Tencent Partners with Avalanche

After Alibaba and Amazon AWS, now it’s time for Tecent to join the Avalanche blockchain. Emin Gün Sirer explains in the video bellow how the partnership will work and how it can benefit the Avalanche ecosystem:

 

Video description:

Tencent is bringing Avalanche technology to millions of developers on Tencent Cloud.

To accelerate Avalanche’s expansion in the APAC region, a fully-dedicated Avalanche node has been set up on Tencent Cloud infrastructure to support rapid and efficient node deployment for developers and validators.

Related content:

Security checklist for developers: http://tiny.cc/security_checklist

Advisory Business (SEC): http://tiny.cc/CFO-ADV2B

About Tencent

Tencent is a Chinese multinational firm that provides a wide range of services and goods related to the Internet. The company’s headquarters are in Shenzhen, China, and it was created in 1998. WeChat, QQ, and other social media platforms, together with video games, movies, music, online shopping, and cloud computing are all part of Tencent’s commercial portfolio.

Cloud computing services are offered to companies and institutions all around the world by Tencent Cloud, a wholly owned subsidiary of Tencent. Computing, networking, storage, and security are just few of the many services it provides.

In 2021, Tencent announced that 1.25 billion people worldwide used WeChat each month out of a total of 1.25 billion. The total number of active users on Tencent Cloud is not known to the public.

About Avalanche

Avalanche is a decentralized blockchain network that was first introduced in 2020. Its goal is to create a highly scalable and interoperable ecosystem for the creation of decentralized apps (dApps) and smart contract deployment.

One of the most important aspects of Avalanche is its consensus method, known as Avalanche-X. This consensus technique allows the network to execute transactions quickly, with finality attained in a matter of seconds. It also has a high throughput, allowing it to process thousands of transactions per second (TPS).

Another critical feature of Avalanche is its subnets functionality. This enables the formation of several blockchains inside the Avalanche network, each with its own collection of validators, consensus rules, and virtual machines. Developers may use this capability to create customized environments for their dApps, giving them more freedom and control over their projects.

Avalanche is also intended to work well with other blockchains. This implies that assets and data may be easily exchanged between Avalanche and other networks like Bitcoin or Ethereum. The implementation of a bridging mechanism, which allows the development of bridges between Avalanche and other chains, facilitates this interoperability.

The partnership between Avalanche and Tencent is a important pace to the whole industry.

Which stablecoin is the safest? (A deep analysis)

Could any stablecoin survive a recession?

One of the most relevant questions in the cryptocurrency market is about the safety of stablecoins.

In this article, I will not only show you which stablecoins are safe and unsafe, but I will also show you how to evaluate a stablecoin in practice.

On this image you are seeing the top 10 stablecoins on the market. In addition to these, I will talk about FRAX and Synthetix Dollar, because they are becoming popular.

It will be a article focused on stables linked to the dollar. Are you ready? So let’s get started:

First, we need to divide stablecoins into two major groups: Fiat-collateralized stablecoins, which supposedly have actual dollar reserves for each token issued, and algorithmic stablecoins, which maintain parity with the dollar using cryptocurrency reserves.

For the fiat-collateralized group, we must first ask whether dollar reserves actually exist. In theory, there will always be a company responsible for custodying dollars and issuing or burning tokens.

When this company receives a $1000 bank transfer, for example, it issues 1000 tokens to the user, where each token is worth $1, 

and keeps the actual dollars in custody. When the user wants his dollars back, he needs to return the 1000 tokens to the company,

which will burn them and return the real dollars to the user.

But why would anyone contact the company Tether Limited, for example, to issue USDT if he can buy USDT directly on an exchange? To avoid price swings.

The price of a stablecoin on exchanges can vary depending on supply and demand at the time, especially if an investor suddenly moves large amounts of money. But relax, even if the price fluctuates due to supply and demand, the tendency is for a backed stablecoin to maintain its peg over time.

 

As there is always the option for the investor to return the tokens to the company and receive their equivalent dollars. This is what gives the token its value.

Although the concept of fiat reserves is solid and brings security to the model, all risks are associated with the company that manages the stablecoin.

After all:

1. Who guarantees that the dollar reserves actually exist?
2. What financial assets are held as reserves?
3. Which are the main blockchains and exchanges where the token resides?

To answer each of these questions, we need to find:

• Audits and certifications regarding financial reserves.
• Secure assets equivalent to cash.
• Onchain data about the token.

As financial reserve is a lot of money, it is natural that the company tries to remunerate this capital in some way, which is why question number 2 is so important. It could be that the company lends money to third parties, invests in bonds or whatever, so we need to be aware of all the risks.

 

In the case of algorithmic stablecoins, the approach is different.

As cryptocurrencies are used as reserves, being automated and auditable on the blockchain, we can always know the current situation.

The custody of the reserves is managed by smart contracts, so the security is associated with the algorithm, 

as well as the blockchain used.

The main questions are:

1. Which cryptocurrencies are accepted as reserves for issuing the stablecoin?
2. How secure is the strategy to maintain the peg?
3. What happens if the peg is lost?

So now that we know what to look for, let’s start by evaluating fiat-backed stablecoins, because it is easier.

We first need to understand what kind of assets the companies hold as reserves and how risky each one is. The first three items are popularly called “cash-equivalents”, although corporate commercial paper does not have the same security as the others.

