Synthetic Stablecoins on Lightning
In a recent article, BitMEX founder Arthur Hayes outlined his idea for a new model to replace existing stablecoin models. He calls it the Nakadollar, and describes its goals as follows:
The goal is to create a token that is worth 1 USD but does not require the services of the fiat banking system.
The goal is not to create a decentralised fiat currency. MakerDAO is great, assuming it actually is decentralised, but for 1 USD of value it requires locking up >1 USD worth of crypto. It removes more liquidity than it adds, which is a net negative for the system. What we need is a mechanism that allows you to lock up 1 USD worth of crypto to obtain 1 USD worth of a stablecoin.
Hayes then goes on to describe the idea. The Nakadollar is a stablecoin created with Bitcoin that’s hedged using a perpetual futures contract on a derivatives exchange (or set of exchanges). This article is actually a continuation of an idea that Hayes first proposed in 2015, in his article “In Depth: Creating Synthetic USD.”
The core idea behind synthetic stablecoins is simple— rather than creating a tokenized version of dollars held in bank accounts (the model used by Circle, Tether, and others), this model uses derivatives to hedge the price of Bitcoin, pegging it to the dollar and creating a stablecoin in the process.
If this sounds familiar, that’s because it’s the exact same model that we use at Kollider to create our synthetic stablecoins.
In Hayes’ most recent article, he takes the idea even further, outlining a plan for a DAO made up of a variety of member organizations that would handle the creation of these stablecoins, along with ideas about how to handle oracles and governance. It’s worth reading in its entirety.
Hayes wrote the article in response to recent events that led to the market re-assessing the risk of other stablecoin models. In this article, we’ll discuss some of the tradeoffs of those models, explain why we prefer the synthetic dollar model, and explain how Kollider’s synthetic stablecoins work.
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Since the creation of the first stablecoins, a number of different models have proliferated— from fiat-backed to crypto-collateralized to fully “algorithmic.”
Despite these various models, the vast majority of the top stablecoins by market cap are based on the traditional model of a single centralized custodian that holds dollars and issues tokens on-chain to represent those dollars (as evidenced here by USDT, USDC, BUSD, TUSD, USDP, and GUSD).
However, recent market activity has highlighted some of the issues present with those models.
Following the collapse of Silicon Valley Bank last month, USDC— considered by many to be the safest and most reputable stablecoin— depeged from the dollar, trading as low as $0.94. This happened in response to news that Circle, the company that issues the stablecoin, had significant reserves tied up in the failed bank.
This incient highlighted one of the major risks of this stablecoin model (and the one that inspired Arthur Hayes article)— fiat-backed stablecoins are inherently tied to the fiat banking system. When problems with that banking system emerge, whether they be regulatory, solvency, or other problems, the value of those stablecoins is at risk. Hayes solution, and the one we’re working on here at Kollider, allows us to remove fiat banking from the equation by creating the stablecoins entirely within the context of a cryptocurrency derivatives exchange.
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Every single stablecoin model carries some form of risk and certain points of centralization. But it is possible to create capital-efficient stablecoins that don’t require the use of fiat banking rails. We do this today with Kollider synthetic stablecoins.
Here’s how they work:
Synthetic stablecoins use derivates on the Kollider Exchange to offer fiat-denominated price stability to users. In other words, Kollider offers users the ability to hedge their price exposure to Bitcoin by pegging all or part of their balance to a fiat currency.
When a user pegs a certain part of their BTC balance to USD, Kollider takes that bitcoin and uses it to create a position on the Kollider Exchange. The account simultaneously holds the bitcoin (meaning it’s long bitcoin) while also opening a perpetual short position (meaning it’s short the same amount of bitcoin). Taken together, these two positions mean that the account has zero exposure to the price movements of bitcoin.
If the price of bitcoin goes up, then the long position gains value, and the short position looses value. Importantly, the value gained by the long position and the value lost by the short position are the same. This means that the dollar value of the position does not change. The same goes in reverse— if the price of bitcoin goes down, the short position gains value and the long position looses value. As a result, these positions maintain a stable value in dollar terms.
For a slightly more technical explanation, you can browse our docs and test out the position calculator on our website.
We believe this model is important for a few reasons.
First, it allows for users to access dollar (or other fiat currency) denominated stablecoins without having to touch any traditional fiat banking system. That not only means that this model avoids some of the risks that caused USDC to depeg, but it also allows for much wider access. Users all over the world can opt into this model without needing any banking relationships.
Second, this model is highly scalable and capital efficient. As Arthur Hayes notes:
If this solution were embraced by traders and exchanges, it would lead to a large growth in Bitcoin derivatives open interest, which would in turn create deep liquidity. This would help both speculators and hedgers. It would become a positive flywheel that would not only benefit the member exchanges, but also DeFi users and anyone else who needs a USD token that can be moved 24/7 with a low fee.
And finally, this system is possible today. In fact, we have built a fully functional version of this system that is live with Kollider synthetic stablecoins. And you can test them out today using LndHubX directly, or by using Kollider Wallet.
We believe that synthetic stablecoins are an important step towards global financial access built on Bitcoin, and we’re excited to continue to push development forward in this area. If you have any feedback, we’d be happy to chat!