ESD has features similar to “DeFi ETF”. While possessing DeFi value capture features, its token price volatility is lower. These two features make it a high-quality super-current collateral.
Written by: Complement Capital
Translation: Lu Jiangfei
This article will introduce Empty Set Dollar (ESD) in detail and why it is a very important DeFi project.
- In the ESD project document, they claim that ESD is a “decentralized self-stabilizing dollar”;
- Robert Leshner, the founder of Compound Finance, called it “a new algorithmic stable currency”;
- In the ESD white paper, it is also referred to as “flexible supply stable currency”.
So, what exactly is ESD? We believe that it is one of the most important components in the DeFi industry.
ESD overview
Before officially entering the topic, let’s first give a brief explanation of the following parameters that will be mentioned, such as:
- “Epoch” cycle
- Coupon validity period
- Guaranteed token holder (bonded token holder) supply allocation percentage
- Guaranteed liquidity provider
These settings may be affected by governance changes. Some parameter values used in this article only represent the parameter values at the time of writing (November 4, 2020). This article was also updated on November 4 to reflect the debt approved by the ESD governance vote on November 3 Mechanism changes.
Let us enter the topic below.
What exactly is ESD?
ESD is an encrypted token with coding rules for supply expansion, so it can be regarded as an algorithm token or a flexible supply token. However, none of these descriptions can accurately capture the basic core theme of ESD, namely: anonymous, “self-interested” individual collections. ESD is a very reliable dollar mechanism that allows the dollar to be represented on the chain. The form is more stable, you can think of it as a kind of “synthetic dollar” (USD “synthetic”), always consistent with the US dollar. ESD does not need the support of a 1:1 anchor reserve, but a stable asset, and a “by-product” based on a series of rules that encourage human behavior.
Let’s start with an in-depth discussion on how it works.
Empty Set Dollar, ESD for short, is a synthetic asset, just like MakerDAO’s DAI or Synthentix’s sUSD. The goal of ESD is to keep prices stable by tracking the value of the dollar. In addition, there is a USDC-ESD liquidity pool on Uniswap that will be used as an ESD price prediction machine. According to the ESD design mechanism, the supply of ESD can be continuously expanded to ensure that the number of ESD and USDC in the liquidity pool is always equal, so that the value of 1 ESD can be consistent with 1 USDC (or 1 USD legal tender).
Side note: ESD currently sets an “8-hour” cycle, that is, every eight hours is an “epoch”. During the “epoch” transition, the ESD smart contract will check the price of ESD tokens. It should be noted that the ESD price will not be evaluated when the “epoch” boundary switches instantaneously, because doing so can easily lead to its price being manipulated. In fact, ESD uses the Uniswap Time Weighted Average Price (TWAP) algorithm, so its measured price should be the average of the previous eight hours and multiplied by the weighted value of each price stay time.
In order to give everyone an intuitive understanding of the way USD works, let’s take an example: Suppose the ESD token price remains at $1.05 for the first six hours of a certain period, and then remains at $1.02 for the next two hours, then According to the time-weighted average price algorithm, the time-weighted average price of ESD is approximately $1.0425, namely:
1.02+（1.05-1.02）*0.75
Even if a buyer purchases a large amount of ESD tokens two minutes before the end of the “epoch” and pushes the token price to $1.50, the impact on the time-weighted average price is completely negligible.
If the value of ESD exceeds 1 USDC, the smart contract will think that the market demand for ESD tokens is too high, and the supply of tokens in this era cannot meet the current market, so it will increase the supply by minting more ESD tokens ( We will explain in detail how to distribute the supply of newly minted tokens in a later article). Then, in each subsequent “epoch” cycle, the ESD agreement will continue to increase the supply until the total supply is consistent with the total demand, in which case the ESD price will fall back to $1. But when there are too many new tokens minted or external demand drops, then the price of ESD will fall below $1. Since the ESD agreement cannot know whether the supply is growing too fast, or whether there is some external reason that causes the demand to fall, it has introduced a unique mechanism called “coupons” that can help the system restore a fixed exchange rate.