Money market funds are also considered very safe, but they are not the same thing as cash. I recommend reading this paper to be aware of the risks.

Following our list, security begins to fall exponentially, either by volatility or by asset quality. The list goes on with: Precious metals, Corporate Bonds, Funds, Stocks, Loans, Digital tokens, and so on. The risk of each one will depend on many factors, but the fact is that thinking of these last categories as being as stable and safe as cash is not appropriate.

Ok, so let’s find out the reality of each stablecoin by answering the 3 basic questions.

Tether Limited is currently audited by BDO Italia. In the past, it has been audited by 5 other firms.

Looking at the history, the first firm that audited Tether was charged by the SEC for “serial violations of the federal securities laws” and “improper professional conduct”. That is the first red alert.

BDO Global is one of the top 5 accounting firms in the world, but researching the history I found some scandals that the company was involved in.

 

On Tether, it has already been proven that there were irregularities in the past, and Tether paid a fine of $18 million for not having part of the reserves for the entire period of operation. While critical, that particular situation has put the market at ease, as many feared the problem could be much bigger.

Okay, we have already seen that there are some weak points regarding reserves.

On the second question, the distribution of capital is quite questionable, as about 18% of the reserve is held in the form of risky assets such as digital tokens, loans and corporate bonds, without specifying the particular companies and projects.

On question number 3, about 52% of the USDT supply in circulation resides on the Tron network, 44% on Ethereum. I have my reasons for finding Tron’s blockchain insecure, but I’ll leave that for another article.

Speaking of exchanges, the growing dominance of Tether on Bitfinex is another wake-up call.

In summary, we have that:

• The suitability of Tether Limited is questionable due to past events;
• The auditing of the reserves has a risk associated with the company BDO;
• The distribution of the token on blockchains and exchanges is not adequate;
• Around 18% of the reserves could become insolvent depending on market conditions.

In other words, I definitely do not consider it a good choice to use USDT as a store of value for the long term.

Well, it’s time to talk about USDC. USDC is managed by Centre, a consortium formed by Circle and Coinbase.

Like Tether, USDC’s balance sheet is audited by one of the largest accounting firms in the world. In this case, Grant Thornton. But unfortunately that firm is not scandal-free either.

In terms of prestige and credibility, Thornton appears slightly ahead of BDO.

One difference with Tether is that USDC’s audits are monthly and done by the same firm for over 4 years. USDC’s track record has no cases of misconduct or scandal so far.

On the onchain data, 90% of the supply resides on Ethereum, and the remaining 10% is spread across various other chains. That setup looks great.

The USDC balance on exchanges also looks relatively healthy, proportional to the volume of each player.

Regarding the transparency of reserves, 100% of the funds are held in US treasuries and cash, which seems to be a safe setup. 

This distribution has been much worse in the past, but Centre has recently tailored the balance sheet more diligently.

In terms of licensing, Coinbase is a heavily regulated publicly traded company in the US. 

Although the company is making a loss due to volume declines in the 2022 bear market, the company’s financial situation does not appear critical.

As a negative point is the fact that the company has introduced the term that, in case of bankruptcy, customers holding assets in the exchange will be considered unsecured creditors, i.e. they will be the last in the priority list in terms of restitution.

In summary, we have that:

• The auditing of the reserves has a risk associated with the company Grant Thornton;
• The distribution of the token on blockchains and exchanges is adequate;
• The distribution of the reserves in financial assets seems adequate.

It can be seen that the USDC stablecoin is much safer than the USDT, but it is still important to be cautious. Depending on the duration of the bear market, financial problems at Coinbase and Centre’s operation could eventually bring complications for USDC. Not to mention the basic regulatory risk that the entire stablecoin market faces. It is important to monitor closely. 

The upcoming quarterly reports will be important to also reveal the impact of USDC’s withdrawal as a trading pair on Binance.

Before talking about Binance USD, which is the next asset in terms of market value, it is worth talking about Pax Dollar, as the company Paxos is responsible for the custody of both Pax Dollar and BUSD.

So let’s get to it!

Paxos’ reserves has been audited monthly for over 4 years by the firm Withum, which is much less well known than Thornton or BDO. Perhaps because it is less popular, or on merit, I have not found any past scandals involving the company. Nor have I found any evidence of fraud involving the Paxos company.

The USDP token basically exists only on Ethereum, which is good.

About the balance sheet on exchanges, there is an exaggerated dominance of Binance.

About the distribution of reserves, the USDP balance sheet is composed 100% by US Treasury and cash, which is considered safe. Unlike Centre that changed the composition of its balance sheet over time, Paxos has maintained this policy since the creation of Pax Dollar.

In regulatory terms, the Paxos company is authorised by the New York State Department of Financial Services to offer USDP, Pax Gold and BUSD. 

The company has also secured other memorable licenses in other sectors, such as the SEC’s permission to Settle Equities on Blockchain.

In summary, we have that:

• The reserves are audited by Withum and regulated by the New York Department of Financial Services (DFS);
• The distribution of the token on blockchains is adequate;
• The distribution of the reserves in financial assets seems adequate.

It is worth highlighting its proximity to Binance, which despite being positive because Binance has validated and trusted Paxos’ service, brings a possible risk of contamination in case there is a problem with Binance, since it is the exchange that concentrates the most USDP. Another point is the fact that Paxos is a privately held company, which makes it difficult to know the current financial situation of the company.

