Stablecoin as a Catalyst for DeFi Ecosystem Expansion

Gongpil Choi

Abstract

This paper explains a new breed of stablecoin specifically designed for decentralized finance (DeFi) ecosystem expansion. It differs from earlier versions by specifically addressing the needs of DeFi participants, who constantly face frictions related to volatility, slippage, and forced liquidation. The so-called DeFi stablecoin is designed specifically to satisfy critical requirements for promoting the DeFi ecosystem by providing reduced volatility, improved capital efficiency, and better decentralization over a long-term period of time. Unlike other protocols for cross-border payment and value transfer, the current version tries to achieve the required stability of native protocol tokens, which act as catalysts for liquidity provision within the ecosystem. A grassroots DeFi stablecoin using the native protocol token requires the combinatorial use of centralized stablecoin, e.g., USDC, with specific choice parameters over volatility, slippage, and expected return. The eclectic approach to secure better liquidity instruments for DeFi depends on the use of fiat-backed stablecoin as a pillar to stabilize any native token with good disclosure and transparency. A preliminary empirical study shows that the current approach reduces volatility, allows more capital-efficient market transactions, and makes the financial system more resilient to different shocks. And future studies need to find whether this hybrid approach can serve as a prudential supervisory guideline for the DeFi ecosystem and embrace the multi-collateral mix.

Keywords: Decentralization, DeFi, stablecoin, tokenomics.

G. Choi is a Director of the Korea Fintech Society, Seoul, 02841, South Korea (e-mail: gpchoi88@outlook.com).

Corresponding author: G. Choi.

Received: September 10, 2022; Revised: October 15, 2022; Published: December 5, 2022.

Despite potential benefits and strong interests in stablecoin, there are few that can deliver de facto stability, if not easing frictions among DeFi transactions. There is a trade-off between technical feasibility of reaching proposed stability and the governance issue of keeping it over time. Stability usually implies a peg with the dollar, but this falls short of stability for those seeking stable purchasing power. And most stablecoins are vulnerable to inflationary bias due to its peg to fiat money, while native tokens suffer from market crashes related with the recurrent lack of market liquidity. As such, seeking “stability” in crypto world is still a tougher challenge: Some seek a decentralized strategy (e.g., DAI), while others stick to centralized stablecoin (e.g., USDT, USDC). There are also algorithm-based stablecoins that carry innovative technique, but records show less than satisfactory performance over time [6][8]. It turns out that the stability enjoyed by the fiat currencies carries enormous economic costs as shown by attempts in the crypto world to emulate the nominal peg on denomination. That is, it requires tremendous efforts by non-sovereign issuers to achieve reduced volatility, especially over longer time horizon. Regardless of the composition of collateral pool and ways to engage in stabilization mechanism, however, reduced volatility still is the most desired feature in the crypto-driven DeFi arena. Based on the reality check that favors reduced volatility over a hard peg with the dollar, the primary focus on stablecoin development in this paper lies in introducing common features that promote the DeFi ecosystem. Therefore, given the rapidly expanding volume of literature on stablecoins, we first emphasize the design principle in the construction of stablecoin primarily for DeFi applications.
The target-oriented construction of stablecoin has become necessary since the two different spheres of legacy and crypto remain separate even though they still are complementary toward a better alternative: The former needs new arena for expansion, and the latter needs legacy support for securing pledgeable collateral. Specifically, given the recent backlash against global stablecoins, e.g., Diem phase-out, Terra-Luna debacle, assessing the waters on a grand scale cannot help DeFi community to hold on to stablecoins for their own use. Against the backdrop of uncertain environment, the DeFi stablecoin provides practical aid to market participants with limited resources to allow them balanced means of payment and settlement. Lack of DeFi stablecoin reflects the hard reality where global stablecoins remain dominant even in DeFi applications, which spells trouble for native protocol coins to remain within its boundary. In fact, given the huge demands for community driven market needs, lack of DeFi stablecoin has led to heavier reliance on global stablecoins, which have hindered steady decentralization. Around 89% of all the transactions in DeFi revolve around the a few of key stablecoins (USDT, USDC, BUSD, and UST)1 . This is simply because of the huge collateral requirements that underpin all financial transactions in real as well as crypto world. And there is obvious discrepancy between the real needs for stablecoin and its supply. In fact, the necessary collateral requirements in DeFi are mostly available among centralized stablecoins, which are subject to existing regulations in one way or the other. However, the crypto world still lacks collateral resources to tackle various transactions without significant uncertainty. In the upcoming version of the stablecoin with the compliance requirements for KYC/AML fully satisfied, it should play a crucial role in expanding the crypto ecosystem as well as proving to be a reliable and convenient vehicle for value transfer among users. In a sense, DeFi stablecoin mitigates blockchain trilemma2 , especially by easing the tradeoff between decentralization and scalability.
The first part of this paper reports on the nature of liquidity in a DeFi setting, which examines the extra scalability of the TON3 ecosystem with the proposed stablecoin operation. This also requires investigation into the complex governance structure because there are tiers of decision-making for maximum interactions among participants, including various incentives related with endogenous tokens vesting to ensure liquidity within the system. Liquidity in DeFi stretches over various protocols and requires lots of interactions among stakeholders to sustain incentives for the secured liquidity over time. And the ensuing section holds empirical investigations into various configurations of parameter space about collateral pool and stability mechanism. The results would mostly confirm our conjecture that a specific legacy collateral with regulated assets needs to include the new collateral pool for stablecoin, where actual decomposition over legacy vs. crypto depends on simulation results and user preference. And the possible research extensions are summarized in the conclusion.

