The problem: Our traditional central bank-based and fiat currency-centered global financial system established aftermath the World War II has exhausted its viability. Loose monetary policies of central banks to stimulate economic growth led to systematic failures, including asset price bubble in early 2000s, the global financial crisis in 2008, and spiraling inflation in 2022. There is a growing consensus among investors and academics that monetary policy is political not technical, further eroding credibility of world’s central banks as neutral and unbiased guardians of global economy .
Recent developments in blockchain technology have enabled the alternative decentralized finance (DeFi) model based on secure distributed ledgers in which a variety of crypto assets circulate. The DeFi system substitutes for banks and other centralized financial institutions in managing money, financial products, and financial services. Unlike traditional financial instruments, such as fiat currencies and securities, digital assets, including cryptocurrencies and security tokens, offer fast, secure, reliable, and low cost transactions .
Valuations of digital assets, led by two largest cryptocurrencies – Bitcoin (BTC) and Ethereum (ETH) – have greatly increased in the last decade, and their risk-adjusted returns (measured by Sharpe ratio) were on par with or exceeded high-performing traditional assets . A rapidly growing number of investors now have digital assets in their portfolios. Digital assets’ prices and returns have significantly higher volatility than those of fiat currencies, securities, and physical assets, such as gold . This constitutes a major challenge for their widespread adoption.
In theory, the volatility problem can be solved by creating efficient portfolios of digital asset classes that balance their risks and returns . Until recently, the main solution to volatility of digital assets has been their collaterization by fiat (e.g., USDT and USDC), other crypto assets (DAI) or physical assets, such as gold (GDX).
Recent innovations in the blockchain industry that led to emergence of algorithmic instruments provide an alternative solution to the volatility problem. Unlike collateralized solutions, algorithmic instruments are backed by an onchain algorithm that regulates the supply and demand of a digital asset . Performance of algorithmic instruments depends critically on their economic design. This point is well illustrated by the demise of Terra (UST) whose peg to USD collapsed. A number of analyses have attributed the collapse of UST to flawed economic foundations of its key lending protocol, Anchor [6, 12].
Possible Approach: I will not name the project here, but it uses a dual-token algorithm that 1) combines scarcity pricing with 2) the Proof-of-Burn cryptographic mechanism to achieve a low volatility asset for managing risks in crypto denominated portfolios. This limits volatility resulting from sharp declines in demand for digital assets akin to those that led to debacle of UST. The algorithm does not result in a stablecoin. Instead, in line with the modern portfolio theory, it’s main purpose is to reduce the risk of holding a digital asset portfolio by combining instruments whose returns are correlated but exhibit different degrees of volatility. Do you know of any other DeFi projects that function as risk-hedging instruments? I think this is a fascinating area of discussion given how volatile crypto can be. Would be amazing to hold onto a token that retains its value relative to big market corrections and downswings.
3] Caginalp, Carey, and Gunduz Caginalp, “Opinion: Valuation, Liquidity Price, and Stability of Cryptocurrencies” in: Proceedings of the National Academy of Sciences 115: 1131−34; 2018)
6] Gen,¸ Ekin, “Algorithmic Stablecoins: What They Are and How They Can Go Terribly Wrong” in: Coindesk Crypto Explainer+:) https://www coindesk.com/learn/algorithmic-stablecoins-what-they-are-and-how-they-can-go-terribly-wrong/; 2022
7] Hileman, Garrick, and Michel Rauchs, “Global Cryptocurrency Benchmarking Study” in: Cambridge Centre for Alternative Finance. Cambridge: Cambridge Judge Business School, University of Cambridge; 2017)
9] Liu, Yukun, and Aleh Tsyvinski, “Risks and Returns of Cryptocurrency” in: The Review of Financial Studies. 34.6: 2689−2727; 2021)
11] Markowitz, Harry M., “Portfolio Selection” in: The Journal of Finance. 7(1): 77−91; 1952)
12] Onchain Wizard, “Understanding the Mechanics of the Rise & Fall of LUNA/UST” in: Onchain Wizard’s Newsletter:) https:// onchainwizard.substack.com/p/onchain-wizard-understanding-the; 2022
14] Tooze, Adam, “The Death of the Central Bank Myth” in: Foreign Policy:) https:// foreignpolicy.com/2020/05/13/european-central-bank-myth-monetary-policy-german-court-ruling; 2020