Anyway, I would opt for Pax Dollar instead of BUSD, as BUSD inherits all the USDP risks, with no upside, and multiplies by the Binance risk. That’s two points of centralization.

Now that the Paxos service is understood, there is not much to talk about BUSD, because BUSD is the same as USDP plus Binance risk.

Only two backed stablecoins remain in our analysis: TrueUSD and Gemini Dollar.

TrueUSD’s reserves is audited by Armanino LLP, which is similar in size and credibility to Withum, which audits USDP. I also found no past frauds or scandals involving this firm or TrueUSD.

Armanino’s audit happens in real time and can be followed online. 

However, their report informs in a superficial way how TrueUSD’s balance sheet is distributed, even mentioning “highly liquid investments of sufficient credit quality” without informing exactly what they are about or what percentages are allocated.

TrueUSD is integrated with Chainlink to provide reserves guarantee in real time, so that, if at any time the reserves balance is lower than the token supply, everything is frozen. It is an interesting initiative, however it does not invalidate the lack of transparency regarding reserve investments.

TrueUSD claims to be regulated by the Nevada Department of Business, however I could not find an official document validating this claim. 

Regarding onchain data, TrueUSD’s distribution on blockchains has considerable exposure to the Tron network. Unfortunately I could not find token distribution by exchange, as it is less popular.

In summary:

• The reserves are audited by Armanino LLP;
• The distribution of the token on blockchains is questionable;
• The distribution of the reserves in financial assets lacks transparency.

Although it seems like a solid project in theory, the difficulty of validating information leaves the security of this stablecoin open in my opinion. The company could collaborate with more transparency and links to documentation that validates its statements.

Alright, let’s now review our latest fiat-backed stablecoin: Gemini Dollar.

This stablecoin is managed by Gemini, the company of the Winklevoss twins. GUSD’s backing is audited monthly by BPM LLP. It is a similar sized company to Withum and Armanino. I have not found any scandal associated with this accounting firm.

About Gemini, as a problem we have the recent CFTC lawsuit regarding bitcoin futures contracts offered in 2017. The consequences the exchange may suffer from this are still uncertain, although apparently unrelated to GUSD.

GUSD’s reserves are held in cash deposits, U.S. Treasury and Money Market Funds, without saying the proportions. 

The GUSD token exists only on Ethereum,

and Gemini is the dominant exchange, virtually isolated. Like Paxos, Gemini is regulated by the New York State Department of Financial Services.

In summary, we have that:

• The reserves are audited by BPM LLP and regulated by the DFS;
• The distribution of the token on blockchains is adequate, but there is little liquidity outside the Gemini exchange;
• The distribution of the reserves in financial assets seems adequate.

These characteristics put GUSD in a similar category to USDP and USDC.

Okay, we are done with the fiat-backed stablecoins. Before doing a ranking, we need to look at algorithmic stablecoins.

I will comment on these projects in a generic way, because a detailed explanation about each algorithm deserves separate articles, as I have already done about the DAI cryptocurrency and also about the DJED stablecoin that has not been released yet. I recommend reading those articles calmly later.

In summary, DAI was the first proof that it is possible to maintain parity in an asset without depending on the asset in question. Those who readed the articles on DAI and DJED realised that the biggest risk to a parity algorithm is when the market goes through a flash crash.

If the fall of the cryptocurrency serving as collateral is very large in a short period of time, the value of the reserves can become lower than the market value of the stablecoin. Depending on the situation, this can lead to a death spiral.

There is no magic, the only way to minimize the risk of insolvency is to have a large level of overcollateralization, i.e. far more reserves than the amount of stablecoin tokens issued. However this also reduces the efficiency of the process.

I particularly believe that the technical mechanism and the theoretical level of overcollateralization of the DAI and DJED projects are adequate. The way DAI and DJED deal with insolvency are similar: they use a second token to increase reserves. It is a clever concept, but not perfect.

I believe that the security of this model will improve when the cryptocurrency used as collateral, whatever it is, becomes sound money recognized worldwide. 

The day Ethereum, Bitcoin or any other crypto has massive adoption, being used as a store of value even for crisis scenarios, algorithmic stablecoins will become very secure. In the current scenario, I will make brief considerations about each stablecoin.

DAI, besides having a suitable mechanism, is the most time-tested. As a negative point is the increase in the amount of USDC in its reserves, which ended up inheriting centralization and custody risks of fiat-backed stables. Besides, the project has already announced that DAI will abandon the dollar peg in the future, changing its mechanism, which should take about 3 years to happen. The project is also allocating funds in US Treasuries, questionable decisions for those who started with a principle of decentralization and alternative to the traditional financial system. In other words, for the long term, DAI brings a lot of uncertainties.

DJED looks very interesting, but I wouldn’t use it as a reserve without waiting to be proven by time and adverse scenarios, after all the project hasn’t been launched yet. The same goes for very new stables.

Following our list, we have FRAX. FRAX is a stablecoin that works with a hybrid system, using both stablecoin reserves and a price stabilization based on another FXS token. This protocol deserves a separate article and promises to evolve over time, however as currently the reliance on USDC is still large (close to 90%), it might be more prudent to expose yourself directly to USDC.

Next on the list is USDD, which is an arm of the TRON project. That alone should already be a danger sign, but it gets worse. The concept of USDD was born along the same lines as LUNA UST. However Justin Sun has been trying to add real reserves that do not rely solely on TRX to USDD, as LUNA was trying to do and broke down before completion. With only a few months of existence, USDD has already significantly lost the peg at least twice. Staying away is the best thing you can do.

