Angle is a revolutionary new stablecoin protocol built to provide high on-chain liquidity for a wide range of assets, starting with Forex currencies like the Euro. In this series of articles, we explore the various types of stablecoins and illustrate how Angle’s design combines the advantages of these different approaches while remedying their flaws.
This is Part 4 on derivatives backed stablecoins. You can read Part 1 on centralized stablecoins, Part 2 on decentralized and over-collateralized stablecoins like Maker's DAI, and Part 3 on under-collateralized algorithmic stablecoins.
Building decentralized stablecoins is hard: it implies taking volatile (or not) crypto-currencies as collateral and issuing something which has a stable value on top of it. The goal of most decentralized designs is then all about one thing: absorbing and distributing the volatility risk of the collateral to be always able to propose to stable token holders collateral in value superior or equal to what they own in stable tokens.
In this series of articles, we have explored some widespread approaches to cope with this volatility risk. We went over algorithmic/under-collateralized designs where one option to absorb risk consists in having a volatile supply (like Ampleforth does), or where another choice is to rely to a secondary volatility token (often a governance token) which price is used to absorb the risk in case of a collateral price decrease or a bank run event (like FRAX).
We also dived into over-collateralized protocols like Maker where this volatility risk is taken by collateralized debt position (CDP) owners who risk to loose money in liquidations if the value of the collateral they brought falls too low.
While having CDPs and vaults like Maker really fragments the volatility risk, the counterpart with these designs is that it's hard to build really stable tokens with it as there are no direct arbitrage opportunities with the protocol when price deviates from peg. Some promising new designs like Liquity are however emerging and start to remedy this issue.
One idea to absorb the volatility risk is to sell it through derivatives contracts like perpetual futures to people who are looking for volatility. They will take on this volatility on behalf of the protocol, getting rewarded in case of collateral price increase and incurring losses when collateral price decreases.
This idea is far from being new in crypto. Back in 2017, Variabl came up with it but was never launched on mainnet. Since then and even though derivatives have been battle tested in crypto with exchanges like Bitmex, and on DeFi protocols like PERP Protocol, there have been very few projects leveraging these products to build stablecoins.
Before going into more details, it is important to understand how derivatives can help a reserve of collateral backing stablecoins remain stable in value.
How issuing derivatives can help the protocol hedge against collateral volatility?
Derivatives-backed protocols generally all revolve around the idea of relying on other people looking for volatility to hedge the protocol against ETH price variations. The goal is to balance the protocol so that when collateral prices increase and the protocol has a surplus, it can transfer it to traders hedging the protocol as a profit for them. In the case of a decrease in price, the protocol is protected by traders' positions as it can capture their losses to cover for the decrease in collateral value.
In this example, the product taken by the person covering the collateral from the protocol was a derivative product called perpetual futures.
Pika Protocol is using a similar design to build their stablecoin.
In few words, the Pika Protocol is a decentralized non-linear inverse perpetual swap exchange: it is a marketplace between people who own long perpetual positions and people with short positions like what can be found on Bitmex: when the underlying price increases short traders have to give collateral to long traders and when price decreases longs have to pay shorts.