But before introducing the “coupon” mechanism, we need to introduce another related concept: debt.
“Debt” and “Coupon”
When an “epoch” period ends and the time-weighted average price price is less than $1, the ESD agreement generates debt. Debt will continue to accumulate in the agreement over time. Therefore, if the ESD price falls below the anchor exchange rate for multiple “epochs” periods, the debt will grow larger. In this case, the accumulated debt will capture the lack of demand over time. Until the debt is paid off, no new ESD tokens can be allocated. When the ESD price exceeds the fixed exchange rate, any newly created supply of ESD tokens will be repaid with “coupons” before being distributed to token holders, and then the debt will be repaid.
If there is not enough capacity in the market to purchase ESD for less than $1 and restore the pegged exchange rate, you can use “coupons” as a backup plan. If the price stays below $1 for a long time, ESD will evaluate whether it needs to solve the problem through other methods to ensure the continuous development of the project.
“Coupons” can incentivize token holders to voluntarily destroy ESD tokens and are also a voucher that can be exchanged for ESD in the future. These “coupons” can be purchased at discounted prices. Although “coupon” holders take certain risks, offering discounts can also be regarded as a reward. During the downturn in market demand, the discount of “coupons” is not strong, because ESD token holders have little incentive to take the risk of buying coupons. However, as debt accumulates more and more, the discount of “coupons” will become more and more powerful, which means that people who buy “coupons” can get more attractive returns. But there is a very important issue that needs attention, that is: the coupon will expire within 90 “epoch” cycles (currently equivalent to 30 calendar days)! This means that “coupon” buyers must be very confident in ESD and firmly believe that the insufficient supply of ESD tokens is temporary, otherwise, their investment in “coupons” will all disappear. Therefore, “coupons” are not intended to be used by retail investors in essence, but are expected to allow professional investors to assume the role of buying. If you want to understand this problem, you need to take a step back and first look at how the ESD system works.
We can think of accumulated debt as a “memory” of the system, and every debt is a “memory” of a difficult period. However, debt does not want to be a mechanism for stabilizing the price of ESD. The real stabilization mechanism should be the market’s belief in the ESD system, that is, ESD should be anchored to the value of 1 USD from beginning to end, as long as it falls below 1 USD , Traders can buy ESD tokens at low prices and sell them at anchor prices for profit. The profit calculation is based on whether the difference between the current market price and the dollar is maintained for a longer time than the trader expected and the ESD has not returned to the dollar. The debt mechanism provides enough time for the system to calculate the decline in demand so that the system can estimate how many “coupons” to issue. Once we return to the fixed exchange rate, the debt will be reset to zero and no new “coupons” can be issued at this time. If the ESD price falls below the anchor exchange rate again, the “coupon” cycle will start again, and debt will accumulate from zero. At this time, the discount of the “coupon” will also become lower.
On the other hand, the “coupon” design idea is actually to hope that ESD will restore the pegged exchange rate after it has been below the pegged exchange rate for a long time. Investors can buy debt because they firmly believe that demand will increase or is about to increase. They will make a decision based on their “game experience”. If they are wrong, failing to pay off their debts before redeeming the “coupons” means that all the ESD they have invested in buying debt will be lost. If they are correct, they will make a fortune. The benefits include:
- (Below face value) The difference between the ESD transaction price and $1;
- Additional ESD brought by “coupons” discounts.
Investors who purchase “coupons” can also do things that the ESD agreement itself cannot do, for example, they can create their own needs. In fact, ESD believes that only those who have a large amount of money can effectively use “coupons”: they buy tokens to push up prices and keep prices above the anchor exchange rate until the debt is paid off and the “coupons” are redeemed ——This is also one of the main reasons why ESD is not a purely algorithmic stable currency. ESD is more like a system that combines algorithms and incentives for user behavior to achieve price stability. Therefore, it is not recommended for inexperienced investors to use “coupons”, because if they cannot accurately determine when to buy coupons, they are likely to suffer huge losses.