The next token is also questionable. Neutrino USD, built on the WAVES blockchain and using WAVES as collateral has an unrobust parity mechanism, which is reflected in a very bad stabilization. Being constantly far from the value of 1 USD, the project has flirted with death several times.

In the list of the top 10 stablecoins, only FEI USD was not mentioned. FEI deserves a separate article to explain its dynamics, which uses Ethereum as collateral, but instead of relying on another token to maintain parity in cases of insolvency like DAI and DJED, FEI works with punishments for selling the token. 

The further away from parity, the more FEI USD are burned from the portfolio of those who decide to sell. It is a differentiated strategy that also needs time to prove itself. For now, things have not been very good for the project. The interest and volume for this stablecoin has reduced, and after more than 1 year of operation, FEI USD has been trading around $0.98. 

As promised, I will still briefly mention sUSD, as it has gained popularity. sUSD is part of the Synthetix project, which issues many types of synthetic tokens. It has the largest overcollateralization on the market, however these collateral are entirely based on the SNX token, which makes the concept more risky. I particularly think that a collateral needs to have value in itself, separately and independently from the issued stablecoin. If the value of the collateral is directly associated with the issued stablecoin, a dangerous cycle is closed, similar to the LUNA UST case. Although not exactly the same, the similarity makes me think it is more prudent to wait a long time until this project proves itself.

Some years ago, after having studied the UST model, I decided not to invest in this kind of stable. I don’t regret it.

Well, now that we have covered all the main stablecoins in today’s market, I will make a summary:

I am a big believer in the concept of algorithmic stablecoins and I see a great future, but there is still a lack of reliable players. At the moment, no algorithmic stablecoin available on the market meets my criteria for long term hodl. If you need it in the short term, I would recommend only DAI and FRAX.

On fiat-collateralized stablecoins, I would go as follows: 

• USDP, USDC and GUSD are the safest. If you need to keep money in dollar-linked crypto, diversify between them. Don’t put everything in the same stable, and understand that none of them deserve your blind trust. If you plan to hodl, keep up with news, balance sheets and updates on these projects on a monthly basis. Any sign of danger, migrate. 
• Taking it this way, you can carry your money in stablecoins for longer periods with low risk, TrueUSD would be the next candidate on the list. From here on down, forget hodl.
• If you use Binance to do crypto buying and selling, I don’t see a problem with using BUSD in there. But just as it’s not wise to keep your tokens in exchanges, it’s not wise to keep in BUSD, especially knowing you can eliminate a layer of risk with USDP instead of BUSD.
• USDT can be useful for immediate liquidity and practicality as it is the most traded currency in the market today, but don’t consider using USDT for more than a few minutes or hours. Make whatever trade you need, transfer, swap, whatever, and get out of risk immediately. No medium term strategy should involve USDT.

How Liquidity Pools work (Yield Farming)

Understand how liquidity pools work on decentralized exchanges like Uniswap, Sushiswap, Pancakeswap, Curve, among others. Let’s start with the basics.

What is liquidity?

When you try to buy bitcoin on a traditional exchange, a buy order is placed. Similarly, those who want to sell bitcoins place a sell order.

A trade will only occur when the price that one person is willing to buy is equal to the price that another person is willing to sell. When there are many people involved, this happens all the time.

When you can easily buy or sell an asset at a price very similar to the last price that was traded on the platform, it means that the asset has liquidity.

Now imagine the opposite. Imagine that an asset has few buy and sell orders, where the highest buy order is $10 and the lowest sell order is $20. Since the price difference is too big, there is no trade. The last trade that took place on this asset was two days ago, at the price of $14. In this case, you don’t know the real price of the asset you only know that there is someone willing to buy for $10 and someone willing to sell for $20. If you want to buy for less than $20 or sell for more than $10, you will not succeed. This means that this asset is not liquid.

Very popular assets usually have high liquidity. It is also common for popular exchanges to have high liquidity. On the other hand, smaller exchanges and little-known cryptocurrencies have always suffered from the problem of lack of liquidity. This is when the concept of a liquidity pool emerged, which became very famous thanks to the Uniswap exchange.

A liquidity pool works like a box divided into two parts, where each part stores a token. This could be, for example, the ETH and USDC tokens. An ETH/USDC pool exists to provide liquidity for buy and sell orders between these two tokens. Let’s use this pool as an example:

Let’s say the price of Ethereum is $1000 at the time the pool was opened. This means that the allocation of tokens in this pool at the time of opening was in the ratio 1000 to 1, since 1000 USDC tokens were needed to purchase 1 ETH token.

Let’s imagine that the pool started with 50,000 USDC tokens and 50 ETH tokens. Whoever provides liquidity to the pool is called a liquidity provider, and is rewarded for it. The fee charged for any trade goes entirely to the liquidity providers.

Let’s understand now how a buying and selling process works.

Alright, consider that a user owns 7.008,77 USDC tokens and decides to buy them all in ETH. Instead of doing this on a centralized exchange like Coinbase, he prefers to use a decentralized Exchange, and has discovered our pool. When he makes this purchase in our pool, he will be sending USDC tokens to the pool and receiving ETH tokens in return. As a result, the pool will be unbalanced.

 

If the user were to receive ETH at the exact 1000:1 ratio, he would receive about 7 ETH.

