Robert Lauko - Scaling Without Breaking - Next Generation of DeFi Stablecoins

baby [Music] thank you Julian for making it all happen um so the very first item on the agenda is one of the best examples of decentralization in stable coins uh Robert lauko from liquidy please please stage is yours thank you Garrett [Applause] um clicker thanks hello everybody uh it's a great pleasure for me to be here today and present scaling without breaking the next generation of D5 stable coins I'm Robert lauco the founder and head of research at liquidy so um this doesn't work yet I guess maybe you have to turn it on or no worries I think I will sort that out in a sec but in the meantime maybe I can just introduce you to a concept which is probably familiar to all of you which is the stable coin trilemma I will just throw it on the next slide but I guess it's uh it's easy enough to just um say a few words about it right now I mean you know that stable coins like LUSD they are very decentralized and they are also built to be very robust but they may suffer from some scalability limitations dye um was in a similar situation but they decided to solve this by adding more centralization by adding the PSM module so that they could scale more but of course that came at the expense of decentralization and then you also have other stable coins like the field-backed ones which are obviously centralized but they can scale basically infinitely and then on the left hand side if the triangle was was there but it's not the left hand side you would see the algorithmic stable coins um which I I would say like Luna of course base is cache or basis coin were the prime examples Unfortunately they they didn't work out so um yeah that's the situation um and maybe this oh cool thanks a lot um oh now I have to go back a bit that's all too much Alpha okay yeah this was the situation I was just describing before I think um yeah I don't need to spend more time on this um but let me outline maybe a novel form of stablecoin which may not be as familiar to all of you that like the main suspect but on the left hand side I will just start with summarizing some of the like main challenges of the CDP backed Sable cons like LUSD which are as I mentioned related to scalability limitations and with the scalability limitation there is also another consequence which is that the pair cannot be as stable as you would want to have it because it's only a soft mechanism you don't have like real Arbitrage in in both directions and then another negative challenge or consequence is that liquidity on dexas for example can be a big challenge because you need to pay a lot of incentives which is not sustainable so that's the situation but then on the right hand side I've outlined a novel concept which some projects have tried I call it decentralized reserve and the main difference there is that instead of having like multiple individual cdps or boring positions you have one Reserve ideally a decentralized reserve which belongs to the protocol and which then allows basically people to just come in with their ease or whatever the like the backing asset is and just I mean more stable coins so it basically allows you to Mint and redeem the stable coin at will similarly to usdc but in a decentralized way hopefully and if we achieve that then it also means that the peg becomes much stronger thanks to Arbitrage and also the system itself can then act as a primary amm because the system itself is giving out the stable coin and buying it back basically at all times now the big big challenge with this concept is that now what you need to make sure is that your reserve is always large enough to be able to fully back or over back the stable cons so that it can buy it back whenever somebody resumes and that's not easy um because especially in Bear markets and difficult Market situations um those like existing let's say examples of this concept have proven to be like they haven't really worked as well as in theory um and and there like on the left hand side you see the corresponding challenge with the cdps is just an efficient liquidation mechanism and I think that's the easier problem to solve so now really the challenge that we are now focusing on as a team is how to make sure how to hedge a reserve basically against this price risk and here there are two concepts already that you know from those systems like on the left hand side you see something I call recapitalization by inflation which is basically a simple concept it's it's kind of similar to the algorithmic stable coins like Luna but it has a third token which is the reserve asset so basically what people do is they they can mint and redeem the stable coin by providing some let's say layer one asset it could be easer it could be another like asset from the the chain and then whenever the system has it's kind of below its its uh Target backing Ratio or collateral ratio the system would then mint assert token I call it a recapitalization token that's that kind of the lunalag token which is then minted to basically and then sold to people which would then provide more of this harder Reserve asset to kind of increase the reserve so that it can always then buy back the stable coin when somebody redeems so that's this type of approach and then on the right hand side you see another one which is a bit more let's say traditional or in tradify there are similar concepts of deltronutral hedging so what happens there is you still have the reserve it's on volatile asset and the stable coin as a liability that you need to back but now what people can do is they basically still provide more of the reserve assets so they're like hedging agents that like try to back up the the reserve and what they get in return is some form of derivative like a Perpetual future for example so you would then be kind of on The Leverage long end you are get like you are basically taking over the volatility risk from the protocol