Analyzing the development stages and trends of stablecoins, the fourth generation of stablecoins has more advantages

Twenty-Three Characters / Wen, article reprinted from "Odaily Planet Daily", original title: "Algorithmic Stablecoins Are the Most Aligned with Satoshi's Vision of 'Currency'"

Satoshi Nakamoto introduced a peer-to-peer electronic cash payment system in the Bitcoin white paper, but Bitcoin has deviated from this original design of electronic currency; ETH exhibits certain transactional medium properties but is essentially an application token, making it difficult to meet the design requirements of currency within the blockchain. Central bank digital currencies, while possessing blockchain attributes, remain strongly regulated centralized currencies.

Odaily Planet Daily believes that current algorithmic stablecoins are the most likely candidates to become the 'currency' envisioned in Satoshi's white paper, representing the most native cryptocurrency aligned with the decentralized spirit of blockchain. Why is this the case? How do they differ from previous generations of stablecoins? Where will algorithmic stablecoins head in the future? We will explore these questions below.

Bitcoin Deviates from Satoshi's Currency Vision, ETH Has No Intent to Serve

In the context of the digital age, Bitcoin has deviated from Satoshi's envisioned 'currency'. The current transaction costs of Bitcoin are actually very high, far from Satoshi's proposed solution. As it has developed, Bitcoin's block expansion has rarely been mentioned (except for BSV).

Bitcoin has abandoned the 'currency' role envisioned by Satoshi, instead moving towards the path of digital gold in the crypto world, and it has already acquired hedging properties. Grayscale pointed out in its report "Wealth Transfer Drives BTC to Become a Mainstream Investment Target" that Bitcoin seems to share some commonalities with safe-haven assets, such as: 1. Scarcity; 2. Verifiability; 3. Minimal correlation with traditional financial markets and lack of control.

Once, Bitcoin as digital gold was merely a hypothetical concept, but now traditional institutions regard BTC as digital gold. On November 9, JPMorgan Chase noted in a report that Bitcoin is eating into the market demand for gold ETFs. Family offices and other institutional investors see Bitcoin as a digital substitute for gold, with their demand for Grayscale's Bitcoin Trust exceeding the total demand for all gold ETFs.

In the future, with the maturation of pegged coins and cross-chain technology, Bitcoin will further realize its function as a store of value within the blockchain network. Once Ethereum resolves the issues of slow transfer speeds and high fees, Bitcoin is expected to achieve efficient circulation in the form of pegged tokens, rather than being stuck in its own small blocks; if cross-chain technology matures, Bitcoin could further circulate in the blockchain world (although this circulation will still be in the role of digital gold, rather than as a currency).

So, could the second-largest crypto asset, Ethereum, become the 'currency' envisioned by Satoshi? From the beginning, Ethereum and Bitcoin have had very different positions; Ethereum has never intended to serve as a 'currency' within the blockchain network. Although ETH has indeed acted as a transactional medium in certain scenarios during its development, its value depends on the application value of its underlying network, and the price of ETH is highly uncertain, making it difficult to fulfill the role of 'currency'.

To illustrate this with the March 12 crash this year, MakerDAO used ETH as collateral, but due to severe price fluctuations, asset liquidations occurred, leading to network congestion and subsequent chain liquidations, creating significant systemic risk. ETH is more like the 'energy' of the Ethereum network; it may be more appropriate to view it as an application token.

The era has chosen Bitcoin to serve as digital gold, while Ethereum is clearly focused on becoming blockchain infrastructure. So, who should fulfill Satoshi's envisioned 'currency' role? This question remains controversial in the market, and we believe stablecoins may be the closest option currently available.

The Evolution and Development of Stablecoins

The essence of the 'currency' envisioned by Satoshi is a cryptographic native token that achieves decentralization. While digital currencies issued by commercial institutions or central banks utilize blockchain technology, they carry strong centralized attributes; algorithmic stablecoins are more aligned with Satoshi's vision of a cryptographic native token. Before introducing algorithmic stablecoins, let's review the evolution and development of stablecoins to observe how they have gradually realized the 'currency' form envisioned by Satoshi.

• The first generation of stablecoins is represented by USDT, which tokenizes fiat currency and builds an important bridge between fiat and cryptocurrency.

• The second generation of stablecoins attempts to construct decentralized stablecoins, with MakerDAO's DAI as a representative. MakerDAO initially used ETH as collateral, but later introduced some centralized assets as collateral, such as USDC and wBTC, due to market risk considerations. While the introduction of centralized assets has provided DAI with greater stability, it has also sacrificed some decentralization characteristics.

• The third generation of stablecoins attempts to construct native tokens for the cryptocurrency industry, represented by elastic stablecoins like AMPL and YAM, which do not require collateral and primarily adjust through algorithms and mechanisms. The third generation of stablecoins is very close to the 'currency' envisioned by Satoshi, and its future is as a strong competitor for becoming blockchain 'currency'; however, we are more optimistic about algorithmic stablecoins.

• The fourth generation of cryptographic native algorithmic stablecoins is primarily represented by ESD, BASIS, FRAX, etc. These algorithmic stablecoins reference the design of the earlier Basecoin and combine the experiences of liquidity mining and elastic stablecoins, thus forming a comprehensive system.