Let’s see what the new ratio of tokens in the pool would look like. In other words, 1 ETH is now worth 1.326,05 USDC. 

This makes sense, after all there was an ETH purchase. It means that the demand for ETH has increased, so its price should increase.

But there is a problem here. If we perform the operation this way, the liquidity providers in the pool will be at a loss.

Notice: If Bob is a liquidity provider and initially offered 5 ETH and 5,000 USDC, 

it means that Bob owns 10% of the pool. 

Before the ETH buying transaction, Bob owned in dollars the equivalent of $10,000.00

Notice: Now, considering the current proportion of tokens in the pool and taking 10% of that, at the current price, he has:

If Bob had not provided liquidity, considering the new value of ETH he would have:

Notice that it would have been better not to provide liquidity. This is happening because the entire imbalance between supply and demand is being paid for by the pool.

The user, in this hypothetical scenario, have caused an imbalance but have not been burdened at all.

The concept would not work if it were this way. The actual calculation is done in such a way that the user will pay some of the imbalance and the liquidity provider will pay the other part.

The distribution occurs by the formula:

Where ETHLP stands for liquidity provided of the ETH token. Don’t be alarmed, the concept is simpler than it looks.

As the pool in our example started with 50 ETH tokens and 50,000 USDC tokens we have: k = 50*50000 = 2500000

Now we have another formula, which defines the final ETH price for the pool after any transaction:

In other words, the price of an ETH to the pool will always be given by the current ratio of the amount of USDC tokens and ETH tokens in the pool. But note that this is the final price to the pool it refers to the ratio that an liquidity provider would withdraw from its tokens if it wanted to stop providing liquidity.

With a little algebra, using these two equations to isolate ETHLP and then USDCLP we will have:

That is, since we already know the value of k we can immediately calculate the price of ETH that will be left in the pool from any information from the user that will buy. With the formulas it is quick to see what the final price of ETH in the pool would look like. But how much will the user pay? 

What is the price of ETH for that user?

This can be calculated indirectly.

For example, let’s say the user wants to buy 6,1471 ETH. Putting that value into the formula 1 to calculate the ETHPRICE we get a value of $1.300,00. But that is the final price of the pool, not what the user will pay. 

The user is going to pay USDC, so we need to calculate what the USDCLP is. Now that we know the ETHPRICE, this is easy from the formula 2. We would have USDCLP = 57.008,77. That is, the user needs to provide 7.008,77 USDC for the pool to have this final balance since before the pool had 50,000 USDC. As we already know how much USDC the user will have to provide the price he is paying for each ETH is. 

Notice that this value is higher than the initial $1.000,00 and lower than the final $1.300,00. It means that the user paid a part of the imbalance while the pool paid another part.

If a new user comes to buy ETH, he will pay more than the pool’s current $1.300,00 since this is the value of the current ETHPRICE before the new imbalance. Note: the constant k always remains the same.

In the same way, if this new user is going to sell ETH, he will get less than $1.300,00 for each ETH for the pool owners, who previously gave ETH at one price and are now receiving ETH at another price a return to the initial value of $1.000,00 for each ETH would put them at no loss at exactly the same initial conditions as when they opened the pool.

Observe:

Imagine that another user sells 6,1471 ETH in this pool, which is the same amount that had been purchased previously. 

Applying this value to the formula 1 we have ETHPRICE = $1.000,00. Let’s do a summary then to understand the risks for a liquidity provider.

For a liquidity provider, the prices of the tokens at the moment it provides liquidity serves as a reference.

If, at the time of withdrawal from the pool, the prices of the tokens in the pool are different from the reference price he has lost money, as it would be better to be HOLDING both tokens instead of providing liquidity.

If, at the time of withdrawal, the values are the same as when he provided the liquidity he doesn’t lose. This is why this loss is called “Impermanent Loss”, because it is a non-permanent loss, it can change over time.

So, what is the advantage for the liquidity provider?

Every trade executed on Uniswap, for example, has a fee of 0,3%, and this fee goes directly to the liquidity providers. This way, when any liquidity provider withdraws its tokens, it will proportionally take those fees along with it.

In short, for a liquidity provider to make a profit it is necessary that the fees paid are greater than the loss due to imbalance. This does not always happen, so it is important to be aware of the risk.

One way to minimize the risk is to offer liquidity for tokens that do not usually vary from one another.

For example: the pair USDC/DAI

Exchange Curve specializes in this kind of pool.

Many decentralized exchanges offer extra incentives to liquidity providers by giving native governance tokens (e.g. UNI token on Uniswap). This is called yield farming, or liquidity mining.

So that’s what yield farming is: receiving native tokens for providing liquidity to the Exchange.

The name given to the protocol responsible for determining prices and trades between assets is Automated Market Maker. 

Each decentralized Exchange has its own AMM. For traders, this strategy mentioned in this article “solves” the problem of liquidity on decentralized exchanges.

After all, if the price on decentralized exchanges is mismatched with the market, this will bring an immediate arbitrage opportunity.

Through the AMM system explained in this article, Uniswap “guarantees” automatically executed orders at market price. The name of this is Swap.

If the pool is big enough so that the size of the order is very small relative to the size of the pool, the fee that the trader will pay ends up being around 0,3% only with no loss for having unbalanced the pool.

We showed in this article an example of a very small pool to facilitate understanding, but obviously the pools are much larger than that, which minimizes the unbalancing effect.

