Resolving DUSD’s peg at 1 USD once and for all to create a hybrid stablecoin

DUSD is a hybrid stablecoin on the DeFiChain blockchain that is created from a mix of crypto backed loans and burning the blockchain’s native coin DFI. Until the Terra’s UST downfall in May 2022 and the subsequent crypto crash, DUSD was relatively stable around 1 USD. However, since then, it has experienced wild swings of 30% discounts and 15% premiums. I would like to discuss three things in this blog post:

1. What it takes to keep a stablecoin stable and why DUSD is not stable at the moment.
2. The reason, why DUSD will NOT enter a death spiral like UST.
3. What can be done to stabilize DUSD around 1 USD while keeping fluctuations under 1% — so, to make DUSD completely stable! YES!!

If you rather listen to a Twitter Space than read this article, feel free to do so here:

Stablecoin Basics

A stablecoin is a token on a blockchain that tracks the price of another asset. Most stablecoins track the USD, but others track gold, stocks, bonds, and other financial instruments. To trade closely to another asset’s price, a stablecoin’s value must, by definition, be closely related to the other asset’s price.

Generally speaking, an item’s value is equal to its utility multiplied by the rarity of the item and the number of people who want this particular utility.

In the following timeline, I want to show you, how this simple looking formula is relatively difficult to execute for stablecoins:

2021 — The Early Days: DUSD trading at a Premium

When DUSD was introduced in 2021, it started trading at a 30% premium over the USD. What was the reason for that? The reason was that it had a high utility in the DeFiChain ecosystem and many people wanted it. Back then, there was only one way to create DUSD, which was via cumbersome 150% crypto loans. This resulted in the DUSD price instantly rising to 1.30 USD.

According to the above value formula, the way to drive down the price would be through the three multipliers: Firstly, make people less excited about DUSD, which was next to impossible in 2021, with the bullmarket ramping. The second way was by removing utility features for DUSD, which was not really practical. A third option was to allow people to burn DFI and to create DUSD at a 1% penalty to reduce its rarity. Besides bringing the value of DUSD down to 1 USD, this option also increased the price of DFI, making it outperform Bitcoin in 2021 and 2022 by a multitude, resulting in rejoicing of the entire DeFiChain community.

First Half of 2022: DUSD’s 1 USD Peg

Throughout most of 2022, DUSD traded close to 1 USD almost all the time. When the price went up, people were able to create more, lowering the rarity and value. When the value of DUSD went down, the DeFiChain community added extra utility to it, which raised its value back up to 1 USD. As shown in the chart below, DUSD rarely traded above 101 cents or below 99 cents — just as a stablecoin should:

However, due to the crash of the crypto markets and the markets in general at the end of Q2, DUSD lost part of its utility and with that, its USD pegging. In order to get DUSD to re-peg, we must understand what caused DUSD to lose its peg in the first. Otherwise, we will not be able to come up with viable solutions in the second half of 2022.

May 2022: DUSD losing the peg

As everything else crashed, DUSD, the stable counterpart to all the other cryptocurrencies, became less and less needed. Moreover, after so many DeFi projects failed, people became frightened, and left the sector to move their purchase power somewhere else. If we compare DUSD’s value pre-May to May, we see the following:

• The utility and demand of the people were high before May; rarity was decreasing as a result.
• Utility and people’s demand dropped in May; rarity remained the same.

By understanding that, you realize that the only way to quickly increase DUSD’s value and bring its price back to 1 USD is to reduce its supply, i.e., to increase its rarity.

As far as stablecoins are concerned, two routes have historically worked, while a third has failed:

1. Stablecoins backed by fiat, such as USDT or USDC, can be arbitraged for their underlying assets. In this case, the USD stablecoin is purchased at a discount, thereby bringing up its price, and then exchanged for the actual Dollar. Although this is a proven method, you need to trust the centralized issuer. Furthermore, these types of stablecoins are likely to be subject to tighter regulations going forward.
2. Crypto-backed stablecoins, such as Maker’s DAI, can be arbitraged for an underlying cryptocurrency. This involves buying USD stablecoins at a discount in order to raise the price, and exchanging them for a cryptocurrency that can then be exchanged for Dollars. These types of stablecoins don’t require a centralized issuer, but you do need to trust the blockchain’s smart contracts. Additionally, you risk not having enough liquidity when you try to sell the underlying cryptocurrency. The downside is that such stablecoins require more than 100% of cryptocurrency as backing, which makes them extremely expensive to create.
3. Terra’s UST attempted to solve the rarity problem by allowing a 1:1 swap between LUNA and UST. When USD was above 1 USD, LUNA would be burned to create UST, which would decrease its rarity and price. When UST was priced below 1 USD, it could be burned for LUNA, increasing its rarity, and with it, its value. Compared with Maker DAI’s model, the significant advantage was that it required exactly 1 USD of cryptocurrency to create 1 USD of stablecoin, not 1.5 or even 2 USD as Maker did. Due to this fact, along with a yield model that some may describe as ponzi-like, UST’s demand skyrocketed, making it one of the leading stablecoins at the beginning of 2022. When people’s demand shrank for a short period of time, and they wanted to burn 1 UST for 1 USD worth of Luna, the algo-style-backing caused the price of LUNA to decrease, which required more and more LUNAs. In the end, this triggered LUNA’s and UST’s death spiral, which resulted in people losing over 40 billion dollars in May 2022.