“Coupons” also play a role in another typical situation, namely: ESD tokens are traded at prices lower than the anchor exchange rate for a long time. Assuming that the transaction price of ESD in the three “epochs” cycle is 0.98 US dollars, it seems to be no big deal, but this situation will cause trouble for some ESD users who need to close their positions but do not want to bear the price shock, because debt will It accumulates in three “epochs” cycles, so “coupon” discounts will increase, causing arbitrageurs to step in and make profits. Some people have previously obtained a “small gain” by pulling the price back to the pegged exchange rate, but obviously, the profitability does not seem to satisfy the arbitrageurs. However, the additional “coupon” incentive measures are enough to allow many people to change the transaction decision from “no transaction” to “transaction”. If still not attracting enough people to trade, the “coupon” discount will continue to rise until the arbitrage opportunity is sufficiently attractive to traders.
Once the price stabilization mechanism comes into play, market demand will return again, and the price of ESD tokens may begin to climb above $1. As long as the time-weighted average price ends above $1 in each “epoch” cycle, a new supply of ESD tokens will be created and the debt will be reset to zero. These newly supplied tokens will first fill the ESD liquidity pool and redeem for “coupons.” At this time, “coupon” holders can redeem ESD on a first-come, first-served basis. Only when enough minted ESDs cover the redeemed “coupons”, new ESD tokens will be minted. At this point, we return to the question mentioned during the token distribution, namely: Which users are lucky enough to get the newly minted ESD tokens?
In order to answer this question, we must delve into the Decentralized Autonomous Organization (DAO).
ESD governance system
ESD is decentralized and has been created based on on-chain governance from day 1. That is to say, the protocol can only be upgraded after a quorum of token holders has voted. Those who participate in the decentralized autonomous organization need to invest in token binding. If the token supply expands in the future, then:
- 80% of the newly minted tokens will be distributed proportionally to the people participating in the decentralized autonomous organization;
- The remaining 20% will be allocated to those who provide liquidity in the Uniswap ESD-USDC fund pool.
Of course, liquidity providers (LP) must bind their Uniswap liquidity pool tokens to earn rewards. However, by binding ESD and Uniswap liquidity pool tokens, these token holders will be subject to some restrictions. For example, after unbinding, users who pledge tokens in decentralized autonomous organizations and users who provide liquidity in Uniswap must wait for the end of an “epoch” cycle to transfer their tokens, and those who participate in governance voting Tokens bound to members of decentralized autonomous organizations will also be locked until the voting result is confirmed.
Will the ESD agreement work as expected?
So far, can the design mechanism of the ESD protocol work as expected? The above is a very typical decentralized self-stable system diagram, you can see it in any books related to “self-stable” systems. The idea of this chart is that the initial response speed of many control systems may be very slow in the initial stage. In this case, the system will overshoot and then lower the target value. In fact, a “self-stabilizing” system generally responds to fluctuations by adjusting some internal states to reduce the amplitude of fluctuations, until the final control agency controls the target value of the system within a small range.
Link Wen’s Note: The overshoot is also called the maximum deviation (maximum deviation). Deviation refers to the difference between the adjusted parameter and the given value. For a stable fixed value adjustment system, the maximum deviation of the transition process is the difference A between the first peak value of the adjusted parameter and the given value. The indicator B of overshoot is often used in the follow-up adjustment system. When y(∞) is not equal to the given value: overshoot=[Y(Tm)-Y(∞)]/Y(∞)×100%, (A—maximum deviation; B—overshoot).
ESD is currently in this process, so we don’t know what its future results will be, but ESD is about to enter the end of the second complete cycle. Here is the history of the system so far: As you can see, the “hit value” in the first cycle reached a maximum of $24. In fact, in the boot phase, that is, before CoinGecko added support for ESD tokens, the ESD token transaction price even soared to a higher point (by the way, this is a reasonable estimate based on the high inflation rate during the boot period). And in the second cycle (which looks like a small wave compared to the first cycle), you will see that the ESD token price is closer to $1 than in the first cycle.