um so that's like just on a high level but now um both of those approaches have their challenges like the recapitalization through inflation approach uh has the has first of all the challenge of being very Capital inefficient at least the protocols that are out there they like jet for example requires a Target collateral ratio between 400 and 800 percent which is yeah pretty high and then with the natural neutral hedging approach there are many different ways how you can do it like one is that you would go to a centralized exchange and open a short position so that um yeah then people would then take the long end or long side of the trade but that's not really decentralized then I mean as long as you're using centralized exchanges um I mean but there are also other ways like angled it I mean that's interesting because they did their own built-in kind of Futures Market even though the Futures are a bit more exotic than the normal ones but they are or they were basically trying to um do that internally unfortunately we have seen that some of those examples have failed like kind of U.S or neutrino usdn I mean had a similar Fate To Luna they ended up in a dead spiral because when the price of what was it uh I even forgot like wave I think token was there like reserve asset and then when they had to went wave like plummeted they had to meet more of their like recapitalization token and they just ended up going down to zero um but there are some examples like Dollar on chain which is who knows dollar and chain here by the way oh one two it's very it's very like I find it interesting because it it's older than liquidy and maybe as almost as old as maker but little known that that is still working and there is also Jed which is which is working but they are pretty small and not very like well known then on the adapter neutral um side it seems that all of the projects that have tried it they ended up pivoting they they they saw that it kind of didn't work and then they took measures to make sure that they don't collapse so that's the situation but we still think that this that delta neutral hedging is is the way forward and kind of the Holy Grail but we need to improve it we need to make something change something to make it really work because the challenge as I already mentioned is kind of in a bear Market there is not really a demand for those like risky leveraged positions uh which means that the protocol cannot sell enough of them in a short time period which also means that the protocol may have to kind of subsidize it or incentivize it so that let's say on a on a Futures Market that would mean like a negative funding rate but then the protocol May kind of bleed out over time so we need to make sure we need to cut down on the cost for the protocol that's still attracting people um to those hedging positions so how can we do that we tried multiple ideas I mean we simulated them so one is just like I mean the protocol can charge some fees like commenting and Redemption and other user interactions so we can use the fees or try to use them to kind of Finance some incentives some funding rate but it didn't really turn out to be sustainable but you could also try is dilute existing users like make it or make it more attractive for new hedging agents to come into the system by diluting the existing ones I mean but that is kind of similar to this inflationary model where you are like again at risk of of causing a downward spiral so then eventually we got back to field zero and and we thought like what can we do and then it kind of all made sense yeah let's do something which is inherently more like a hedging product which is inherently more attractive even in adverse Market situations and then we can also cut down on the cost for the protocol and there are really two innovations here I will outline in a bit more detail one is on the user side or user's end like we need to make the product more attractive by adding principal protection so now even in a bear Market the users they have kept downsides so it's not that now you're in a crazy 10x leverage position but but you know when you get in like your losses are kept so that's on the user's end and by doing so we can hopefully increase the market and increase the attractivity for becoming a backer or hedger of the system on the right hand side you see the protocol and for the protocol what we ended up doing or what we found out is that there is a neat way of reducing the hedging costs um by making it so that this principle protection is guaranteed in a very unique way rather than a direct payout and I will show how that works and by doing so again we can reduce the strain on the system so what's this product now first like what is this principle protected leverage or principle protected hedging product uh all about so first of all um it's a Perpetual like it means that you create it it's set and forget you open a position and you are not subject to liquidation either so it's like something you can open and just see how it evolves you don't need to actively manage it which is I think already like a good ux but then more importantly the principal protection and that's the key benefit here what does that really mean so let's say somebody wants to become a backer or hedger of the system by depositing tennis or by opening a position with a principle or size of tennis now I mean there are two scenarios like East can either go up or down so here is just an example for a reserve asset it can be any asset it could be stake these or rocketies whatever but here is yeah so we have like somebody opened the position with 10 East and now when ease goes up and there is this implied leverage because you are kind of getting the leverage from the reserve like those stablecoin minters who mean the stable coin they provide more ease to the reserve of course at kind of at one to one which means that now whoever is a hedger would also benefit from this extra