Design Considerations

1. Destable by design

USDFI introduces a novel primary stablecoin design. Simply put, it’s deliberately unstable first, but stable at last. In other words, it's a design that is deliberately unstable in the short-term, but stable in the long-term. The design is based on the principle that if the stablecoin repeatedly returns to a region of stability after transitory instability, over time the scope and scale of these under-peg events will diminish, and recovery times will become shorter as user confidence and trust in the stablecoin increases.

Unlike fiat currency, user confidence in a decentralized stablecoin cannot be enforced by laws, regulations, or a judicial system. Instead, the protocol's self-regulating credibility must be earned over time to sustain long-term value.

We believe that there is no shortcut to this process and that most decentralized stablecoin designs and their mechanisms directly or indirectly try to circumvent this process, despite the low-time preference required. These protocols try to shortcut an essentially years-long process of earning user confidence and trust.

2. Tracking errors

Every financial asset that tracks the price of an underlying financial asset suffers from tracking errors. In the case of stablecoins, the tracking error is the divergence between the price of an USD stablecoin and the price of USD $1. As the tolerance for price tracking becomes narrower, the tracking error becomes a greater source of instability. This is because smaller deviations from the tracked price trigger greater losses of user confidence in the design.

The tracking error of a stablecoin can be measured by the standard deviation of the difference between the price of the stablecoin and the price of the reference point. The lower the standard deviation, the lower the tracking error and the greater the stability of the stablecoin.

However, it is important to note that there is a trade-off between the stability of the stablecoin and the scalability of the design. Narrower tolerance for price tracking may lead to greater stability but may also restrict the scalability of the stablecoin.[1]

3. Liquidity constraints

There is no such thing as a stablecoin whose backing is instantly fully liquid for USD. Consequently, for every stablecoin there is a condition under which it will not trade at peg. Because of this, traditional stablecoin designs are long-term unstable in a probabilistic sense. There always exists states where the peg can be broken, even if the probability of this happening is small. The loss of confidence in the stablecoin is exacerbated by the fact that once the peg breaks, users do not know what is going to happen or what to expect. This uncertainty is the enemy of investment.

4. Stablecoins do not have automated contingency plans

While every stablecoin design knows a conditions under which it will not trade at peg, no current design offers a protocol-based and automated remedy for this condition. The lack of a solution begets uncertainty and loss of confidence. This is highly likely to trigger more volatility exacerbating the downward instability.

It is clear that a deterministic protocol acting as a backstop of last resort is needed for a stablecoin design. This protocol would provide a mechanism for restoring the stablecoin's peg in the event that it deviates from its reference point. By providing a clear and transparent mechanism for restoring the peg, this protocol would mitigate the uncertainty and loss of confidence that arises when the peg is broken.

5. Building confidence: Stability vs. time

We believe that money can’t buy back confidence once it’s lost, ihis is true regardless of the collateral that may be available in the design. With the USDFI stablecoin, periods of downward price instability are an integral and necessary part of the maturity process. As time progresses, the design gradually shifts towards increased price stability, moving from a softer peg to a harder peg. This gradual shift allows for the development of user confidence, which is the foundation of the USDFI design and the manifestation of its primary value.

This process of developing user confidence takes time and (by lowering the time preference) it allows the design to develop the necessary rigidity and economic security to ultimately fulfill its role as a decentralized digital dollar.

6. The role of speculators

The USDFI stablecoin design provides incentives for speculators to bet on the stablecoin returning to its peg. These incentives are achieved by offering a higher yield in return for acquiring USDFI at a discount during temporary periods of downward price instability. This creates a reoccurring and sustainable incentive for individuals to absorb price risk, and it represents a key aspect of the USDFI design.

On the other hand, users with a high time preference and a need for immediate liquidity can always sell at a discount during temporary periods of downward price instability, essentially trading time preference. This allows individuals to make trade-offs between the level of liquidity they require and the yield they are willing to accept. Vitally, there is no way to deplete the treasury/reserve assets of the protocol during these periods.[2]

Further, we believe a softer peg/exchange rate that adapts to the user’s conversion demand reduces speculative attacks. If a stablecoin design limits or even prevents speculation, all traders believe no other trader will speculate and therefore the perfect equilibrium consequently involves no speculation.[3]

7. Summary: The peg coordination game

USDFI is a mechanism that aims to stabilize the value of a stablecoin by aligning the beliefs of market participants. In this game, individuals form their beliefs about the fundamental value of the stablecoin based on the value of the symbiotic cryptoeconomic mechanisms and its level of acceptance and usage in a digital economy guaranteeing utility. Additionally, they also consider the perceptions of other market participants. The role of USDFI is to coordinate these beliefs among market participants within this economy in the context of time preference. The mechanics of the Trinity and the rules governing them are publicly available on the blockchain, providing transparency and accessibility to all market participants. This allows rational users to implicitly agree on whether to support or undermine the peg in case of a temporary supply overhang. Over time, it's not rational to contravene the perpetual Buyer of Last Resort mechanism.The overarching goal of the currency peg coordination game is to limit confidence crises from in scope and scale, by ensuring available restabilisation mechanisms/automated contingency plans ultimately leading to a stable value for the stablecoin.

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[1] The Basel Committee is trying to address redemption and basis risks which (unwillingly) introduce substantial crypto market stability risks in return, https://www.ashurst.com/en/news-and-insights/legal-updates/basel-committee-second-consultation-on-the-prudential-treatment-of-banks-cryptoassets/

[2] The on-chain treasury effectively acts as a one-way crypto asset vacuum.

[3] Analogous arguments in Routledge, B., & Zetlin-Jones, A. (2021). Currency stability using blockchain technology. Journal of Economic Dynamics and Control, 104155. Put differently, if all liquidity of a stablecoin design is at a specific fixed price (the peg) that liquidity can be exhausted and is triggerable by a speculative attack if it’s profitable to do so. The solution is to have a redemption price as a function of state, i.e. a redemption curve with price versus the level of redemption activity accommodated at that price. However, in the USDFI design the reserve assets of the treasury can’t be drained.