Let’s take a closer look at the second cycle to gain a deeper understanding of what’s happening:
We can see that in the second cycle, ESD tokens once reached a peak of about US$2.40, and dropped to US$0.43 at the lowest. (In fact, the price of ESD tokens may suddenly fall even lower, but CoinGecko data does not Record), and then restored to the anchor exchange rate on November 3, 2020.
So far, we can see that the trend of ESD tokens is in line with expectations, and the initial design of the protocol seems to work well. The agreement can also be adjusted appropriately, and it is hoped that appropriate governance decisions can be made to change certain system parameters and adjust incentive measures.
But it is foreseeable that as we go through more cycles, the ESD system will build sufficient market confidence, so traders can set prices based on the anchor exchange rate to get the expected return, so they may be more inclined to stay below the anchor exchange rate Buy ESD and sell above the anchor exchange rate. In fact, the predictability of the ESD system will attract more professional arbitrageurs. Over time, the competition among arbitrageurs will gradually weaken, making the pegged exchange rate of ESD tokens more stable.
High quality super current mortgage
Although we have also seen a variety of interesting decentralized stablecoin designs (such as Terra, Celo, MakerDAO), in the market share scheme, centralized “players” such as USDC, Tether and Binance still have huge Advantages (as shown in the figure below). Centralized stablecoins may be subject to regulatory and potential review risks. Therefore, the cryptocurrency market needs a truly decentralized stablecoin.
But why can ESD tokens become one of the key components of the emerging DeFi economy? The main reason is: ESD tokens may become a high-quality collateral.
For most DeFi projects, high-quality collateral is essential. When users borrow encrypted assets on DeFi lending platforms such as Compound, Yield, Mainframe, and Aave, or forge synthetic assets on MakerDAO, Synthetix, and UMA, the quality of collateral will have a significant impact on user experience and user benefits. In order for everyone to better understand this point, the following will compare ESD and “DeFi mortgage king” ETH.
When we use ETH as collateral, price fluctuations are the main problem that everyone needs to face. The price of ETH fluctuates sharply over time, and sometimes the price even drops sharply, which may lead to a sharp drop in the value of the mortgage, which in turn triggers forced liquidation. Therefore, when users use ETH as collateral, they have to invest more ETH (sometimes even more than the minimum requirements of the system) for collateral, which will cause a very serious problem of inefficient use of capital. To make matters worse, the borrower/trader will now be asked for a margin call by the trading platform. If they do not provide more collateral or cannot repay the loan within a short period of time, then their collateral will be within a few minutes Cleared by the trading platform. For collateral providers, this is a very bad user experience, but what is even more frightening is that this method is likely to trigger panic selling of collateral, which in turn will cause irreparable systemic risks. The price drop will also cause a chain reaction, and other ETH holders will also choose to sell, which will trigger more margin calls, resulting in a cascading effect of lower prices. On the other hand, the current Ethereum blockchain also has certain limitations, and network congestion will also cause the problem to be further exacerbated.
So, what happens if we don’t use ETH, but use stablecoins as collateral? One of the most direct results is to eliminate people’s worries about collateral price fluctuations, and there is no need to worry about huge losses caused by forced liquidation. When traders lose money in synthetic trading and cannot meet the margin call requirements, they can deal with the situation calmly and cautiously instead of selling urgently, because everyone believes that the collateral will continue to maintain its value. Even if the stable currency falls below the pegged exchange rate, this situation may only be temporary. Therefore, the agreement/lender/dealer-that is, the counterparty of the synthetic transaction-also knows that the trader can sell the stablecoin collateral at the appropriate time. But the problem is that stablecoin collateral also has shortcomings. One of them is that users cannot get a return after the stablecoin is locked. Therefore, the capital efficiency of using stablecoin as collateral is also very low, which in turn leads to unsatisfactory return on investment.