ease like benefit from the upside coming from the East that was deposited by the stable coin minters and then like here just an example like when ease doubles um maybe we have this kind of Leverage which makes your position now verse 40 is so that's the positive scenario but then of course East can also plummet let's say it plummets by half and but then the good thing is thanks to the principal protection you would still get 10 E's I mean nominally you would always be able to claim or get tennis back and obviously if you think about it you have a position of 10 but it can only go up really it cannot go down in terms of it like easier is the numerator but that means that this position on a secondary Market or just a fair value if you kind of try to calculate it should be worth more than 10 is because you would price in the upside without pricing in a downside but that makes it very interesting now for the system now the system can sell this position to the user to the backer at a higher price like at the premium like a position that is kind of has a principle of 10 can be sold let's say for 13 or 14 or 12 whatever is so there is this premium now the system can collect this premium in addition to the principle so it can collect more than the tennis why is this interesting now um one thing is that obviously the protection is only needed when the price of each plummet and it has to plummet a lot otherwise people who have a position I mean they open the position with 10. now ether has gone down but they would still maybe think or hope that either would go up so rather than claiming the tennis principle they would hope for a future where East would go up and then the position would eventually be worth maybe 15 or 20. so the protection is only claimed rarely in those downturn scenarios or a bit more technically whenever the market value of the position Falls below the payoff or the value that the system guarantees then you would want to claim your principle otherwise you won't do that we would rather sell it on the secondary Market to somebody else because you can sell it at a premium this is all nice but there is a problem what if everybody wants to claim their principle at the same time in a big like crash um there is no hard guarantee that the total liability of the system coming from all those um principles is smaller than the total amount of collected premium because the premium that the system can collect is basically this extra Reserve or this extra bucket that then can be used to finance the principal protection but there can be a situation here which is a bit similar to a bank run because yeah the liabilities could still be higher than the collected premiums so we need more we need a second innovation so how can we make this principle protection less of an issue or like a smaller liability for the system you need to decrease the liability and we do that by integrating the secondary Market into the primary system in a very Innovative way um so instead of paying out the principle upon claim we can make sure that people can sell their like existing hedging positions or leverage positions on the secondary market for the principle the system guarantees this by paying out or paying out by kind of boosting up or propping up the positions through a subsidy mechanism which then makes the position that kind of like gradually increase in value until you will find a buyer who pays the tennis who pays the principal and then it turns out if you do that that the protocol only needs I mean first of all the protocol only needs to subsidize a fraction of all the positions because most of the positions won't be in a state where their market value is lower than the payoff and in those scenarios you don't need subsidies you can just pay your position as it is on the secondary Market because there is still a positive premium on it so only a subset needs to be subsidized and out of this subset it turns out that you need to subsidize only a little bit I mean only a percentage up to a level where now your position is again in a shape that you would have a positive premium on the secondary Market so what this means is that in the end the protocol subsidy is basically a fraction of a fraction of the total principles like the sum of all the principles that it needs to protect so we have cut down on the total liability twice like kind of um by taking a fraction of a fraction and last but not least um the way this subsidy mechanism works is that it keeps all the subsidies within the system so it's not really paying out any value it's not leaking value but here you will see a bit more practically how that looks like so um the key idea here is that I call it the leverage position here this is the the item in in question here the system has like a built-in auction mechanism that is managed by controller this controller always tries to make sure that the system The Reserve or the stablecon supply is sufficiently backed so you can have a controller that kind of takes the backing ratios and input and kind of now prices the positions on the primary Market based on the urgency of the need for more capital and this is kind of like an auction and when people open new positions they would not just top up the reserve but they would then pay an extra premium which goes to a separate bucket which you see here this is this pool there down there and now let's say Bob bought such a position and later on he wants to sell it on the secondary market like the built-in Market in the system and hopefully he can just sell it as his without subsidies but in a like bear market and maybe his position is now in a very bad shape he cannot do that so then the system would just detect that I mean Bob would just raise his position he and invade a while and then there is a timeout and after the timeout the system would then start subsidizing this position over time again like similar to an auction it would kind of increase the