Is DUSD doomed to the same fate as UST?

Now that DUSD is trading slightly under 1 USD, one wonders if we will see a similar death spiral for DeFiChain as we saw with Terra Luna. And, if not, why not, and how can we get DUSD back to 1 USD?

The short answer is straightforward: NO, DUSD CANNOT CREATE A DEATH SPIRAL AND TAKE THE ENTIRE DEFICHAIN ECOSYSTEM DOWN WITH IT!

The long answer is actually also quite straightforward: The reason it is not possible, is, that there is no instant mechanism, to increase DUSD’s rarity by reducing its supply — THIS IS BY DESIGN!

There were many DeFiChain community members who understood Terra Luna’s design risks and avoided creating a similar burn mechanism in 2021. While this avoids a death spiral, it only allows for a slow DUSD burn via swap fees or an instant reduction via the loan backed part of the DUSD. This worked well enough throughout May. But, when the crypto market as well as the general market as a whole completely collapsed in June, the swap burn and loan fees weren’t fast enough to reduce DUSD’s supply, thus increasing its rarity. This resulted in a lower and lower price for DUSD, depending on how much it was needed.

It is essential to understand that the price of DUSD would automatically go back up to 1 USD if one or more of the following scenarios happen:

1. The crypto market moves up, increasing the utility of the DUSD.
2. More people are getting excited about DeFi again and interested in getting exposure to DUSD or dTokens such as dTSLA, etc.
3. The existing DUSD burn mechanism can make DUSD rare enough for it to return to 1 USD.

While these events may happen, the community should take matters into their own hands to stabilize the price permanently and fast. In order to achieve this, let’s explore some possibilities in more detail.

Fast and Permanent ways to get DUSD to 1 USD

Based on the three factors that affect value, we can immediately see various ways to increase the price of DUSD:

Utility: While the community cannot influence the entire market, it can add many more places within the DeFiChain ecosystem where DUSD is needed. A few DeFiChain Improvement Proposals already achieved this by making DUSD, rather than DFI, the means to pay back loan interests. Furthermore, loan interest may increase exponentially as DUSD’s price drops. All this is already helping and I will discuss some more ways how to make DUSD even more useful further down below.

People: DeFi’s attractiveness will come back after people realize how powerful true decentralization is. The DeFiChain community just has to stay patient and spread the word. If you have great ideas for marketing, please share them with the DeFiChain Accelerator Team: https://defichain.ac/

Rarity: Just like all other stablecoins, rarity is the most impactful factor to adjust. It is vital to keep in mind that DUSD can be created in three different ways in order to not only understand but also come up with possible solutions:

1. Like Maker DAI through overcollateralized loans. These so-called loan-backed-DUSD can be created and burned very quickly. The main disadvantage is that it takes a lot more USD in cryptocurrencies to create 1 USD of DUSD. Furthermore, if this was the only way to create DUSD, it would trade at a premium due to its strong utility, just as it did in 2021
2. The second way is the same way Terra’s UST was created: By burning DFI. In contrast to Terra Luna, DUSD has the crucial difference of not having a DUSD for DFI burn, which would create a death spiral.
3. The third way is via a futures swap from other dToken. Although this is not a commonly used path, the community could contemplate a suggestion to deactivate this path for now.

Some members of the community mistakenly believe that loan-backed DUSD will restore DUSD’s price to 1 USD. The reason DUSD is trading below one dollar is not due to lack of loan-backed-DUSD, but due to oversupply of DUSD. While the community needs to set a cap on how many DUSD can be created via a capital-efficient DFI burn (this was done with the DEX stabilization fee proposal), in the current situation, creating more loan-backed-DUSDs won’t help much. We need fewer DUSD, not more. This is absolutely essential to understand, as some proposed solutions tackle an entirely wrong problem.