In practice, providing liquidity to smaller pools results in more governance tokens received to encourage small pools to grow.

Exchange Sushiswap is a fork of Uniswap, which came up with the idea of providing SUSHI governance tokens before Uniswap gave UNIs.

Pancakeswap is Binance’s version of AMM exchange.

How does DAI keep its price stable?

Today we are going to explain how the DAI cryptocurrency manages to keep its value constant against the dollar, even though it is not dollar-backed.

Unlike traditional stablecoins like USDC and TrueUSD, where each token is issued from the deposit of dollars that are held in a company’s custody, algorithmic stablecoins use sophisticated mechanisms to pair their value to the dollar. In the case of the DAI cryptocurrency, this mechanism is based on the concept of loan with guarantees. 

For example, let’s say you want to take out a $1000 loan from a bank. Usually, the bank will require some collateral which can be used in the future to repay the loan if you don’t pay back what you owe. The bank will also charge interest on the loan. The DAI cryptocurrency model works the same way: you can borrow dollars by providing a guarantee and paying interest. 

These borrowed dollars are issued through the DAI token, which is equivalent to one dollar. The guarantee provided is made by another cryptocurrency, such as the ETH token.

 

Let’s imagine the following scenario: the price of one ETH is $500, the interest charged for borrowing DAIs is 1% per year, and you want to borrow $1000. You could, for example, leave 4 ETHs as collateral for the loan. In other words, you lock 4 ETHs to be entitled to receive 1000 DAI tokens. This way, if you don’t return the 1000 DAI tokens with the respective interest the protocol can sell your ETH tokens to pay off the debt. Notice that in this example the collateral is twice the value of the debt. This is important because the price of the ETH token fluctuates. 

If the guarantee were exactly the value of the debt ($1000) and the price of the ETH token were to fall the loan would be insolvent.

 

So in practice there is a limit beyond which the user is liquidated. 

In the case of loans with the ETH token as collateral, this limit is 1,5 times the value of the debt. 

If you placed 4 ETH tokens as collateral, you would be automatically liquidated if the price of 1 ETH drops to $375 losing your ETH tokens as your collateral would reach the limit of $1500.

It is evident that the higher the value of the collateral, the safer the user is from not being liquidated.

The moment a user pays off their loan, the deposited collateral is unlocked and the returned DAI tokens are burned.

If the user has been liquidated, the collateral is sold to buy DAI tokens,

which are burned in the same way.

 

This is a good summary of how the system works, from the creation to the destruction of DAI tokens.The amount of DAI tokens circulating in the market depends on the amount of collateral that is currently deposited.

Seeing the advantages of this system, John decided to issue DAI tokens as a loan to buy bitcoin depositing ETH as collateral. In this scenario, John did not have to sell his ETH tokens, betting on the appreciation of both.

When John used his DAI tokens to buy bitcoin, he traded with Olivia who sold her bitcoins in exchange for DAI.

Note that Olivia can hold her DAI tokens as long as she wants without paying any interest, because she just made an exchange of one token for another in the market. The person who needs to return the DAI tokens and pay interest is John, who issued these tokens. At some point John will need to repurchase DAI in the market to pay off his debt and get his ETH tokens back.

By now you may be noticing that collateral serves as backing to allow DAI tokens to have real value in the market.

But who guarantees that its value remains stable to a dollar?

This is done through the interest rate, also called the Dai Savings Rate (DSR). 

If the interest rate that was 1% rises to 8% borrowers are encouraged to return their DAI tokens and settle the debt soon, removing tokens from the market.

The opposite occurs if interest rates are low, which would encourage more people to issue DAI tokens (increasing the supply of tokens in the market).

Thus, if the token price in the market is losing parity with the dollar up or down due to momentary swings in demand, the interest rate change helps move the supply, keeping the price stable.

Now that you have a good general understanding of how the system works, we can get into the details.

We’ve seen the conditions for a liquidation to happen, but we haven’t seen how it happens.

In practice, an auction takes place for each liquidation, where interested users can offer amounts to buy the locked collateral.

If John applied for a loan of 1000 DAI offering 4 ETH as collateral

and was liquidated when the price of the ETH dropped to $375, 

it means that at that time an auction is started having a duration of 24 hours where different users can dispute with each other who makes the highest bid for the purchase of these 4 ETH.

The bids are made in DAI tokens. If the auction ended with a final bid of 1400 DAI for the 4 ETHs, it means that the winner of the auction paid the equivalent of $350 per ETH. In that scenario, the 1000 DAIs referring to the original loan will be burned and the surplus amount will go into a surplus reserve, which can be used in problematic scenarios.

What scenarios?

Well, imagine that the auction had ended with a bid of 300 DAI for the 4 ETHs. This could happen if at the time of the auction the market is experiencing a flash crash. 

This means that the debt has not been paid, creating a deficit in the system.

The first candidate to cover this deficit is the surplus reserve. This reserve is also fed by the interest rates charged on loans.

If a very large amount of deficits occur that the surplus reserve does not cover, a debt auction is started, where MKR tokens are issued and auctioned to cover the debts in DAI. These MKR tokens correspond to the Maker project, which is responsible for the governance of the DAI token.

MKR token holders can vote on the parameters of the system, deciding on the values of important parameters such as the limit of collateral for settlement, auction criteria, etc. They also decide on the upper limit of the surplus reserve.

