simply by constructing an economic model and story, especially when anti-inflation stablecoins are not a necessity. In conclusion, this can only be considered a financial experiment, and it is not recommended for users to invest a large amount of capital.

We will continue to update Blocking; if you have any questions or suggestions, please contact us!