1.CoinMarketCap Top Stablecoin Tokens by Market Capitalization (as of March 10, 2022).
2.Finding a balance between the security, decentralization, and scalability is difficult on blockchain.
3.Native protocol token of Tokamak Network, CoinMarketCap.

The primary goal of securing native token with reduced volatility is derived from the needs for market liquidity. Lack of liquidity restricts the potential of native protocol tokens to play a bigger role, and it can be overcome via repeated transactions among existing protocols. Therefore, reduced volatility per se is not a sufficient condition where liquidity concerns stay imperative within the ecosystem. In fact, the salient feature of generating liquidity in DeFi is different with the legacy system and the ground-up approach for networked liquidity is closely related with staking. This endogenous generation of liquidity is innovative as it hinges on AMM (Automatic Market Maker) and DEX (Decentralized Exchange). We first need to face the reality where there is no central bank that supply stable liquidity and there is no workable short-term money market The primary goal of securing native token with reduced volatility is derived from the needs for market liquidity. Lack of liquidity restricts the potential of native protocol tokens to play a bigger role, and it can be overcome via repeated transactions among existing protocols. Therefore, reduced volatility per se is not a sufficient condition where liquidity concerns are still imperative within the ecosystem. In fact, the salient feature of generating liquidity in DeFi is different with the legacy system and the ground-up approach for networked liquidity is closely related with staking. This endogenous generation of liquidity is innovative as it hinges on AMM (Automatic Market Maker) and DEX (Decentralized Exchange). We first need to face the reality where there is no central bank that supply stable liquidity and there is no workable short-term money market equivalent, and no deposit insurance facilities. Further, the most pressing issue within the DeFi ecosystem is the lack of pledge-able collateral, which requires pre-defined level of stability in value among assets that can be secured. Since liquidity is not provided by the centralized entity, it is important to generate it in a decentralized manner. In this setting, it is critically important to start building liquidity using stablecoin before strengthening various reward programs for longer-term staking, not vice versa. At the least, we need to secure pledgeable collateral for stable liquidity provision. Therefore, in the early stage of development, most have centered on reducing volatility, which still is the number one problem for DeFi expansion. Over time, we also have realized the need for resilience against shocks and efficient market transactions with less slippage. In short, reduced volatility, less slippage and stability remain the key design features for the DeFi expansion because these allow stable liquidity provision in a decentralized manner.
This paper differs from others by touching on wider aspects of transactions for liquidity in DeFi system; we expect stablecoin to help reduce volatility, slippage (impermanent loss) and ensure better protection against shocks for more active transactions for ecosystem expansion. Too often, native tokens are not used due to frictions that require extra costs and steps (e.g., gas fee, and extra- hopping). In this vein, the proposed stablecoin, TOK, should serve as reliable answers to easing frictions in the overall DeFi ecosystem. Alternatively, we seek the broader functions of stablecoin in the DeFi ecosystem in the absence of centralized trusted parties. It should not only provide extra cushion against volatility but also help participants to avoid frictions that captivate their efforts in a myopic manner. Due to its inherent weakness and lack of market infrastructures in the DeFi, huge efforts are necessary to engage in even basic market transactions, all without fully considering the longer-term impact on the projects and ecosystem. As such, we here define desirable stablecoin as a linker for stability and growth for a given ecosystem that is built around an open network, which calls for dynamic incorporation of legacy assets as needs for volatility moderation arise. If legally supported central banks cannot be allowed, then stablecoin remains the most efficient tools to expand the decentralized environment.
