Malt Protocol — The answer to the algo stablecoin question
If you have been following the world of algorithmic stablecoins over the last several months you will be aware of the issues that they are all facing. None of them are able to hold their peg and many of them are suffering from manipulation by big players. This has highlighted the ever growing need to rethink the ideas behind algo stablecoins from first principals — learning from the mistakes of the coins and forks of those coins that have come before.
Malt is a brand new, built from scratch stablecoin that aims to address many of the issues plaguing the existing algo stablecoins. It is currently in active development and is due to launch sometime over the next month. This article is an attempt to highlight all of the issues we see with existing algo stablecoins and tease some of the innovations that Malt brings to the table to solve them.
The problems
Show me the incentive and I’ll show you the outcome — Charlie Munger
To set the stage I am going to be talking specifically about ESD/DSD and other forks as they are the biggest players in the algo stablecoin space right now.
Here is a quick list of issues we see with those protocols and we will further elaborate on each of them throughout this post.
- Lack of real incentives to sell just above and buy just below peg.
- Whales and early adopters accumulate massive amounts of coins which can be used to manipulate price later.
- Any attempt at stability is on a lag due to bonding lockup periods.
- Expiring debt with an arbitrary premium creates unnecessary risk for the people trying to help the project.
- Mechanism of stability (ie increase supply above peg and decrease supply in under peg) is ineffective first order thinking.
- Speculators don’t make money when the coin is actually stable
The underpinning of each of these issues is a misalignment of incentives. A truly good solution to the algo stablecoin problem would be a protocol with a set of incentives that genuinely aligns most actors with the protocol itself. All of the above issues are at direct odds with that idea as they each align the incentive against the protocol.
Let’s dig into each of them in more detail:
Lack of real incentives to sell just above and buy just below peg.
The lack of good incentive structures is an underlying theme of the current implementations of algo stablecoins.
When above peg there is no immediate incentive to sell (which is what is needed to bring price back to peg). Instead the incentive is to hold because the coin is about to go into expansion and users will earn rewards. That is the exact opposite behaviour of what is desired.
Below peg there is no immediate incentive to buy. The only mechanism in place is coupons, but they don’t directly encourage buying. If anything people want to wait for price to fall further to get juicier premiums on the coupons. Swing traders also want to wait for lower prices before buying. The coin needs immediate buying to bring it back to peg, not supply reduction that takes its time.
Whales and early adopters accumulate massive amounts of coins which can be used to manipulate price later.
You have got to get in early if you want to make the money
Let’s be honest, most early adopters of projects like this don’t really care about the protocol itself — they are in it to make money. Protocols kind of understand this in that they offer increased rewards during the early phase of a coin to attract these speculators in and reward them for the risk they are taking.
However, when thinking about this process through the lens of incentives things start to break down.
The protocol is giving a ton of coins to people who just want to make money. However, for them to realise that profit they need to sell those coins. That selling pushes price down and usually down far enough to take the coin below peg. Price above peg is easy to fix because the protocol has direct ability to mint new coins. Price below peg on the other hand is the hardest place for the protocol to rectify. So here we have what seems like a good idea on the surface — attracting early adopters — turning into a situation where the protocol has incentivized pushing the price into the area it has the hardest time fixing.
This is compounded further when the early adopters and whales can use their large stacks to manipulate price further to make even more money. This is really highlighted with the current situation with DSD price suppression attempting to force expiry of 80m+ debt coupons to permanently burn supply.
Any attempt at stability is on a lag due to bonding lockup periods.
I’m going to be blunt. Lockup periods on bonding is lazy. It is a lazy attempt at locking up supply and / or stopping people from selling their tokens in an attempt to try generate asymmetry in the supply/demand. And what other purpose does it serve? In some sense it is a band aid over the issue mentioned above where early adopters accumulate a lot of coins. The protocol admits these people are accumulating a lot and will probably sell so we will band aid that problem by forceably stopping them from selling for 12/24/36 epochs etc.
Again, let’s think about this through the lens of incentives.
