Very interesting post, thank you!
I have some thoughts:
Options versus Debt:
I would argue that simply accepting a medium amount of quadratic drift (eg. standev ~1-4% per year) is underrated. The cost is definitely significant. It’s unintuitive, and it makes this design unusable as an “accounting stablecoin” (ie. being able to “pretend it’s USD” to people you send and receive it from, or capital gains tax authorities).
I think the main difference you were pointing towards regarding the liquidation-based model compared to the options-based model is the fact that, at least in the context of exposure to the underlying asset, debt has this property of giving you “simulated USD” (100% exposure) right up until liquidation, whereas options’ underlying exposure drifts quadratically from 100% (which is unachievable) exposure. The underlying problem though is that the synthetic tracking the underlying asset in the options case will still be “liquidated” metaphorically as the exposure trends towards 0; the question then becomes whether the market for options could ever be deep enough that the strike prices fall to a point where the risk of quadratic drift is actually lower than the risk of liquidation in the debt model.
All attempts at providing this functionality have to deal with a fundamental issue. The system as a whole can only hold ETH. Its assets and liabilities in T must add up to zero. So for every holder of positive-T, there must be a holder of the same quantity of negative-T. What happens if T rises so high that a holder of negative-T goes “bankrupt"?
Generally being on the sell-side of a perpetual will always have this requirement of having to actually have the underlying asset at hand for future “delivery,” as in the case of futures, or similarly having to actually buy back a security later in a short sale. In DeFi since we can’t rely on institutional trust we basically end up constantly forcing the user to “buy back” the value of the underlying asset in real time; really options have this same property, except that instead of having the user post realtime collateral to ensure 100% exposure, you decrease their exposure quadratically to obviate the need to rebalance. The user-side still incorporates this risk of a lack of exposure to the borrowed asset under extreme volatility though.
This post proposes to make synthetics rely only on “slow” oracles by flipping the problem on its head: we remove the entire concept of liquidations by making the “base building block” of the system options rather than debt.
To me the benefit of oracle security and simplicity is much more valuable than the underlying economics to the user; the fact that you can rely on “slow oracles,” as you call them, has huge benefits to security, and as you mentioned is basically analogous to a prediction market. I actually think this is extremely cool, as it lets people manage their finances as a permutation of prediction-market bets tracking underlying consumption goods, and since stable savings are really only ever ephemeral for the intelligent investor who keeps their wealth in actual assets, the quadratic drift becomes less of an issue as most users will likely be rebalancing their exposure to consumer goods every month or two to match their own market behavior anyway. Actually this idea is worth more discussion so I’ll talk about it more at the end of this post.
Potential Improvements
However, it makes much more sense, if you view it not in the context of “I want simulated USD”, but rather in the context of “I want price stability” (ie. ability to pay a known quantity of one’s own future expenses).
I do think this model is superior to the debt model for those who seek stability rather than underlying “simulation” as you called it; I’d much rather live in a world where everybody uses ether as a rule, but purchases their own basket of “stability contracts,” than live in a world where virtually nobody uses ether and holds “stability units,” as the widespread use of units of account exogenous to the protocol open it up to all kinds of unhealthy relationships with —mostly negative these days— geopolitical developments.
I also think the underlying options-based synthetics can be optimized for greater efficiency regarding exposure to the underlying asset. For example, it’s worth considering whether the strike price could be made dynamic to accommodate volatility; the irony of the current model is that actually the options are more efficient the lower the volatility (higher the stability) of the asset the user wishes to hedge against, which is precisely the opposite of the desired effect. In other words, there’s less of an incentive to hold the synthetic that gives you exposure to USD if ether is stable, but the synthetic is better at giving you exposure to USD the more stable ether is (due to the lower likelihood of drift close to the strike price).
Remember, as a P1500 holder, your goal is to “hold” USD and have no exposure to ETH. What this graph tells you is: the safe bet is to hold deep “in-the-money” options, and then rotate them into options with a lower strike price as soon as the price gets anywhere remotely close to the the strike price.
As shown by the derivative of the nominal exposure graph, the quadratic drift effect means that actually the deeper in-the-money the (P, N) option is, the more the marginal decrease in value of P corresponds to a relative increase in units of ether to offset the value lost; on the opposite end of the spectrum, an out-of-money options means that the marginal decrease in value of P actually corresponds to far less of a relative increase in units of ether to offset the loss (more exposure/less hedging). This is also true of the holder of the N-side of the option: in-the-money, a marginal increase in N corresponds to less of an increase in in units of ether (worse leverage), and out-of-the money the marginal increase in value corresponds to a relatively larger increase in units of ether. Since the P-side desires stability, they are in pursuit of the deepest in-the-money option that maximizes the offsetting of their losses; the N-side of the option, however, is the speculator who is in pursuit of leverage, so their optimal option is sufficiently out-of-the-money to the extent that each marginal increase in value actually gives them more units of ether —analogous to leverage on the upside of the underlying asset.
A dynamic strike price would allow both parties to minimize their exposure to the extreme-case of quadratic drift by trading a marginal amount of their beneficial “away-from-the-money” (either in or out) region for less drift at the extreme end (the other side of the money). For example, if the strike price was actually ± (depending on the side of the money the option is currently on) the square root of the difference between the strike price and the current price, you’d dampen out the extreme-end risk for both parties in exchange for marginally worse best-case returns.
Modular and Composable Stablecoins as Homogeneous Monetary Goods
Suppose that you have some ticker
T, which represents a price index denominated in ETH. For example,Tcould equal the USD/ETH price (ie. inverse of ETH/USD). Or CPI/ETH (aka CPI/USD * USD/ETH). Or the same for any other commodity. Or more exotic indices (eg. average rent prices in a city). You want to give users the ability to have exposure toT.
The idea of creating a market for economic goods (through the use of derivatives) in order to simulate a set of homogeneous modular and composable stablecoins is absolutely remarkable to me. This would be the theoretically optimal form of money as it would allow individual economic agents to actually compose their own stores of value relative to their own consumption in the market. Here’s the thought experiment that led me to this conclusion:
Allow me to make an analogy from thermodynamics (thermodynamics seems to be gaining popularity as a medium to make deep philosophical analogies): it’s common knowledge that a gas will expand in volume to fill whatever container it is in; if you change the shape of the container, the gas will maneuver to fill the gaps; if you add more gas, it will spread out to reach volumetric equilibrium.
I claim that money is just monetary gas filling an N-dimensional container, where N is the number of economic goods available for purchase in the economy; if you add more money to this container (the economy) it will spread out to reach equilibrium relative to the aggregate demand of each individual good N; if you change the shape of the container (change prices/demand or add more goods), the money will move to fill the gaps to reach the same equilibrium of prices.
Note that by the efficient market hypothesis, this notion of equilibrium is only increasingly true, and never completely. In this analogy, if you take N coordinates within the container’s N-dimensional coordinate space, you have a personalized stablecoin that represents unique exposure to a set of desired economic goods. The entire container is a modular and composable stablecoin system that lets users pick their own coordinates of exposure relative to their own spending habits (i.e what is the optimal store-of-value for them) relative to their actual consumption needs into the future.
This is a vastly superior means of storing value than the current model where we use a ‘one size fits all’ catch-all unit of denomination such as the dollar, or prospectively, ether. These monies here for example would be represented by the “top right” of this N-dimensional economic container, or in other words, the aggregate of everything.
I wrote about this further in this research post if you’re interested; I really think the future of currency isn’t a currency at all, but a modular and composable market for homogenized economic goods.