If the surplus reserve has more money than this limit, the extra amount will go to a surplus auction, 

where DAI tokens are sold in exchange for MKR tokens, which in turn are burned.

Thus, the supply of MKR tokens is regulated by the system situation decreasing when the system is robust and increasing when the system is in deficit.

It is worth pointing out that as the project progresses, the dynamics can also evolve.

Today it is already possible to deposit different tokens as collateral, with each one having a different set of rules depending on its liquidity.

How Djed stablecoin works (extended Djed)

Today we will learn how the stable coin Djed works. There are two models: minimal and extended Djed.

In this article I will try to explain the most robust and complete model: the extended Djed. So, let’s understand some important concepts to avoid confusion.

First, it is important to understand the difference between buying stablecoins from other users on exchanges and buying stablecoins directly from the autonomous bank that manages the stablecoin.

When you buy stablecoins on exchanges, you are just exchanging one token for another, For example, you sell ADAs in exchange for Djeds.

What is the difference of buying stablecoins from the autonomous bank?

When you buy from a autonomous bank, you don’t sell your ADAs you just leave them locked up as collateral to issue Djeds. 

The logic is the same as we saw in the article about the DAI cryptocurrency. It is a loan. You deposit a guarantee and borrow stablecoins.

That way, when you return the stablecoins to the bank, your ADAs will return to you. For those who need dollars today and don’t want to have to sell their ADAs borrowing Djed might be a good idea.

The ADAs deposited as collateral form the bank’s reserve. The Djed coins have value in the market because at any time you can go to the bank and return these Djeds to get your ADAs back.

By establishing that 1 Djed is equivalent to 1 dollar, the amount of Djeds you can issue at the bank depends on the current value of the ADA coin. If 1 ADA is worth 2 dollars, theoretically 1 ADA would allow you to issue 2 Djeds. 

But this would be very risky for the protocol, because if the market value of ADA fell below $2, the bank would not have enough reserves to pay the user who returned their 2 Djeds, implying that the market value of Djed would be less than $1 in this scenario.

To avoid this situation and not suffer from ADA price fluctuations the dollar value of the bank’s total reserve needs to be greater than the total value of Djeds issued.

If the dollar value of the total reserve of ADAs is 1,5 times the total value of issued Djeds.

It means that the price of ADA can be 0,67 times lower in the market without compromising the parity of the Djed.

After all, 0,67 * 1,5 = 1. Note that the more reserves, the more secure parity becomes.

Now consider this, if the dollar equivalent value of the bank’s reserve is decreasing,

users should ideally be encouraged to deposit more reserves without issuing new Djeds. The protocol allows this by buying “Reserve Coins”.

It works like this: Imagine that the dollar value of the bank’s total reserve is 1 million and there are 700.000 Djeds in circulation. This means that the bank has a surplus of $300.000,00 at the moment.

Now consider that there is a coin called RC and that there are 1.000 such coins in circulation. This coin will represent the surplus of the bank, because its value depends on the surplus the bank has. If the surplus is $300.000,00 and there are 1.000 RCs in circulation, each RC is worth approximately $300,00.

In practice it is not exactly that as there are more fees and parameters involved, but we will talk about them later. You can buy RCs directly from the autonomous bank. The bank sets the price of the RC and you provide ADAs in exchange.

Consider also that RC gets cheaper and cheaper as the surplus approaches zero. But RC is never worth zero.

I put on the image some exaggerated values just to illustrate, but in practice the reference point is not the surplus reaching zero but the surplus reaching a limit value considered safe by the protocol. This safe value is defined by a parameter that we will discuss later. 

Back to our example, let’s look at the implications.

If the bank surplus has decreased, it means that the price of RC has decreased. So users may want to buy RC because it is cheap and may increase in price later. The lower the bank’s surplus value, the more attractive it will be for users to buy RCs, which counterbalances and increases the surplus.

Similarly, if there is too much surplus in the bank, the value of the RC will be high, which will encourage users to sell their RCs to realize profits.

Note that every time a user buys or sells RCs with the bank, the bank is issuing or burning RCs.

Since the value of RC depends on the bank’s surplus and the total number of RCs in circulation, a purchase or sale of RCs should not have much impact on the RC price. After all each transaction changes both the value of the surplus and the amount of RCs in circulation, and the price of RC coin is somehow proportional to this ratio.

On the other hand, fluctuations in the value of ADA change the value of RC as they directly impact the value of the surplus.

If there are too many RCs in circulation, increases in the surplus will represent a very small gain for RC holders.

Therefore, to avoid this dilution, there is a disincentive to buy RCs after a certain threshold through a fee that makes these purchases more expensive.

Similarly, this dynamic fee makes RCs cheaper and cheaper as the surplus approaches a threshold value. This threshold is a parameter that determines how much surplus the autonomous bank should have in reserves.

The buying and selling prices of RCs are determined by two equations that basically try to make the system converge to this optimal point where the amount of reserves the autonomous bank should have is optimal considering all factors.

 

Ok, but what would happen in very adverse scenarios?

If the value of reserves falls so low that there is no longer a surplus and the stable coin loses parity, users can still sell stable coins to the autonomous bank.

But instead of receiving the equivalent value of 1 dollar per Djed, they will receive the proportional value of the amount of reserves in relation to the total number of Djeds in circulation. The difference in this amount relative to $1 is made up by giving users RCs, increasing the number of RCs in circulation.