inherent the intrinsic value of the position until the market value exceeds this payoff or this no sorry this principle of 10 and once that happens Alice or whoever is the buyer would then buy this position for tennis principle so that's how the system guarantees really um this the sale otherwise there would be no guarantee but thanks to the subsidies we can kind of make sure that whoever wants to sell their position um would be able to sell it eventually for the principal of course the system needs to subsidize like take the subsidies from somewhere and it turns out I mean according to our preliminary modeling efforts that the subsidy payments will be much less even in in bed like price scenarios much still much less than the premium payments that people pay so this this pool should be replenished more than it kind of depletes over time so there is like a positive influx like the influx is higher than the outflux so yeah can we cracked the stable coin trilemma I think we can by building upon like the previous ideas of that to neutral hedging but also taking them to the next level by adding principal protection and then the third ingredient is this built-in secondary Market to cut down on the protocols liability and costs so that that's it from my end I mean we are now opening up our research because we are still in a research or conceptual phase so not just launching it but we want to Now open up like our discussion to the community so we would love to get you or people involved in this discussion um because I think we need to get your feedback your inputs and ideas to make the product even better and and just also to see whether there is enough demand for this novel hedging product uh right now we are mainly looking for this pricing question but uh yeah we would be just it would be awesome if you could follow us on Twitter or even better if you could scan that QR code down there and then um join our Discord and last but not least we would also want to invite you to some uh to a community event which will probably take place in August but uh watch out for an announcement thank you so much and I hope that we'll have some time for questions then yeah thanks for that I'm one extractify guy doing options derivatives and looking into this and actually building our delta neutral stablecoin and the main question here in this model when you basically trying to make a principle protected product is in threadfy it's basically like buying put options so it looks a little bit like this and it seems like the main question here is just the price of this protection which given the current volatility levels just fundamentally doesn't stack with the available funding which you can get out of say the risk-free rates Etc so have you looked already into the economics of how high is the cost of providing the principal protection in that case how do you think if it's viable so maybe I mean just before talking about the costs I mean the first question is what kind of Premium can we expect I mean that also depends like both the premium and the expected subsidies depend on the fair value like how to Value such a position the cool thing here in the main Insight is that thanks to the built-in Leverage the volatility of the underlying which is leveraged up would be much higher and you know from black souls and the like that volatility is one of the key as the the biggest impact on the price So based on the volatility we can expect like really high premiums in the first place on the other hand even when when the position plummets a lot you know then maybe you are down like in the red but still just the fact that thanks to the leverage this position could be go could go up to above the principle relatively quickly that should be priced in as well but of course there is a threshold so there is kind of a threshold below which we expect people to um claim their principal protections like then the system needs to pay out subsidies and there is also like an upper bound where we expect people to claim their like course or we call them like the intrinsic value the payoff from the system so there are those two ways like claiming the protection or claiming the intrinsic value and uh yeah I mean VR we are doing currently we are research on that question with academics uh and together in a collaboration so we want to make sure that this really adds up in the end yeah cool thanks very interesting to discuss that in more detail sure hey there I'm Ben I'm trying to understand your claim that uh this will help solve the scalability trilemma for stable coins particularly asking about the scalability of collateral and trying to understand how particularly given that the system uses leverage how you can expect to find enough collateral to scale the system to trillions of dollars and in particular using censorship resistant collateral that's a great question and that's still one of the biggest open challenges I must admit because of course scalability here always depends on the economic bandwidth of the underlying blockchain like layer one and of course on the scalability of the collateral now it of course depends on what you use as collateral if you were to just use planes then I guess scalability wouldn't be an issue for the foreseeable future of course we we want to also look into a staked ease or like more yield bearing options there and then of course it's very important that those underlying um staked ease products scale well with demand but of course scalability here is limited by the scalability of the lower layers otherwise I mean the system may become a bit like like if your your stable coin is the main driver for the value of the collateral then that's probably not the best thing because then it destabilizes the whole economics so to answer your question we are still looking into the Best Collateral asset all right any more questions going once going twice all right everyone thank you give a big hand thanks a lot