Dan Eric policy (Dan Elitzer) wrote in his ” superfluid mortgage ” (Superfluid Collateral) article proposed a solution to the problem of capital efficiency. In the model given by Dan Eritzer, the collateral is secured, but at the same time the collateral is liquid. In a sense, the secured collateral can be reserved for mortgage transactions and may be liquid in a short period of time. From another perspective, the secured collateral is liquid, but at the same time it can be used for lending transactions and gaining income in some way. Doesn’t this effectively solve the capital efficiency problem mentioned earlier? Okay, yes, but maybe we can do better-
When I use ETH as collateral, it means that I hold a position in an asset, and the asset price may increase with the overall growth of the DeFi ecosystem. Under this model, the role of ETH is somewhat similar to that of stocks, because it captures value through the growth of the cryptocurrency market, and this growth is also highly correlated. Holding ETH is a bit like buying a DeFi “exchange traded fund”, so this is actually what users can get from ETH collateral. They hope to mortgage ETH to get high profits, but they find that the DeFi market may grow Will exceed the rate of return they earn, so people need to be able to act as super-current collateral for the “DeFi Exchange Traded Fund”-and this is the problem that ESD hopes to solve.
As the market demand for ESD tokens continues to increase, the value of ESD secured tokens will also continue to grow. Therefore, if ESD becomes one of the leading decentralized stablecoins in DeFi (yes! This is a great possibility!), the market demand for ESD tokens may keep pace with the growth of DeFi. Moreover, if the ESD token can prove its price stability (yes, this is more likely!), then the volatility problem will disappear, the over-collateralization problem will be solved, and the resulting systemic risk will also end. Collateral providers no longer need to be bound by margin requirements. You will find that the DeFi user experience has become better after the introduction of ESD tokens.
When a certain agreement accepts ESD tokens as collateral, the agreement understands that ESD’s stabilization mechanism can ensure that the value of tokens quickly returns to the anchor exchange rate state, so even if sometimes the price of ESD tokens is lower than the anchor price, the agreement will give a certain tolerance degree.
In fact, ESD and ETH have the same characteristics as “DeFi ETF”, but while possessing DeFi value capture characteristics, the price volatility of ESD tokens is lower-there is no doubt that these two characteristics make it one This kind of high-quality super-current collateral is more attractive in the market than other collaterals.
What risks need attention?
Finally, we have to discuss a question, are there any shortcomings in ESD tokens? Well, ESD does have some problems, mainly the following three:
First, the biggest competitors of ESD tokens are MakerDAO and centralized stablecoins. At the same time, the decentralized stable currency market is heating up, with a large number of new opponents pouring in every week, so market competition will become increasingly fierce. ESD may not grow with the growth of the DeFi market, which brings some risks.
Second, in the long run, whether ESD tokens can continue to maintain a “stable” state is still unknown, but as ESD token holders gradually adjust the system dynamics, the stability mechanism may be further developed. But it should be noted that the stability mechanism may not work, especially considering that the DeFi “hacker army” has been trying to destabilize the mechanism.
Third, the price volatility of ETH may also decrease over time. In this case, ETH can still maintain its dominant market position as the “King of Mortgage”. These are potential risks that exist in reality.
However, we are still optimistic about the future vision of ESD, and can’t wait to see how this project will develop further. With ESD tokens:
- Users can invest in tokens that grow with the growth of DeFi;
- When users need to spend ESD tokens, they can benefit from its stable price;
- When users lock ESD tokens in the lending market, synthetic trading applications, and other new DeFi protocols, higher returns can be obtained.
In our opinion, this is an amazing innovation!
If you want to experience ESD, you can get the ESD application on the website ; if you want to read the white paper, you can visit here .
Information disclosure: The Complement Capital team is the holder of ESD tokens.
Source link: complementcap.substack.com
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