How can WENWEN Protocol avoid the death spiral?

The second half of 2020 was the DeFi summer, with the emergence of the loan market, insurances, derivatives, and synthetic assets. Stablecoin is the foundation of the DeFi ecosystem, and it is growing rapidly from the launch of Tether as the first stablecoin in 2014 to now more hundreds of stablecoin projects and tens of billions of market value. At present, the most common three types of stablecoin in the market are: fiat collateralized stablecoin, crypto collateralized stablecoin, and non-collateralized algorithm stablecoin. Fiat-collateralized stablecoins must rely on high-quality, liquid assets and be centralized to protect stablecoin holders from credit risk, market risk, operational risk, and issuer bankruptcy. The disadvantage of over-centralization and lack of sufficient transparency runs counter to DeFi’s intention. Although the crypto collateralized stablecoin is decentralized, over-collateralization reduces the efficiency of capital use, and it is prone to liquidation risk when the price of the collateral asset falls rapidly. While these trade-offs may be acceptable in the narrow use cases of stablecoins, they could limit the usefulness of stablecoins in mainstream applications. Algorithmic stablecoins are designed to avoid these problems. Although many uncollateralized algorithmic stablecoins offer highly trustless and scalable models, the problem with algorithm design is that their mechanisms are often too complex to guarantee the stability of price and they are exposed to the death spiral. This article is going to explain the stabilization mechanism of the WENWEN Protocol and how can the protocol avoid the death spiral.

Algorithmic stablecoins do not require collateral reserves. Instead, the peg is achieved entirely by algorithms and smart contracts that mirror the monetary policy to manage the supply (expansionary and contraction policies to control the supply to keep the stablecoin price pegged to $1), such as Basis Cash, ESD, AMPL, FEI.

Currently, the two most common types of stabilization mechanisms are rebasing and the dual token mechanism.

A rebase stablecoin is designed to stabilize the price by automatically adjust the circulating supply according to the stablecoin price fluctuations, such as Ampleforth. This mechanism directly adjusts the number of stablecoins in a user’s wallet. For example, when a user has 10 AMPL, the current circulating supply of AMPL is 100, and the current price of AMPL is $1. When AMPL’s price drops to $0.9, the system will perform rebasing to bring the price back to $1, the number of AMPL in the user’s wallet will shrink to 9, and the total circulating supply will reduce to 90. However, this mechanism can put users under stress and trigger a cascade of redemptions by directly shrinking the amount of stablecoins users have. It continues to create more panic selling, and the stablecoin would suffer from more loss of confidence and more redemptions. This self-reinforcing negative feedback loop, if not stopped, can rapidly turn into a death spiral.

In the dual token mechanism, algorithmic stablecoins use the secondary token to absorb the risk of the stablecoin price deviates. Using Basis Cash as an example, when BAC’s price is lower than $1, the protocol will issue a bond (BAB). Users can purchase it at a lower price and redeem it for $1 in the future. Although this mechanism reduces the possibility of a cascade of redemptions to occur, it brings a new problem — — “Black hole of debt,” because the lower the stablecoin price, the greater the arbitrage profit, and it also means more debt will be accumulated. When the debt reaches a certain level, it becomes challenging to repay the system in the future and restarts the ecosystem.

The vault’s repurchase mechanism and the dual token system in the WENWEN Protocol brought a way to deal with the ‘death spiral’.

WENWEN Protocol takes inspiration from the central bank model in the real financial world. It attempts to design a protocol that stabilizes the stablecoin’s peg rate through open market operations (market-making) via a simple and effective “algorithm-central bank mode. In addition, combined with innovations including the dual token system, multi-stablecoin pairs, and liquidity mining rewards to provide a highly scalable, decentralized algorithmic stablecoin that does not require collateral.

The WENWEN Protocol stabilization mechanisms are inspired by the central bank model and use simple and effective algorithms to achieve price stability. When prices fluctuate, the vault acts as the central bank, stabilizing the stablecoin price through repurchase and additional issuance rewards.

