Crypto's holy grail
Stablecoins have become an essential part of the crypto ecosystem, providing a much-needed layer of stability and predictability to an otherwise volatile market. These digital assets are designed to maintain a stable value, usually pegged to a fiat currency such as the US dollar, by holding reserves of that currency or through algorithmic mechanisms.
Currently, stablecoins represent more than 10% of the entire crypto market capitalization, exceeding $120 billion, according to data from CoinGecko. They offer several advantages over traditional cryptocurrencies, such as lower volatility, faster settlement times, and lower transaction fees. However, recent events have highlighted a critical issue with stablecoins: counterparty risk.
Last week, the collapse of Silvergate Bank and Silicon Valley Bank resulted in the two largest stablecoins, DAI and USDC, losing their peg against the dollar. At the time of writing, both coins were trading below $0.96, raising concerns about their stability and viability as a means of exchange and store of value.
Counterparty risk is inherent in most existing stablecoins, which are backed by reserves held by banks or other third-party intermediaries. This creates a single point of failure that can be exploited by bad actors or affected by systemic shocks, such as bank failures or regulatory actions. Hence, there is a need for a stablecoin that is fully decentralized and has zero counterparty risk.
While several attempts have been made to create such a stablecoin, they have not been successful so far. DAI, for instance, is overcollateralized, meaning that more than $1 is needed to create $1 of DAI, making it capital inefficient. UST, an algorithmic stablecoin, had Ponzi-like characteristics and crashed spectacularly last year.
A possible solution proposed by BitMEX CEO Arthur Hayes is the creation of a synthetic USD, the Nakamoto USD (NUSD), that is pegged to the USD using spot Bitcoin and perpetual contracts. By using Bitcoin and BitMEX futures contracts, it is possible to create a synthetic stable asset that maintains a $1.00 price regardless of Bitcoin's price movements. This NUSD can be stored outside the traditional banking system.
The mechanics of this solution are somewhat straightforward. Imagine you have one Bitcoin worth $1.00 that you want to use to create a synthetic stable asset that maintains the $1.00 price even if Bitcoin's value changes. To do so, you deposit your one Bitcoin worth $1.00 on an exchange and purchase an inverse perpetual swap (XBTUSD on BitMex) with the payoff function $1/Bitcoin price in USD.
Let’s take a look at the mechanics of this novel solution. Imagine you have 1 bitcoin that is currently worth $1.00. You would like to use this bitcoin to crease a synthetic stable asset that maintains the $1.00 price if bitcoin rises or falls. To do so you deposit your 1 bitcoin worth $1.00 on an exchange and then you purchase an inverse perpetual swap with the payoff function $1 / Bitcoin price in USD. The properties of this function is such that:
-If bitcoin is worth $1.00 then the bitcoin value of the perpetual swap XBTUSD is 1 BTC (1/1)
-if bitcoin is worth $10.00 then the bitcoin value of the perpetual swap is $1/10 or .1 BTC.
-If bitcoin is worth $0.10 then the bitcoin value of the perpetual swap is $1 / .1 or 10 BTC
Bitcoin price falls from $1 to $0.1.
Value of XBTUSD Swap in BTC = $1 / $0.1 = 10 BTC
PNL of XBTUSD Swap Position = 10 BTC (current value) — 1 BTC (initial value) = +9 BTC
I have 1 BTC deposited as margin with the exchange.
The total equity balance on the exchange is 1 BTC (my initial deposit) + 9 BTC (my profit from the XBTUSD position), and the total balance is now 10 BTC.
The Bitcoin price is now $0.1, but I have 10 BTC, and therefore the USD value of the total portfolio is unchanged at $1, $0.1 * 10 BTC
Bitcoin price rises from $1 to $100.
Value of XBTUSD Swap in BTC = $1 / $100 = 0.01 BTC
PNL of XBTUSD Swap Position = 0.01 BTC (current value) — 1 BTC (initial value) = -0.99 BTC (i’m losing money)
I have 1 BTC deposited as margin with the exchange.
The total equity balance on the exchange is 1 BTC (initial deposit) — 0.99 BTC (loss from my XBTUSD position), and my total balance is now 0.01 BTC.
The Bitcoin price is now $100, but I have 0.01 BTC, and therefore the USD value of the total portfolio is unchanged at $1, $100 * 0.01 BTC.
This proposed solution could be the holy grail of crypto, a crypto-native stable coin that has zero counterparty risk. It is fully decentralized and not subject to the control of any single entity, making it much less susceptible to the types of failures that caused USDC and USDT to lose their pegs. Moreover, it is not overcollateralized, as is the case with DAI, and it avoids the Ponzi-like characteristics of UST.
The creation of NUSD could usher in a new era of stability and growth for the crypto industry. It would allow traders and investors to hedge against volatility, access liquidity, and enjoy lower transaction fees, all while minimizing counterparty risk. It could also provide a powerful tool for individuals and businesses to protect themselves against currency devaluation and other economic risks.
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