Stablecoins The Holy Grail of Offshore Funds, Leverage, and Liquidity

Unlocking the Power of Stablecoins Offshore Funds, Leverage, and Liquidity at Their Finest

Author: Kylo@Foresight Ventures

Tips:

• Combining heterogeneous chains with stablecoin protocols easily generates Ponzi magic

• MakerDAO’s bull-bear strategy switch is achieved by transferring revenue sources from on-chain to off-chain

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• AAVE’s next strategic step is to increase GHO yield through Aura

• In the future, based on the curve and convex ecosystems, a large number of crvUSD cannon fodders will continue to emerge

• Abracadabra points out a definite direction for the development of stablecoin protocols in bull market cycles

Web 3 Stablecoins

There is always an ideal of a decentralized central bank in Web3, which can operate independently of all fiat systems and completely rely on various on-chain assets to implement a complete set of central bank currency issuance logic. This utopian ideal motivates countless developers who have designed a series of stablecoin systems. But regardless of whether their starting point is noble and whether stablecoin systems are mathematically valid, most stablecoin protocols are inevitably labeled “Ponzi” and “over-leveraged”. When the tide recedes, all stablecoin magic is stripped of its shameful cover-up, and assets and liquidity flow away like water, leaving only the bare mechanism framework. In the end, only sufficiently robust and over-collateralized stablecoins survive.

Perhaps we can consider what stablecoins really mean for the Web3 industry? Setting aside the idealistic thinking about stablecoins, they can construct sufficiently elegant Ponzi systems; they can also act as a new asset issuance method to bring sufficient liquidity to the chain; they can also act as leverage to increase the available liquidity for users on the chain.

In summary, the charm of stablecoins for the Web3 industry lies in Ponzi, leverage, and liquidity. The main purpose of this article is to explain some of the tricks of certain stablecoin protocols, mainly including some Ponzi designs and the stablecoin operating models of MakerDAO, AAVE, Curve Finance, and Abracadabra. In fact, there are also stablecoin designs based on arbitrage principles such as Luna-UST, Ethena Labs, which we will discuss specifically in the next article.

The rational construction of Ponzi using collateralized stablecoins

When we create a brand new asset and assign value to it with other real assets, in a sense, this new asset also acquires value. This means that the value of the created asset needs to be verified through a value anchor. Taking stablecoins as an example, the value anchoring of various junk stablecoins is achieved through stablecoin trading pairs. The role of these stablecoin trading pairs is not to truly confer various values to junk stablecoins, but only to assign them their current face value. Real value refers to the exchange value, while face value is only the nominal value, which can be directly influenced by oracles or marginal value.

To better understand the meanings of “new asset pricing,” “value anchor,” and “the true value versus face value of stablecoins,” we can look at them through the lens of heterogeneous chain stablecoins. Any heterogeneous chain essentially functions like a fiat currency system, where stablecoins within this ecosystem can be minted by collateralizing the native token of the chain. In theory, the native token of this heterogeneous chain has a price in off-chain centralized exchanges (CEX), which allows it to be used as collateral within the ecosystem to mint a large number of native stablecoins. Then, through a cross-chain bridge, a portion of stablecoins like USDC can be transferred into the ecosystem to pair with the native stablecoins and give them face value. USDC then becomes the value anchor for these native stablecoins, with an anchored value of 1. However, this anchored value is essentially the face value, not the true value of the stablecoin. Since the quantity of true assets coming from the cross-chain transfer of USDC is much smaller than the quantity of native stablecoins minted, these native stablecoins cannot achieve the same level of backing as USDC.

But the Ponzi nature of the financial system often lies in the confusion between true value and face value. The total valuation of assets in financial markets is determined by face value, and face value determines the marginal price of transactions. This means that within the financial system, by using a small amount of assets with true value as value anchors, the face value of new assets can be maintained, thus influencing the marginal price of transactions and expanding the nominal total asset value of financial markets.

