A Plethora of Stablecoins: Price-Stable Protocol Utility Tokens

Imagine this: It’s the year 2020 and it turns out there’s no “single stablecoin to rule them all.” Instead, all utility tokens are now designed to be price-stable. Centralized crypto exchanges have either closed shop or refashioned themselves as underground gambling platforms. Decentralized exchanges power seamless, instantaneous and often automatic conversions between the various protocol tokens. Each one is pegged to some real-world basket of goods, often essentials like the price of food, water or housing. Capital is allocated efficiently and instantaneously to the most promising new projects and innovations. Investors are indistinguishable from users and are handsomely rewarded for spotting promising protocols and allocating their computational resources and governance expertise to support them.

Sounds pretty good right?

I believe there is a good chance this will actually happen and that price-stable protocol tokens will be more secure and preferable to universal stablecoins.

Below is an idea for a protocol utility token with stablecoin qualities that will limit speculation and pave the way for mass adoption of decentralized technologies. This can be achieved by putting a cap on the price of the token, thereby removing any expectations of passive profit.

Disclaimer* — It will probably also pass the Howey test, however I’m not a lawyer so this by no means constitutes legal advice.

Background — The Howey Test

In the US, the Howey test is used to determine if something is considered a security or not. If you end up selling an unregistered security to non-accredited investors, you may end up in big trouble with the SEC and will possibly have to face fines and rescind the sale (this means returning ALL funds to buyers). Obviously this is a big problem if you’re trying to do a public sale of tokens to raise funds for your world-changing decentralized protocol.

For a vivid example of what a lawsuit might look like, checkout the class action suit against Ripple or read about it on Cointelegraph.

So here is the actual test — if you answer YES to all of the questions below, your token is most likely a security.

  1. It is an investment of money
  2. There is an expectation of profits from the investment
  3. The investment of money is in a common enterprise

Any profit comes from the efforts of a promoter or third party

(source: https://consumer.findlaw.com/securities-law/what-is-the-howey-test.html)

Most tokens will probably satisfy points one through three. Point four is where there may be some wiggle room. The problem is that if you token is traded on the open market it is susceptible to speculation, and if people are buying it with the purpose of just holding it and waiting for the price to go up, then 4 is most likely a YES. (There is an effort to classify to treat some tokens as commodities, in which case it maybe ok for tokens to appreciate in value, but this is still uncertain and untested legal territory).

Speculation

Aside from current legal concerns, I would argue that speculation is a bad thing when it comes to building something useful. Speculation obscures the underlying value of the services a protocol may offer and in many cases reduces the incentives to actually make something useful. Why BUIDL when you can just pump-n-dump?

Extreme volatility can also potentially hurt people that are actually using the platform — for example if they join at the peak of a bubble and end up losing funds with a crash despite making valuable contributions.

At the same time, it’s important to offer a way to reward early adopters who are instrumental in the success of new protocols. Price-stable utility tokens may provide a way to do both of these things — offering greater rewards to early users as well as mitigating speculation.

Stablecoins

Stablecoins are what you think they are — stable. Their design includes an underlying mechanisms to maintain a stable price against some predefined metrics, like the price of USD. If you’re not sure about how they work, check out this great overview by Haseeb Qureshi before you continue:

*pay close attention to non-colleterized stablecoins

Stablecoins are not without risk. Maintaining a stable peg, to say USD is not easy and relies, to a degree, on social consensus around the value of the token, especially if it’s non-collateralized. This is particularly difficult for a general-use universal currencies because they don’t have fundamental underlying value. There is no clear reason to use one stablecoin over the other. There is always potential for these coins to crash to zero and never recover. Protocol-specific tokens are safer in this regard because they are backed by the value the protocol is able to generate (more on this later).

Designing a Stable Protocol Token

One can easily implement a stablecoin mechanism within a protocol-specific utility token. For example, you can create a smart contract that can mint and sell a token for $1 at any given time. We have now put a hard cap of $1 on our token. The proceeds from the sale go into a rewardPool and can be distributed to users who provide services to the network in proportion to their staked tokens — running full nodes, validating transactions, participating in governance etc.

The smart contract can then observe the actual value of the token on the open market and start increasing the reward payouts if the price starts to decrease. Say we have $1M in our rewardPool. We can define a rewardEpoch (ex. 3 months), and set our rewardRate for that time at 1 — actualTokenPrice. So if the price falls to $.9 the rewardRate is 1 — .9 = .1 or 10%. As the token drops in value, there’s a greater opportunity to earn rewards, increasing the demand for the token and putting upward pressure on the price. Even in the case of an extreme market-wide crash, the protocol will be able to make steady payouts to users doing valuable work for the full duration of the rewardEpoch, giving ample time for the price to recover.

Of course if the price is still $0 after the expiration of the rewardEpoch, the treasury will run out of money and will be unable to pay rewards. In this case the protocol can start issuing IOUs — the right to redeem rewards at some point in the future. If the protocol is able to provide valuable services to real people, it will be able to recover from such an extreme scenario. The token price is unlikely to go to $0, because its price is always backed by future utility.

*In order to properly incentivize early adopters, it will probably make sense to offer a greater reward rate (earlyAdopterIncentiveRate) up-front that gradually decreases as the protocol matures — similar to bitcoin inflation rate schedule.

Definitions:

backingCurrency — Currency used to purchase the stable token (like ETH).

rewardPool — A reserve pool of the backingCurrency held by the contract. When users buy the token with ETH, the ETH gets added to the rewardPool and is slowly paid out as incentiveRewards.

incentiveRewards — Rewards paid out to users contributing work to the protocol. Rewards are paid out in proportion to the user’s stake.

actualTokenPrice — The price of the token traded on the open market.

rewardRate — Percentage of the incentive Rewards to be distributed during the rewardEpoch.

rewardEpoch — The time it takes to distributed the current rewards at the current rewardRate. This could potentially be the half-life of the rewardPool.

earlyAdopterIncentiveRate — Incentive rate paid out to early adopters (similar to inflation rate). Starts out a given % and goes to % over time.

