Thread by @samkazemian

A 🧵 on algorithmic stablecoins & capital efficiency

A lot of algo stablecoin critics continue to feel vindicated when a new project feils.

But skeptics misunderstand nuances in how the space is evolving. Let me tell you why your life will be ruled by algo stables soon 🙃

People call algos a ponzi or claim they will never work...and even if they did work, they say "Why would I ever use a partial/no backing stablecoin when I can use 150% backed $DAI?" They don't understand that capital efficiency is for SUPPLY SIDE money, not consumer side use

From a consumer perspective, all things being exactly equal like liquidity, integrations etc..no rational actor should EVER choose to use a stablecoin that's lower collateralized than one more backed. That's obvious. Hell, give me 1000% backed $DAI. Forget the 150% collateral!

Ask yourself the OTHER side of the question. Why doesn't @MakerDAO just INCREASE the overcollateralization ratio if that's what people REALLY WANT in their stablecoin? Why doesn't someone come up with a Maker fork that's 1000% collateralized? We'd all use that right?

Because it would be incredibly expensive to create this money. Liquidity would seize, lending it would be disastrous, borrowing 1000% $DAI would cost an arm & a leg APR. The supply side creation of this stablecoin would be insanely expensive to meet demand.

Who in their right mind would collateralize $1000 ETH to create 100 of these 10x backed stablecoins? Why would they do such a thing if they can generate 750 $DAI with 150% collat ratio? Literally everything you could do with 10x $DAI would cost more like LP, lend/borrow, etc.

Of course CONSUMERS would love 1000% $DAI and hate lower collat coins. But that's not how free markets work. The shortage for such crazy backed cash would manifest in ridiculously high borrow rates, inefficient loans, and wasted collateral. Lower backed coins are cheaper to use.

So why is it that everyone is trying (and feiling mostly) to create fractional/unbacked stablecoins? Because capital efficiency shows itself on the OTHER SIDE of the coin (no pun intended). Cheaper lending/borrowing, cheaper loans, more liquid credit creation, better efficiency.

When designing @fraxfinance we worked backwards exactly from this premise. How much unbacked cash does the market want and allow us to create? $FRAX changed how a lot of projects think about algo coins. As of this writing, FRAX is the only algo that has never broken its peg.

We introduced DeFi to the concept of a fractional-algorithmic stablecoin. The market sets the collateral ratio (CR). When FRAX is $1.01 the CR lowers. When the price of FRAX is $.99 the CR increases. The ratio of collateralized to unbacked FRAX is set by market forces.

When the market is clamoring for FRAX and price is $1.01, we use this as input to lower CR. All seigniorage, fees, and excess collateral goes to the governance token Frax Shares $FXS. It's also minted on the other side for collateral to increase the CR when FRAX is $.99.

This simple concept allows the protocol to ask the market "just how much supply of money are you ok with being unbacked?" The market responds collectively through the price of $FRAX. It's essentially a democratic way of voting for the capital requirement of the Fed/banks.

In $FRAX v2 we introduced the concept of algorithmic market operations (AMOs) which allows the protocol to do anything with new $FRAX and collateral as long as the market doesn't respond by pricing FRAX at $.99. That's the market responding and saying "don't do that any more."

AMOs are the Turing-complete and final state of "protocol controlled value." We can literally do anything with AMOs like mint $FRAX into @CreamdotFinance @compoundfinance @AaveAave for cheaper rates than any other stablecoin. We can provide $FEI-like liquidity to ourselves too.

In fact, we've released 3 big AMOs since v2.

@CurveFinance AMO, Lending AMO @CreamdotFinance & collateral rehypothetication for yield through @iearnfinance @compoundfinance @AaveAave. Again..if the market responds with $.99 FRAX, these AMOs stop and unwind to increase the CR

As a result of such capital efficiency, $FRAX is one of the largest collateral lenders on @compoundfinance, the #1 user of @iearnfinance $USDC vault, and more growth day by day. THIS is where capital efficiency shows. Slowly..then all at once.

I joke that all roads lead to $FRAX. Every stablecoin protocol in DeFi is learning these things little by little. Check out this $DAI proposal by @StaniKulechov it proposes minting raw $DAI directly into Aave for borrowing. Sound familiar? Lending AMO
forum.makerdao.com/t/discussion-d…

A lot of projects in the space will realize all roads lead to $FRAX. We're excited to build along with them. As the inventors of the fractional-algorithmic stability mechanism, we essentially scale DeFi's thirst for stable cash. And we have so much more coming soon 🤫