Repurchase:

When the stablecoin price has small short-term fluctuations (deviation of more than 1%), the vault adjusts the circulation of stablecoin in the market through repurchase to stabilize the price of stablecoin. The protocol also allows other users to arbitrage the profit from the price dislocation to bring the price back to the peg.

Using the USDN as an example:

When the USDN price is higher than $1, the vault will use its own USDN to buy back the WBTC, increasing the USDN supply in the liquidity pool and bring the price back to the peg

When the USDN price falls below $1, the vault will use the WBTC owned by the vault to buy back the USDN to decrease the USDN supply in the liquidity pool and bring the price back to the peg

At the same time, other users can also take this arbitrage opportunity to earn a profit.

Using the USDN as an example:

When the USDN price is higher than $1, users can sell their USDN at a higher price

When the USDN price is less than $1, users can purchase the USDN at a lower price

Additional Issuance Reward:

The WENWEN Protocol uses the quantity theory of money to stabilize the price through monetary expansion and contraction policies. Since the total amount of tokens issued in the vault is fixed after genesis, when the demand for stablecoins is in a long-term expansion or contraction phase, the protocol adjusts the price of stablecoins by issuing additional reward SHAREN or stablecoins. Currently, users have to stake SHAREN or stablecoins to participate in the additional issuance rewards mechanism to receive stablecoin rewards

Using the USDN as an example:

If the USDN price is higher than $1, holders of SHAREN will receive USDN rewards, the supply of USDN will increase

If the USDN price is less than $1, holders of USDN will receive SHAREN rewards. Users can use SHAREN to purchase USDN, which increases the demand for USDN

The vault’s repurchase mechanism and the dual token system in the WENWEN Protocol brought a way to deal with the ‘death spiral’. The protocol does not reduce the number of stablecoins held by users during the contraction phase, avoiding panic selling when the stablecoin price falls, nor creating a ‘black hole of debt’ by constantly issuing protocol debts. From the perspective of traditional economic theory, all money in circulation is a liability of the central bank. That is, every stablecoin (such as a USDN) issued can be regarded as the protocol’s liability. Unlike traditional central banks, the interchangeable function of the two tokens gives the stablecoin the convertible bond attribute and SHAREN the convertible share attribute.

Firstly, during the contraction phase, the protocol will issue SHAREN equal to the amount of stablecoin that needs to shrink to encourage users to continue to hold the stablecoin during the contraction period, increasing the demand for the stablecoin and reducing selling pressure. If users do not want to suffer the loss due to the short-term drop in the stablecoin price, they will need to hold the stablecoin to receive the rewards and use SHAREN to buy stablecoin for compensation. At the same time, users can also choose to keep the SHAREN issued by the currency expansion phase to receive more stablecoin dividends rewards. Users can swap SHAREN and the stabecoin at any time, allowing them to decide which token to hold or the ratio of holding both tokens depending on their risk appetite and return expectation.

Secondly, the central bank model of the protocol has the advantage of vault reserves to stabilize the stablecoin price. A death spiral can only occur if the stablecoin price enters a long-term downward phase, but there is a floor value for the stablecoin price, which is the value of the WBTC controlled by the vault divided by the total number of stablecoins. When the price continues to fall, the vault can continue to carry out repurchase in the open market. When the vault holds a large number of stablecoins, the vault will continue to receive SHAREN issued to obtain absolute voting rights, thus restarting the ecosystem. Therefore, the currency price will only have a temporary fluctuation instead of a ‘death spiral’.

WENWEN Protocol avoids the centralized risk in fiat-collateral stablecoins and the inefficient capital use and liquidation risk in crypto-collateralized stablecoins. Meanwhile, it also avoids the death spiral exposed to many algorithmic stablecoins. WENWEN Protocol attempts to provide the DeFi ecosystem with a collateral-free, highly scalable, and decentralized algorithmic stablecoin with the innovation of the dual-token system and the central bank model.

WENWEN is building the decentralised monetary system of the future