Stable Protocol Tokens are Safer Than Stablecoins!

Universal non-collateralized stablecoins don’t offer any underlying value so they will inherently be less trustworthy than a stable utility token of a widely-used and valuable protocol. In other words, a universal non-collateralized stablecoin like basis (aka basecoin), necessitates continuous growth to sustain its price. A stable protocol token needs one of two things: user growth or users willing to pay for its services. So its possible to mirror traditional startup evolution — at first the stability is driven by growth and eventually transitions to the monetization phase.

During the growth phase, there are more users joining the protocol, buying tokens and staking them to perform work and earn rewards. This puts upward pressure on the price, stabilizing it and increasing the rewardPool. As the pace of growth slows, a need emerges to monetize the protocol.

The monetization phase involves a token sink dynamic: taking tokens out of circulation by burning them. This can be accomplished by offering protocol-level services. Once a user purchases a service, the tokens are burned, decreasing the overall supply and propping up the price. This allows the protocol to reach a state equilibrium — the demand for services paid for by consumers (users consuming services) are balanced by the rewards reaped by the producers (users doing valuable work).

Hypothetical Scenario

Lets imagine a decentralized Twitter app called Dwit. The founders launch a DWT token capped at $1. It shows great promise as investors pile in and $20M worth of tokens are sold in a public sale. The company retains $10M for operational expenses and deposits the remaining $10M into a contract as the initial rewardPool. Anyone can purchase as many new DWT tokens for $1 from this smart contract for the rest of time, thereby contributing to the rewardPool. The funds in the contract cannot be withdrawn manually and from now on can only be distributed as rewards. The early adopter incentive reward rate is set at 10%, gradually decreasing to 0% over 10 years.

During a crypto flash-crash of 2019 the price of the token temporarily drops to $0.10. The incentive rewards are automatically adjusted to maintain a steady rate of rewards (paying more ETH in a given time period). This quickly restores faith in the DWT token and the price rebounds to just under $1 within a few days.

Within a few years, Dwit becomes successful, experiences wild growth and the reward pool balloons to $800M. The price hovers around $.98 and early users were able to earn significant rewards at a 2% standard reward rate plus a 10% early adopter rate of the ever-growing rewards pool.

As the growth rate slows, the 10% early adopter rate approaches 0%. Luckily the protocol supports a decentralized advertising exchange where anyone can pay some DWT tokens to promote content. When advertisers purchase DWT tokens to promote content, the money they spend goes to the rewardPool and gets redistributed to users providing curation services and running the Dwit nodes. When advertisers pay for promoted content, the tokens get burned, reducing the token supply and maintaining upward pressure on the price. After 10 years the platform is doing great and DWT token are still trading at $1.

Risks and Concerns

Below are just some initial thoughts on possible issues with this design. If you think of any game-theoretic or economic or legal issues feel free to leave comments below.

Protocol Failure

If the protocol fails to live up to its potential and fails to attract users the price of the token will drop to $0. To offset this risk it is important to be able to offer greater opportunities to earn rewards to early adopters as the protocol grows. This is the reason for the earlyAdopterIncentiveRate. My belief is that utility tokens will actually fail quicker as they don’t have a chance of being artificially propped up by speculators. This will enable a much better analysis of potential risks and rewards and mitigate manipulation and losses.

Volatility of Backing a Currency

Next to the failure of the underlying protocol, the price of actual backing currency is a big risk. Although the utility token is pegged to the dollar, its is most likely purchased with a volatile cryptocurrency like Ethereum. This exposes the incentivePool to risk — if ETH goes to $0 the rewards distributed by the contract will be worthless. However if the underlying protocol is able to offer value, it is possible to recover from this situation. For example, the contract could be forked to be used with a different cryptocurrency and issue IOUs for future payouts as growth recovers.

Incentivizing Early Adopters

It’s important to design a dynamic that appropriately rewards early adopters for the risk they take on. I think it is possible to use earlyAdopterIncentiveRate to do this. However, psychologically it may still be difficult for users to justify purchasing a token that is guaranteed to never increase in value. One may consider designing a token that slowly increases in value over time, possibly using a quadratic bonding curve. Another options could be having a two-token model where with an additional security token that allows earning passive income and is sold to accredited investors.

Access to Incentive Pool

In order to fully guarantee that no single party can drive the price of the token to $0, no one should have access to the funds held in the contract. If they do, they can continuously re-use the funds to buy more tokens, generating an infinite supply and driving the price to $0. It would be valuable, however, if there was a process for diversifying the reserve currency to mitigate dependency on a single currency.

Token Velocity Problem

Protocol-specific payment tokens that don’t provide an incentive to HODL will go to zero (read more here). The important distinction in the case of price-stable utility tokens is that users are required to stake them in order provide services to the network and thereby earn rewards. As a result there is an incentive to hold the token, but only for those who actually provide services to the protocol.

Incentive Reward design

It’s important to design incentives in such a way so as not to prioritize large stake holders from earning a bigger portion of the rewards as smaller ones. Distribution of rewards should be linear in relation to stake.

Conclusion

These a very early ideas and design examples for a price-stable utility tokens. There are many variations of the mechanism to explore and test. We hope to keep working on these designs and implement and test them as part of the protocols we are developing for Relevant. If you are working on similar ideas, we’d love to hear from you! Get in touch via Slack or Twitter.

Thanks to Jehan for the fruitful conversations.

read original article here