My Second Appearance on the Blockchain Debate Podcast with Sam Kazemian

Motion: Algo and fractional stablecoins are flawed (Bennett Tomlin vs. Sam Kazemian) The Blockchain Debate Podcast

Guests:Bennett Tomlin ( Kazemian ( Yan (’s motion is “Algo and fraction stablecoins are flawed.”A good stablecoin can sustainably hold its peg, and recover quickly from a premium or discount. This is a basic requirement for stablecoins. An obvious design is the bank coin model, where coins are backed 1-to-1 by fiat. But this creates a single point of failure and incurs compliance overhead. Hence MakerDAO, which made a smart contract driven stablecoin, and is de-coupled from the banking system. But it requires over-collateralization. So new designs popped up and tried to make the next capital-efficient stablecoin to allow under-collateralization, with innovative collateral adjustment mechanisms. We call these algorithmic and fractional stablecoins. Historically, most of these coins failed to hold their pegs. Is there a fundamental problem? Or can these challenges be overcome?The two debaters today include the founder of an algo/fractional stablecoin that has been holding its peg relatively well since launch, that is about half a year, as well as a well-known critic of various stablecoins.If you’re into crypto and like to hear two sides of the story, be sure to also check out our previous episodes. We’ve featured some of the best known thinkers in the crypto space.If you would like to debate or want to nominate someone, please DM me at @blockdebate on Twitter.Please note that nothing in our podcast should be construed as financial advice.Source of select items discussed in the debate (and supplemental material):Dragonfly research on FRAX stablecoin: Tomlin article on FEI stablecoin: stablecoin: Tomlin blog (mostly crypto): DAO's Black Thursday: bios:Bennett Tomlin regularly publishes articles about fraud in the crypto space via his blog. His dayjob is data scientist and fraud investigator in the pharmacy benefits area.Sam Kazemian is cofounder and CEO of Frax Finance, a stablecoin project that brands itself as the world's first "fractional-algorithmic" stablecoin. Sam also started Everipedia, the first decentralized online encyclopedia on the blockchain.

I returned to the Blockchain Debate podcast and in this episode I debated whether or algorithmic stablecoins are a valuable idea. I reference several different pieces of my work, so will drop the links to them below.

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$ALCX: Alchemix Cannot Turn Lead to Gold

There is a brand new DeFi protocol that lets you immediately take out a loan for half your collateral and the protocol will automatically pay back your loan. Financial magic, involving transmuting one coin, into another, while depositing one in a pool, magically you can get a loan and have no risk of liquidations (not really but that’s what people are claiming [1, 2, 3, 4, 5, 6, and the coup de grace their website (archive)]). I think this protocol is flawed. You can find the whitepaper here. (Archive) (My copy)

Continue reading “$ALCX: Alchemix Cannot Turn Lead to Gold”

How Does a Stablecoin Make Money?

Note: This is an old post with some minor flaws, I am posting it here in protest of Medium.

This post is prompted by something interesting I have noted in the cryptocurrency space, namely that there has been a significant proliferation of so called “stablecoins.” Besides the proliferation there has also been recent VC investment into some of them, making me wonder, “how does a stable coin make money for a VC?” Let’s look into this and make sure everything adds up.

Update: I published a deep look at the Basis protocol here.

Let’s start with Basecoin, oh wait I mean Basis Protocol. This “stablecoin” has raised well over $100 million dollars from VC investors. I’m worried about these investors, many coming from top firms after looking at the economics of this BitShares 2.0 (Worry anyone else that the founder of that project is the founder of the new $4,000,000,000 darling EOS?). The way it works as best as I understand is using a three-token system. The tokens are as follows:

  1. Base Shares
  2. Base Coins
  3. Base Bonds

The base shares are created in the genesis block and all new base coins go to them as “dividends” (holy shit I hope they spent some of that $100 million on Securities lawyers). The base coins are a separate coin that is issued to holders of the base shares when the price of the base coin exceeds peg, in theory diluting their value and bringing the value back to peg. Base bonds are issued when the value falls below peg. When this happens you can purchase a Base bond for the current value so say $.80 and then redeem it for $1.

Now where this gets even trickier is when it comes time to issue new coins is that it goes first in, first out. So it goes to the oldest bond holder first, and then continues down the line, and if there are in theory no bond holders then the coins are issued to the share holders.

Now what is the issue with this system? Economics mostly. Let’s start with what is the most obvious to me, my incentive if I am a whale and if this is liquidity is to become a large share holder, and then whenever I get a dividend to immediately sell it, purchase bonds, wait for them to redeem, and then dump again. If the market gets too big for me to do this alone, I do what all the whales are already doing in crypto and organize this process with a few other people.