 

The lower the reserves, the more discouraged users are from selling RCs, according to the RC selling equation, and more encouraged to buy, according to the RC buying equation.

In summary, one of the key ideas for maintaining Djed parity with 1 dollar is to counterbalance a possible loss in value of reserves with an increasingly interesting opportunity to buy RCs, representing high profits should the system stabilize again.

I have omitted several aspects of the protocol in this article trying to bring a generic and simplified explanation, but all the details and equations can be checked in the official paper. This is the first stable coin protocol that has gone through formal verification.

In this example I used ADA as a reserve and dollar as parity, but the concept can be applied to any asset that you want to hold parity or reserves allowing the most diverse types of stable coins.

If we think about the DAI stable coin, it is managed by the Maker project within the Ethereum platform.

In the case of Djed, the COTI project will be responsible for managing the protocol within the Cardano platform. A small portion of the fees from these protocols goes to the project that manages them. 

In the case of COTI, the project has pursued several partnerships and licenses with financial solutions, and will be able to use this expertise to drive the adoption of Djed.

Cardano, on the other hand, benefits from having a robust stablecoin running under its architecture similar to what happens with Ethereum in relation to DAI. But the integration of Djed into the Cardano ecosystem will be even deeper.

One of the goals is to use Djed as a reference for charging fees on the platform, making predictability easier for pool operators and users by introducing the concept of stable fees.

References:

• Oficial paper: https://eprint.iacr.org/2021/1069.pdf
• IOHKs post: https://iohk.io/en/blog/posts/2021/08/18/djed-implementing-algorithmic-stablecoins-for-proven-price-stability/
• Presentation by Bruno Paleo: https://www.youtube.com/watch?v=zG-rxMCDIa0&t=8366s
• Stable fees concept: https://iohk.io/en/blog/posts/2021/06/10/stablefees-and-the-decentralized-reserve-system/
• Coti blog: https://medium.com/cotinetwork/why-being-the-issuer-of-djed-cardanos-official-stablecoin-is-a-game-changer-for-coti-f4945494fc40
• Djed website: https://djed.xyz/

Understanding veTokenomics, the new DeFi paradigm

The DeFi world is developing very fast. One of the novelties that is having a lot of success is the veToken model. In this article we will understand how it works and all the details you need to know.

So, what is veTokenomics?

The concept came up with the Curve project, one of the largest decentralized exchanges on the market. Curve’s native Token is CRV. This token is not issued by mining or staking, but by providing liquidity to the exchange’s pools.

For example, if you add DAI and USDC tokens to the DAI-USDC pool, you not only get the swaps fees, but you also get CRV tokens.

But the developers at Curve had an idea: give an extra benefit to those who block CRV tokens.

The longer you leave your tokens locked up without being able to sell them, the more rewards you get by adding liquidity to the pools.

The concept is very simple, you choose the period you want to keep your CRV tokens locked up, minimum is 1 week and maximum is 4 years, and you receive a higher amount of CRV by providing liquidity. This boost, as it is called, can be up to 2.5x.

 

 

If you have blocked 4 CRVs for 4 years, you will receive 4 veCRVs in return. This veCRV token is used by the protocol to calculate rewards.

If you blocked 4 CRVs for 1 year, you will receive 1 veCRV.

In other words, the veCRV token represents not only the quantity, but the time commitment you have applied to the protocol, where hodlers benefit the most. And there is a detail: the amount of veCRVs drops over time. So you start, let’s say, with 1000 veCRVs, and after some time you have 800 veCRVs.

In practice, the amount of veCRVs is always recalculated based on how much time is left before your tokens are unlocked. Besides granting a boost in rewards, veCRV tokens also serve for governance, giving you the right to vote on protocol decisions. This is where the name “ve” comes from, which is an abbreviation for “Vote Escrow”. 

And there is another benefit for veCRV holders. 50% of all fees captured by the Curve exchange go to veCRV holders, as if they were dividends paid to shareholders.

Congratulations, you now understand the concept of veTokenomics!

So far we have only talked about the DEX Curve, but the concept has already been implemented by several projects.

In short, the dynamic consists of:

The user blocks his tokens, receiving in return veTokens. These veTokens grant a number of benefits such as a boost in rewards, voting rights, and participation in the protocol’s profit distribution.

One question you may be asking yourself is whether it is possible to buy veTokens directly on the market. The answer is no.

The veCRV token is non-transferable and cannot be sold. That token only exists associated with addresses that have blocked tokens in the protocol. But because DeFi is a rapidly expanding and innovating world, the concept of veTokenomics brought consequences.

The first of these was the “Curve Wars,” a battle that is in effect until now. Let’s understand what happened.

Part of the voting right that veCRV holders have is to choose which pools will receive the most CRVs. That is, those who own a lot of veCRVs, besides earning dividends and getting a boost in emissions, can still vote to make their pool the one that issues the most CRVs.

So think a little.

There are protocols called Yield Aggregators, which basically take your tokens and allocate them to the best liquidity pools to get the highest possible returns.

Because these protocols act like investment funds, managing many tokens, they can concentrate large amounts of veCRVs, making their pools get the most benefit. This is how the Curve wars came about, with protocols fighting for veCRV dominance.

Currently, the one who is winning this battle is the Convex protocol, which came up with an innovative idea, bringing benefits to users from a well-designed dynamic, which will be the subject of our next article, where I will explain the Convex protocol in detail.