In the heterogeneous chain ecosystem, a common scenario is that a large number of native tokens are collateralized to mint a large number of collateralized stablecoins, which serve solely as LP trading pairs with native tokens within the ecosystem. A small amount of USDC is bridged to this heterogeneous chain ecosystem and acts as the anchor, giving the native collateralized stablecoins a face value of 1. Due to the only purpose of a large number of native collateralized stablecoins being used for LP trading pairs, there is also a high demand for native tokens, driving up their price. It is worth noting that the price of the native token is determined by the face value of the native collateralized stablecoins, which is 1. CEX captures the on-chain price essence by capturing its face value through an oracle. This creates a nominal price difference between CEX and the on-chain market, and arbitrageurs often buy native tokens with real currency (USDC) on CEX and sell them on-chain to complete arbitrage. However, unbeknownst to these arbitrageurs, when they execute the purchase of native tokens on CEX, they passively become part of this Ponzi architecture: as liquidity providers, they expand the exit liquidity of the native token…

The above play with heterogeneous chain stablecoins is just one of the fundamental plays within the plethora of Ponzi schemes in TradFi or DeFi. The Luna-UST architecture, which many are familiar with, is essentially based on this logic. The face value of UST is anchored by Curve 4pool and the market cap of Luna, while ANC and LUNA within the ecosystem are supported by the face value of UST. Additionally, this logic can also explain the exchange rate between the US dollar and RMB, as well as the market manipulation through BTC trading pairs on the Upbit exchange. We can delve into the specific details in subsequent discussions.

MakerDAO

MakerDAO started with a simple Collateralized Debt Position (CDP) model and did not have the complex designs of PSM and D3M. Users would collateralize with ETH and generate DAI based on a specific collateralization ratio. At this point, users could choose to exchange DAI for ETH and repeat the process in a loop. Many users were engaged in this looping process, which meant they were selling DAI. As a result, DAI often experienced a slight deviation from its peg before the DeFi summer. MakerDAO addressed the issue of DAI deviation through the implementation of the Dai Savings Rate (DSR). When users mint DAI, they have to pay a certain interest rate, which is then transferred to the depositors of DSR. Therefore, MakerDAO can adjust the supply of DAI in the market by adjusting the deposit interest rate of DSR, thus maintaining the peg of DAI.

MakerDAO introduced PSM after the DeFi summer. With a massive influx of funds, the returns from DeFi farming became incredibly exaggerated, and DAI was commonly used in DeFi farming. This created a demand for DAI, causing DAI to become overvalued. To address both the overvaluation of DAI and maintain its stable price, MakerDAO introduced PSM. Users could use assets accepted by PSM, such as USDC and USDP stablecoins, to exchange for DAI at a 1:1 exchange rate. This mechanism greatly enhanced the stability of DAI’s price. However, later on, the large USDC component of PSM’s composition dominated DAI collateral, laying the foundation for the ripple effect of USDC deviation.

The Direct DAI Deposit Module (D3M) was a collaboration between MakerDAO and AAVE and Compound regarding DAI deposit rates. The interest rate curve of AAVE and Compound is directly related to the utilization rate of the deposit pool, which means that the borrowing interest rate can possibly skyrocket at certain moments. To maintain the stability of DAI borrowing rates, MakerDAO introduced D3M. By providing AAVE and Compound with emergency minting capacity, the borrowing rates for DAI were limited within a certain range. This introduction dealt a blow to the market competitiveness of on-chain fixed-rate lending products. In addition, the introduction of Morpho Labs also seized a portion of the fixed-rate lending market from another perspective. Currently, only space for lending of long-tail assets remains in this field. The collaboration between MakerDAO, AAVE, and Compound regarding D3M may eventually be terminated as the SLianGuairk Protocol gradually matures.

MakerDAO made several adjustments to the direction of DAI’s products during the transition of bull and bear cycles, including:

• Further reducing the types of collateral for DAI and only retaining core currencies such as ETH, wBTC, stETH.