On one hand the protocol wants to reach stability, which requires selling above peg and buying below. Simple as that. However, to counteract the massive amounts of coins being accumulated they enforce a lockup.
So what ends up happening? Well for a start any sell pressure above peg can only come in after a user has waited a few epochs of expansion to gain some rewards plus the lockup period. So that sell pressure reeeeaaallly takes it’s time arriving to the party and in the meantime price is allowed to happily grow well above peg.
To make things worse everyone is on the same lockup period and will unbond at similar times to try beat the crowd. So the sell pressure arrives late and all at once. This creates massive overshoot to the downside.
So in an attempt to stop selling, the lockup ensures all the selling happens at once instead of randomly distributed over time and it happens much later than the protocol needs. This means price will overshoot to the upside as we wait for the lockup period then overshoot to the downside when everyone sells at the same time.
Lockup increases price volatility.
Expiring debt with an arbitrary premium creates unnecessary risk for the people trying to help the project.
Speculators are looking for asymmetrical opportunities to make money. People who engage in the protocol’s debt mechanism are trying to help the protocol and the protocol is rewarding them for it. However, the debt mechanism of ESD/DSD also means the speculator could lose 100% of their capital (I know dsd are working on a proposal to avoid this though, which is great).
The risk of losing 100% of the principal is a psychological risk too far for many investors, even if the opportunity has positive expectancy overall. This can be seen in the current aversion to purchasing debt from these protocols. Structuring the deal as 100% loss on the downside and 45% gain on the upside just isn’t that attractive. That doesn’t mean it’s not profitable — the win rate is likely good enough to make it a profitable trade. But it’s definitely not a comfortable trade, and that shouldn’t be overlooked. Trade comfort is a big factor that will determine what trades people make in practice.
So one may ask why not just let the coupons never expire? Well that isn’t good either because then there is no way for the token supply to ever meaningfully contract. The entire point of expiring debt is that it results in a permanent burn of supply — which hopefully results in some kind of supply/demand change that leads to upward price movement back to peg.
What if there was a way to guarantee supply contraction when under peg without the need for expiring debt and therefore without the need for unnecessary risk to investors?
We aren’t saying too much just yet, but Malt has a solution that is exactly that. More info will be released closer to launch.
Mechanism of stability (ie increase supply above peg and decrease supply in under peg) is ineffective first order thinking.
The only thing that corrects price above peg is selling and the only thing that brings price back up to peg when below is buying. Everything else is just noise. Yes, econ 101 tells us that increasing the supply with a constant demand will bring price down and decreasing supply with constant demand will bring price up. But these actions are one step removed from what really needs to happen. If no one is buying or selling the price does not move. Period. Everything else is just an attempt to stimulate buying and selling imbalances.
When above peg, existing coins increases supply (econ 101 checked) but gives that increased supply to people who can’t sell it immediately. Below peg users can voluntarily burn supply (econ 101 checked) but in practice its existing holders burning with no new buying activity.
If true stability is to ever be achieved, incentives must be realigned with the true market moving activity — buying and selling — instead of second order actions like supply changes.
Speculators don’t make money when the coin is actually stable
The goal of a stable coin is to be stable. Surprising isn’t it? The mechanism of this stability in algo stablecoins is incentivizing users to participate in the protocol. That participation is what provides the stability. Unfortunately, the only way to make money in current implementations is through extended expansion and debt cycles. The incentives encourage instability, not stability.
This may be the single biggest misalignment of incentives in these protocols. It’s in every investors best interests for the price to swing hard around peg without ever reaching stability, that is where they make the most money.
Roundup
The existing algo stablecoins are littered with misaligned incentives that mean the protocols will likely never achieve anything that resembles true stability.
We understand that it’s a bit of a tease to tell you all of these issues but not explain how Malt addresses them. But we will say that Malt addresses each and every one of these issues in a way that (in our opinion) far better aligns incentives for all market participants.
Speculators will still be able to speculate. Early adopters will still get rewarded fairly for the risk they take in becoming early users of the protocol. And all other issues above are addressed in turn as well.
More info will be released over the coming weeks.
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