Fundamentally, liquidity needs to be generated by market transactions by many buyers and sellers. Even though market services are available for supplying temporary credit to enable transactions for liquidity constrained investors, the return to these services are eventually made possible via numerous interactions among market participants on shock-prone collateral base. There is lack of specific incentives for undertaking the project on a time consistent basis in the DeFi ecosystem, yet. The current reward program promotes closed liquidity mining instead of allowing more open and diverse applications outside. Users supply liquidity for an exchange pair on an AMM protocol, receive an LP token in return for the choice, and then stake the LP token for returns that are compensated in a project’s native token. This scheme gives third-party liquidity providers an incentive to supply liquidity for a token. In addition to generating greater cumulative fees on AMM swaps, incentivized by deeper liquidity, they could earn further yield by staking and receiving more of the project’s native token. However, it is unclear whether the resulting high APY promotes ecosystem buildup because there are few external links that can lead to solid returns. Therefore, it is expected that DeFi stablecoin should satisfy not only reduced volatility and balanced governance but also system considerations for balanced incentives for ecosystem expansion. That is, we need to have balanced incentive structure and the right governance to help promote DeFi ecosystem via proper liquidity provision. Therefore, the practical answer to address the liquidity problems in DeFi lies in hybrid stablecoin, i.e., a combination of crypto assets such that the legacy support in terms of its contributions that are explicitly measured and configured. Since the extra incentive to secure liquidity has close link with its volatility, the overall costs to maintain the liquidity throughout the DeFi protocols can be enormous. And even if large reserves can be secured via incentives, its sustainability cannot be enhanced since the underlying collateral pool is subject to various shocks with sizable adjustment for its collateral value and costs associated with increased benefits.
Besides, airdrops are also popular to promote a new project and achieve network effect by expanding the number of new token holders and further incentivize current token holders. As a result, sizable liquidity is generated and held for extra return without contributing to securing the dedicated liquidity for a specified project. In this manner, values get locked up in DeFi circle where exit stays sticky due to the efforts for securing liquidity and price. This creates vicious cycle, where extra issuance of tokens for a particular activity is soaked up mostly for short-term liquidity mining, which subsequently needs to seek extra lockup and stronger incentives to boost liquidity. A series of efforts to attract greater pool of resources for staking and liquidity mining cannot incentivize project-related activities, making stakes for higher return more attractive. For trading on DEX, liquidity is generated via staking in return for extra return. Since this type of market making remains dominant, massive liquidity mining immobilizes new token issuance, and the offered rate of return keeps on increasing until it hits sudden reversal. In short, this mechanism results in reduced liquidity in DeFi space, acting as a barrier for possible new entrants. What can be done to correct the situation? The design principle from the above observations highlights the challenge in the DeFi protocols to engineer incentives for securing stable liquidity without distorting market signals for consistent project implementation over time. This paper tries to address this issue by designing a workable option around stablecoin for the DeFi protocols.