• Setting the collateralization ratio of GUNI to 0.

• Promptly conducting Real World Asset (RWA) business with stablecoin assets in the PSM through Coinbase and specific trust companies when US bond interest rates rise.

The last two adjustments by MakerDAO actually reflect their bull and bear strategies: in a bull market, they earn income on-chain, and in a bear market, they earn income off-chain. GUNI is a DAI-USDC automated income strategy LP launched by gelato during the last bull market cycle. MakerDAO has supported using this LP as collateral to mint DAI. The proposal to use GUNI as collateral for minting DAI faced extensive community discussion, with opposition mainly focused on the risk to DAI’s stability posed by using DAI derivatives as collateral. Supporters argue that the DAI minted with this collateral would form an LP trading pair with USDC locked in Uniswap and would not affect DAI’s price on the circulating supply. After integrating GUNI into MakerDAO, its asset management scale reached billions of dollars, benefiting not only MakerDAO but also Arrakis Finance. As a Uni V3 LP automated income strategy protocol forked from the gelato team, Arrakis Finance gained a significant TVL through GUNI. However, with MakerDAO subsequently removing GUNI as collateral, Arrakia Finance faced a significant loss of TVL. The decline of Arrakis Finance also reflects the final fate of most DeFi protocols reliant on others’ platforms.

In a bull market cycle, on-chain transactions are extremely frequent, and GUNI can capture a substantial amount of DAI-USDC transaction fees. However, when US bond yields gradually rise and on-chain activity becomes calm, GUNI will no longer generate significant fee income. At this point, in order to obtain more income, MakerDAO began to transform into RWA business, replacing a large amount of stablecoins in the PSM with assets related to US bonds. This operation has been fermenting since 2023 Q2, creating the RWA track.

AAVE

AAVE is currently moving towards becoming a Super Dapp. The social protocol, Lens Protocol, and lending business have matured, while the stablecoin protocol, GHO, is AAVE’s next targeted direction. GHO’s collateral minting is currently integrated into AAVE’s lending business, where unused collateral deposited into AAVE can be used as collateral for minting GHO. The minting interest rate of GHO will decrease as the individual AAVE pledge increases, with the current fluctuation range being 3.38-4.83%. Due to the previously lower minting rate of GHO and the relatively low yield farming scenarios available, GHO is currently significantly detached from its anchor. Therefore, anchoring the price of GHO is the next important step for AAVE, and there are two specific ways to achieve this:

• Increase the minting interest rate of GHO to make it close to the rates of DAI and crvUSD
• Expand the use cases of GHO yield farming as much as possible

These two methods complement each other. Lower minting rates, combined with higher yield farming returns, can increase the minting volume of stablecoins while maintaining stability. Therefore, under the current premise of AAVE achieving lower minting rates than the market, increasing GHO yield farming returns is the most beneficial strategy for GHO.

For GHO’s enhanced earnings, AAVE is achieved through Balancer and Aura Finance. AAVE and Balancer have always had a close partnership, and the introduction of Boosted Pool is a milestone in their collaboration. Stablecoins deposited in the Balancer boosted pool can now earn AAVE deposit interest in addition to swap fees. This greatly improves the efficiency of stablecoin funding rates. The next step in Balancer and AAVE’s collaboration revolves around GHO, with Balancer acting as GHO’s liquidity hub and Aura Finance as GHO’s yield booster. To achieve this, AAVE has purchased approximately $800k worth of Aura and has deposited a large amount of veBAL from the treasury into Aura Finance to gain more governance rights concerning Balancer. Currently, GHO’s minting limit is 35 million coins. Once the GHO yield boosting mechanism kicks off, it is expected that the minting limit will increase significantly. To lower the minting rate, AAVE’s staking quantity will also gradually increase. This is a huge advantage for AAVE, Balancer, and Aura Finance, but the magical launch may still need some time.

crvUSD

Although crvUSD is also an overcollateralized stablecoin, its different from the CDP model has created a new design concept for many other DeFi protocols. The design inspiration for crvUSD comes from AMMs, where token swaps are achieved by depositing one type of token and withdrawing another type of token based on a certain algorithm. If we use the principle of equivalence to deduce, the lending process is essentially similar to AMM. Users need to deposit a portion of collateral and borrow another portion of assets based on a certain collateral ratio. This lending method implemented through the AMM model has been adopted by some protocols, such as timeswap and instadapp’s subsidiary product 0xfluid.