The second problem and the more troubling one, where this needs more investors always coming in (gotta maintain the stability fund they talk about) is better captured by Preston Byrne than I could: “It seems to me on this very cursory review that Basecoin depends on

  • Printing free money and giving it to crypto-investors who are inclined to hold it and thus restrict supply;
  • Providing financial incentives to subsequent investors to introduce money into the scheme and subsidize the price of the scheme if the price of a coin should fall below a certain level (say, $1);
  • Vulnerable to a not-at-all-decentralized reliance on price indicators provided by unsupervised, unregulated third-party trading venues already suspected of serious shenanigans;
  • Granting primary benefits of the scheme to early buyers in an unregulated ICO;
  • Where every participant is betting on the price of their assets rising;
  • Which cannot sustain itself without finding new buyers for $BASE.”

Now the question that is blowing my mind is why the investment in this from VC firms? And then I figured it out. The reason this stablecoin has gotten so much investment is because of the structure of the shares. When they buy their shares they are trying to basically buy money printing machines they will continue to issue them dividends, as they accumulate the follies of every retail investor who purchases the coin to use to trade in the crypto world. They’re trying to profit of a couple really nice facts.

  1. Many cryptocurrencies banks have no strong fiat on-ramp and thus depend on stablecoins like Basis protocol for people to trade, creating built in buy pressure.
  2. The initial purchase of shares will allow for the stability fund to maintain the peg long enough for them to cash out their investment.
  3. Plus, if the price of cryptocurrencies continue to rise and more people are purchasing then they can continue to print money for longer.

Not exactly a great product for all of us.

Update: I wrote an in depth look at MakerDAO, Dai, and MKR here.

Update: I wrote a thorough follow-up on Dai and MKR after the transition to multi collateral Dai that can be found here.

So let’s look briefly at another stablecoin. This time MakerDAO.

MakerDAO which issues DAI confuses me because I cannot figure out the advantage to using it. Basically you put up about a whole bunch more money than you want in Ether. They then issue the Dai. So say you wanted $1,000 worth of Dai, you need to overcollaterize and put up let’s say $1,500. Now why would you do this instead of trading into the much more stable USD? Good question. I cannot for the life of me figure it out.

Best part is though how vulnerable this system is. Let’s say that tomorrow there is a another horrible event on Ethereum. Think like the DAO hack, but larger, and they are unable to achieve consensus to roll the chain back. The value of Ethereum plummets and then you are not overcollaterized, you are undercollaterized and the value plummets.

There is also a bunch of the same algorithmic BS that Basis Protocol and BitShares try to use to maintain their value thrown in for good measure.

Oh and the best part if they do end up undercollaterized? They dilute the pooled Ethereum so you can no longer claim back the same amount of Ethereum you put in. How’s that for a fun little twist?

So well I’m confused about this, at least it’s clear how they make money. To pay back their “Stability fee” you need to use their MKR token.

Worst of all? It hasn’t maintained it’s peg.

Finally, we need to discuss the elephant in the room. The one who’s imminent collapse will also be the black swan event that destroys MakerDao and wipes out a ton of value in the crypto ecosystem. Tether. I am not going to go back over ground that has been thoroughly covered, so just read everything Bitfinex’ed said. But more than that, it is supposedly backed, with no audits, and no convertibility yet trades with no counterparty or insolvency risk even when bank accounts get seized.

Plus, it’s linked to Bitfinex, which has also been linked to the delightful market makers over at Cumberland mining as Spoofy McSpoofface detailed already. Namely bad.

Though if you want me to answer how does Tether make money, again I’m not exactly sure, best guess I have is they don’t and it’s all used for money laundering. (Remember Kraken let’s you trade fiat into Tether with no fees, but won’t let you trade using Tether).

Update: I wrote a piece discussing recent developments in Tether here.

Update: I wrote a summary of the Bitfinex and Tether controversy here.

Update: Okay so Tether makes money in two ways, 1. a ten basis points charge on Tether purchases, and 2. Interest on the money held. However, it is still an open question as to whether or not they are actually earning interest due to the complexity of their current banking situation.

That’s the secret behind all of these stablecoins. They hide behind their algorithms and everything else, but they all rely on market-making bots in order to maintain their pegs. Some even outright admit it, like Basis with their “Stability Fund” or this one which is just beautiful:

If you still are in doubt, ask George Soros about what happens when someone tries to peg something. In his case he got rich. For many people in this case they will get caught holding a bag. If you are going to trade crypto, then trade responsibly and do it with real fiat on ramps not magic pegged currencies. And as always nothing I say is legal or financial advice, I’m just an angry guy on the internet.

Update: Added clarifying comment about nature of Cumberland mining.


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