With this understanding, we can use some simple math to calculate how many DUSD we need to burn in order to get the price of DUSD back to 1 USD. If the discount is 10%, all other factors being equal, we require 10% fewer DUSD. With a 20% discount, it would be 20% less. A crypto price increase of 10% or 20% would obviously have the same effect via the utility factors. Thus, a bull market would automatically resolve this issue. Looking at https://www.defichain-analytics.com/vaultsLoans?entry=nbDToken, we can see that we have 173 million DUSD in circulation. Approximately 10 million of these DUSD were created via loans, which is just short of 6%. Therefore, with the current system, any discount of more than 6% cannot be compensated by dramatically increasing the loan interest rate to force people to repay their DUSD loans. It would only result in second-order consequences that are difficult to predict, and not to an increase in DUSD’s price. Yes, it is important to have at least 50% of the DUSD created by loans in the future, but for now, we don’t possess that tool, so we must look for alternatives.

What else can we do to reduce the supply of DUSD? One approach has been the highly controversial DEX stabilization fee: https://docs.google.com/spreadsheets/d/11yTO43MBi3WQhtrIwUSpnNMaPVIy8zVVEz8TUyI46VI/edit#gid=0

The fee penalizes the selling of DUSDs by approximately 29% and goes down gradually with fewer DUSDs in circulation. Most critics misunderstand why the community implemented it in the first place:

1. Regardless of the fee, it indirectly increases DUSD’s utility. Its absence would result in DUSD’s price dropping by the fee’s percentage immediately. Without the fee, people believe they could still sell their DUSD for the price with the heightened utility, which is obviously not the case. Several complaints come from people who do not want a fee, but still want a high price — two things that are not possible at the same time. Nevertheless, if someone believes that another asset could go up more overtime than the DEX stabilization fee, he should sell DUSD now, help the community by burning some of their DUSD, and try to recover the losses elsewhere.
2. More constructive suggestions target the fee amount. This fee is primarily designed to allow anyone to sell, while reducing the DUSD supply by burning part of it. Now, the question is one of game theory: Which fee percentage burns the most DUSD in total? Coming up with a good number isn’t easy. As long as the potential downsides are limited, any suggestion targeting this part of the DUSD mechanics is worth trying.

So, which other proposals might work? It is important to state “might” because no proposal is guaranteed to work. The role of DUSD is quite significant, and many ideas that sound good at first may not work at all or may even have detrimental effects. Some ideas, try to buy back DUSD with DFI — either via the community development fund or through existing rewards. At first, this sounds great, but any DUSD-idea which may hurt DFI’s price, usually backfires, since a lower DFI price reduces the utility of DUSD, and thus negatively compensating any DUSD burn. Thus, it makes no sense to consider using Community Development Fund or DFI rewards without considering secondary consequences. Additionally, this does not even consider that the Community Fund or daily block rewards may not even be large enough to do so.

There have been many great suggestions on Reddit and other social media networks about how to increase utility or rarity. In this post, Community Member Kügi summarizes all proposals: https://www.reddit.com/r/defiblockchain/comments/wk1bh4/summary_of_current_ideas_regarding_the_dusd/ One of the best ideas I have read so far is a combo proposal by DZ and Kügi: https://twitter.com/mkuegi/status/1557087659515846658 The basic idea is to use 1/2 of the DEX stabilization fee to incentivize a lock-up of DUSD and/or DFI. A great thing about this idea is that no DFI is being sold, which would reduce the utility of DUSD. Instead, people have an incentive to buy DUSD and/or DFI. Currently, 50% of the stabilization fee amounts to around 50,000 DUSD per day, which adds up to 17–18 million DUSD per year. The DUSD issue could be solved easily if people want access to a 30% pretty much risk-free yield, as this would lock up over 50mil USD worth of DFI or DUSD.

For my part, I would probably combine this idea with some of the freezer ideas some community members suggested: https://www.reddit.com/r/defiblockchain/comments/qlwozx/freezing_funds_in_an_lm_pool/ A combination of redirecting 50% of the stabilization fee AND locking up funds for those who wish to receive this return. For instance, the community could create special loans with lock-ups of one, three, six, or twelve months. A 3-month loan has twice the rewards as a 1-month loan. The 6-month loan has a 4x multiplier and the 12-month loan has a 8x multiplier. This increases DUSD’s utility and rarity even further, which could lead to a major price rally in DFI and DUSD! This would take a little for the technical implementation, but it could be extremely powerful.

Confident!

I am 100% confident that the community will resolve the DUSD issue in the upcoming weeks. Once this is done, and once DefiMetaChain launches later this quarter, DeFiChain will be extremely well positioned to reach new heights. A thrilling road lies ahead!