Specifically, the current project also emphasizes the role of stablecoin in delivering balanced incentive to various DeFi participants so that no excessive incentives are channeled into securing short-term liquidity with possible detrimental effect over the longer time horizon. Given the lack of term structure in DeFi, extra efforts to help ensure transactions in DeFi can be saved by designing stablecoins in the first place. We derive achievable stability by making use of available stablecoins and strengthen growth momentum by helping native token to generate extra market dynamics for the network, which will be channeled into a momentum for the seigniorage that supports the proposed stablecoin. The degree of dependency on existing stablecoin, i.e., fiatbacked stablecoin is decided by market acceptance of native protocol token for its feasibility. By separating growth dynamics from its inherent volatility, the protocol tokens can help generate extra thrust for the ecosystem expansion. For fragile startups, a stable funding source stays the key factor for any subsequent efforts. Typically, an ICO (Initial Coin Offering) type of fund-raising has experienced serious problems, e.g., pumping and dumping, carpet pulling, front-running, yet the next alternative STO still remains an incomplete option for projects. Even though one can resolve the short-term uncertainty using no action letters in major countries (e.g., South Korea), things are still murky and requires constant liquidity provision with no clear prospects for the future. In this vein, a hybrid stablecoin project seems a realistic approach to secure essentials for the community buildup and enhance transaction volume by offering incipient trust base for the ecosystem.
It happens that the tailored Tokenomics can fail because of the dynamic changes in incentive structure over time in the presence of token vs. liquidity tradeoff. This picture is in stark contrast with the legacy counterpart where inflationary bias strengthens payment functions of fiat money. The endogenous constraints among stakeholders do not allow this aspect in crypto world, and the applicability as a means of payment is limited. The importance of securing DeFi stablecoin stands out from the reality where centralized stablecoins play the role of vehicle currency even in areas where more tailored protocol token is relevant. We specifically target the beneficial role of stablecoin in keeping the balance among various reward benefits using key measures of volatility, slippage, and robustness, with extensions to measure its money-likeness in terms of NQA (No Question Asked).
On the other hand, given the sheer lack of institutional support, the endogenous, bottom-up community driven transactions can also generate enough seigniorage to allow related tokens to support stablecoin, that would help sustain the stable link with the legacy world. For instance, the TON-starter program of TOKAMAK Network provides the community support that provides extra thrust toward Tokamak protocol with enhanced interoperability that satisfies one of the conditions for increased liquidity. As outlined by Abrol [2], the scalability of Ethereum’s second layer has vastly improved over the past years, using solutions such as zk-rollups. This enables more efficient decentralized exchanges, whose speed can now even rival their centralized counterparts with enhanced interoperability. However, one issue of decentralized exchanges lingers with liquidity. Liquidity mining and yield farming have been introduced and some other ways to improve liquidity, e.g., Bonding and POL (Protocol Owned Liquidity) of Olympus DAO (Decentralized Autonomous Organization) have been introduced that led to a wave of new participants in DeFi.
Stablecoin project is a community-driven set of transactions to ensure necessary initial soft peg that one can rely on. The causality is bi-directional in the sense that stablecoin is important for the ecosystem, while the functioning ecosystem brings about market power to generate seigniorage for the required stability mechanisms. The concerns related to relying on legacy trust lie in the use of centralized stablecoins, but the ratio of legacy components can be adjusted based on the growing crypto contributions over time (i.e., sliding scale approach). Likewise, the whole idea about stablecoin for ecosystem development hinges on creating a virtuous cycle (positive flywheel effect) in an inherently unstable world. The DeFi stablecoin needs extra mechanism to connect with the real-world projects for it to perform its desired functions in the ecosystem.

4.The relative weight of legacy assets and stablecoin is determined by parameters regarding composition of collateral as well as stabilization needs by the off-chain oracle feed.

Against the possible burden associated with TON linkage, stability fee may be necessary for redeeming TOK. However, part of legacy stablecoin can help minimize costs and extra return from TOK for yieldfarming can generate extra return compared with cases where one holds on to centralized stablecoin or TON single-handedly. Unlike the DAI protocol, the extra savings from holding existing stablecoin can be greater than the needs for extra return from holding decentralized stablecoin because extra costs incurred in stabilizing the latter one. Also, one can save the equivalent of Dai Savings Rate (DSR), because the possible interest rate earned by holding TOK (i.e., staking reward) over time is almost automatic, lessening the incentive burden to increase the demand for TOK, which has built-in upward pressure from the TON ecosystem. Overall, the cost reduction comes from targeting a stable collateral mix and the interventions by the Treasury are considered automatic using the smart contracts. As such, the open dynamic reserve structure and the transparent engagement principle remain the backbone of the TOK stablecoin. In this vein, the newly introduced stablecoin based on Tokamak Network brings together new innovations in collateral composition and stability mechanism to ensure tailored stability features that tend to differ among diverse groups of investors. The reliance on numerous factors for securing liquidity differs from the traditional liquidity mechanism based on interactions of inside and outside liquidity with public and private suppliers as explained by Holstrom and Tirole [15][16]. Given the overriding importance of securing on-chain DeFi liquidity, we can sum up the design principle of DeFi stablecoin such that some of the identifiable prohibitive factors need to be controlled before engaging in liquidity generation. That is, given the fragile condition of the incipient Tokamak network, its inherent volatility needs some moderation to engage in more efficient transactions for liquidity. As explained, the stablecoin protocol matters since its viability depends heavily on its choice that decides collateral mix, stabilization mechanism, and overall incentive schemes in a dynamic setting.