In the crvUSD model, it adopts a gradually liquidation process similar to AMMs. The characteristic of the traditional CDP model is that as long as the collateral ratio reaches a certain threshold, all collateral will be liquidated at once. However, in the crvUSD model, whenever the price of collateral changes downward, the LLAMA algorithm determines that the price of collateral will be slightly lower than the collateral in Uni V3. In this case, arbitrageurs will use crvUSD to purchase collateral from LLAMA at a lower price and sell it in Uni V3 to profit. Conversely, when the price of collateral moves upward, the price of collateral in LLAMA will be higher than Uni V3, and arbitrageurs will sell the collateral to LLAMA, obtain crvUSD, and buy back assets in Uni V3 to profit.

The advantage of this gradual liquidation through AMMs is that the collateralization ratio can be set low enough. Since the liquidation process occurs gradually as the collateral price falls, this means that there is enough flexibility in the liquidation price. In other words, gradual liquidation involves selling collateral bit by bit, and the more assets obtained compared to selling all collateral at the lowest price at once, the lower the collateralization ratio that can be set. If higher capital utilization is the advantage of crvUSD, then the cost is more impermanent loss. If the price of collateral drops significantly and then rises sharply back to its original price, due to the arbitrage mechanism within the LLAMA algorithm, the value of the user’s collateral will decrease, and the decrease will be the part arbitraged by external parties.

crvUSD has multiple tools that can maintain the crvUSD price anchor:

• High minting rate • Rich crvUSD yield scenarios • pegkeeper’s automatic minting function

According to the above description of AAVE GHO’s theory, minting rate and yield farming income are the two major factors determining the scale of this stablecoin. From these two perspectives, despite the presence of various “cannon fodder,” even if the current crvUSD minting rate is basically at the highest level in the industry, a large number of users still mint crvUSD. If you want to further expand the minting scale of crvUSD, you actually only need to lower the minting rate to the industry average.

From the current situation, crvUSD tends to deviate from the anchor. Due to the high yield farming income, the minting rate of crvUSD is also high. The common practice of DeFi farming users is to mint other stablecoins at a low rate and exchange them for crvUSD through stablecoin swaps to engage in DeFi farming. This arbitrage behavior based on interest rate differences creates demand for crvUSD in the secondary market, which may lead to upward deviation from the anchor. The solution to this upward deviation for crvUSD is also very straightforward: directly minting crvUSD without collateral through pegkeeper and selling it in the relevant liquidity pool of Curve V1. This approach differs from the MakerDAO PSM mechanism in that pegkeeper has almost no financial cost, and its model inherits the high capital efficiency of crvUSD.

crvUSD has gradually built a “cannon fodder ecosystem.” Before the theft at Conic Finance, crvUSD had established a three-tier ponzi structure with Curve, Convex, and Conic. After crvUSD is combined with various stablecoins to form 3pool or 4pool, the income can be passed on to Conic Finance. In the early stages, crvUSD accumulated about 150 million crvUSD in minting volume through this method. Prisma Finance was originally intended to be the fourth level of income after conic finance, but due to the theft at Conic finance, its reputation as part of the income was damaged, and Conic withdrew from the crvUSD cannon fodder ecosystem. Therefore, Prisma Finance essentially inherits the role of Conic Finance for crvUSD in terms of functionality, and its valuation logic is similar to that of Conic Finance.

In theory, crvUSD can continue to incubate more cannon fodder for crvUSD through Curve Finance and Convex ecosystem, which is a potential that other stablecoins do not inherently have. The AAVE and balancer cooperation theoretically aims to replicate the successful path of Curve Finance and its ecosystem, but there is still a long way to go.

Abracadabra

Abracadabra was born during the bull market and is a stablecoin protocol specifically designed for leverage. Its main purpose is to mint various stablecoins using yield-bearing assets with less liquidity as collateral and maintain price stability through the MIM-stablecoin secondary pool. Currently, most of the MIM liquidity is built on Curve, and MIM_spell officially maintains the stablecoin pool in two ways:

• Use $spell to vote for veCRV in the MIM-stablecoin pool.
• Additional spell token incentives for the MIM-stablecoin LP pool.

In fact, Abracadabra’s approach in the previous bull market cycle is likely to be repeated in the next bull market cycle. During a bull market cycle, there is a high demand for users to leverage their assets, hoping to earn interest without losing the interest income and pay a certain interest rate, while obtaining a highly liquid stablecoin and using it for leverage. The above model has two pain points: one is how to find popular and large-scale interest-bearing assets, and the other is how to maintain the liquidity of the newly minted stablecoin.

Abracadabra’s strategy at the end of ’21 was to find large-scale assets with broad user demand as collateral, and build a secondary liquidity pool to enable users to quickly leverage. At that time, Yearn Finance’s yETH pool was at its peak, with a large Total Value Locked (TVL). Therefore, abracadabra took advantage of yETH as collateral, minted the stablecoin $MIM, and achieved leverage through the MIM – stablecoin liquidity pool.

Since the main purpose of users using abracadebra is to leverage using MIM – stablecoin, the depth of the secondary liquidity pool is very important. Abracadabra achieved this by providing incentives for the MIM – stablecoin LP. The spell used to incentivize the MIM – stablecoin LP comes from Abracadabra’s spell repurchase from the secondary market and its ecosystem incentives.

Why can the value of $spell skyrocket 100 times in a short period of time? There are two main reasons:

• All interest income is used to directly repurchase spell, creating a high demand for spell and supporting a rich secondary liquidity. From the perspective of active and passive market making, $Spell has the potential to rise in price.

Abracadabra is a classic case of timing the DeFi ecosystem cycle, and in a sense, this model can “win repeatedly” in a bull market. However, the problem lies in the fact that Abracadabra’s rise in the previous cycle was mainly due to its successful acquisition of a large number of yield-bearing assets from Convex Finance and Yearn Finance. After going through a bear market, the next bull market cycle may introduce new asset categories, weakening the position of Convex and Yearn in the current DeFi field. Therefore, for the Abracadabra team, paying close attention to the changing situation of yield-bearing assets in the market and adjusting their market direction is the only way to maintain their advantage in full-chain liquidity.

From the current strategic adjustments, Abracadabra still maintains a friendly relationship with Yearn Finance, but also continues to explore opportunities in GMX and Kava Chain. Whether it can benefit from the changing market opportunities depends on whether MIM can discover more promising market opportunities before the market does.

Summary

The design of the stablecoin model fundamentally does not have a dark side, but when this model becomes a real-money casino, its dark attributes as a financial game are revealed. However, if we exclude its dark side and look at stablecoins from the perspective of user leverage and liquidity, they truly meet the needs of users. The matching of products and user needs is the righteous aspect of stablecoin protocols in Web3.

For stablecoins, “maintaining yields in a bear market and increasing leverage in a bull market” may be the correct path for stablecoin protocols. Lybra Finance reflects this logic with its rise in the bear market. However, the bear market will not last forever, and timely adjustments at the protocol level according to the market cycle must also be made. The bear market has been too long, and DeFi platforms and stablecoin protocols that require a high amount of liquidity have been dormant for too long. But as the bull market cycle arrives, abundant liquidity and capital will undoubtedly flow into the nearly dried-up DeFi liquidity. The gears of history will continue to turn along their original track, and we eagerly await what lies ahead…

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