Advantages and Disadvantages of the First and Second Generation Stablecoins

Although the four generations of stablecoins can all be said to anchor to the US dollar, they are fundamentally different and can be broadly divided into two categories: the first and second generation stablecoins belong to the collateralized anchoring mechanism, which ties them to the US dollar at a 1:1 ratio, maintaining a small fluctuation range in price difference with the dollar; in the third and fourth generation stablecoin systems, the dollar price is more of a reference price, and the stablecoins essentially seek price equilibrium through algorithms and market adjustments, resulting in a relatively larger fluctuation range.

While both the first and second generation stablecoins belong to the collateralized anchoring model, what distinguishes them? What are the advantages and disadvantages of this type of stablecoin? Why do we say that the third and fourth generation stablecoins have greater potential?

The first generation stablecoin is a completely centralized collateralized anchoring model, with its issuing institution being centralized, issuing stablecoins at a 1:1 ratio through reserves of US dollars (equivalent to collateralized dollars). The second generation stablecoin, while also pegged to the dollar at a 1:1 ratio, primarily uses crypto assets as collateral, maintaining the pegged price through an automatic pricing mechanism built into smart contracts, rather than through the issuing entity. In other words, the second generation stablecoin transforms centralized stablecoins into a decentralized collateralized anchoring model.

The collateralized anchoring model of stablecoins has built a bridge for communication between traditional assets and crypto assets; at the same time, it has established a stable currency unit for the highly volatile crypto world, temporarily fulfilling the 'currency' role envisioned by Satoshi, but this is only temporary.

One of the drawbacks of the collateralized anchoring model is its centralized attribute (even the second generation stablecoin DAI has to sacrifice some decentralization by introducing centralized assets among its collateral to ensure stability). Another drawback of the collateralized anchoring model is that it is not suitable for the impending explosive growth of the crypto world.

Looking back at history, the collateralized anchoring model of stablecoins is very similar to the dollar system established during the Bretton Woods system (35 dollars pegged to 1 ounce of gold). In the process of wealth migration in the digital age, collateralized anchoring stablecoins are very likely to face decoupling or collapse, and indeed, we are witnessing such decoupling happening; for example, Tether struggles to maintain a 1:1 exchange rate between USDT and the dollar at all times. This is another reason why we believe the third and fourth generation stablecoins have more promising prospects.

Why Do Fourth Generation Stablecoins Have Advantages?

Compared to the first and second generation stablecoins, the third and fourth generation stablecoins have abandoned the collateralized anchoring model and instead established a 'currency' system through market supply and demand relationships.

Let's specifically introduce the operational mechanisms of the third and fourth generation stablecoins.

The third generation stablecoin is an elastic stablecoin, and we will introduce its basic operational mechanism using AMPL as an example. AMPL is issued based on Ethereum smart contracts, and the most important part of the AMPL protocol is the "token supply adjustment" mechanism, which can automatically adjust the number of AMPL tokens in all user wallets based on market prices. This adjustment does not dilute the tokens but rather increases or decreases them proportionally. The adjustment is primarily based on changes in market supply and demand, then transmitted through price information, prompting people to engage in speculation and arbitrage, thereby helping AMPL find its price equilibrium.

The demand for buying AMPL stems from the hope that its price will rise, allowing users to gain more tokens for profit, which leads to a strong speculative atmosphere in the AMPL market. The global adjustment of AMPL is somewhat crude, and once most people start panic selling, it can easily lead to systemic risk. AMPL is highly innovative, attempting to find a native currency for the crypto world through market supply and demand, which is commendable; however, this attempt lacks experience and is highly speculative, making it unsuitable as the 'currency' envisioned by Satoshi.

The fourth generation stablecoin is an algorithmic stablecoin. Algorithmic stablecoins reference the design of the earlier Basecoin and combine the experiences of liquidity mining and elastic stablecoins, forming a relatively complete monetary market adjustment mechanism. Unlike the third generation stablecoins AMPL and YAM, the token adjustments of the fourth generation stablecoins ESD and BASIS are not conducted through global adjustments via smart contracts but are completed by users actively, incentivized by economic mechanisms.

We will introduce the algorithmic stablecoin BASIS as an example. The Basis protocol has three types of tokens: BAC (short for Basis Cash), BAS (short for Basis Share), and BAB (short for Basis Bond). The target price of BAC is 1 dollar; BAS and BAB primarily serve to pull BAC's price back to 1 dollar. Holding BAS can earn newly issued stablecoin rewards, akin to enjoying a seigniorage; BAB provides opportunities for premium returns.

Specifically, when the trading price of Basis Cash is below 1 dollar, users can enjoy a discount to purchase Basis Bond, and by purchasing Basis Bond (BAB), users simultaneously destroy Basis Cash (BAC), thereby reducing the supply of BAC and pulling its price back to 1 dollar.

When the price of Basis Cash rises above 1 dollar, users holding Basis Bond can redeem Basis Cash at a 1:1 rate, and once Basis Cash is redeemed by users, Basis Bond will be destroyed. Basis Bond has no interest expenses and no expiration or maturity date. This market adjustment mechanism of algorithmic stablecoins effectively ensures the credit of the issued currency and makes it easier to achieve 'currency' stability.

Algorithmic stablecoins are generally designed similarly, but there are some subtle differences, such as the Coupon in ESD (similar to BAB) having a deadline; additionally, there are differences in epoch time and lock time. These differences can lead to variations in price deviation, market speculation levels, and flexibility of market adjustment mechanisms, ultimately developing different trajectories. In the competition among many algorithmic stablecoins, the market will select the best 'currency'.

Based on our observations, fourth generation algorithmic stablecoins perform more 'stably' than third generation elastic stablecoins.

Firstly, algorithmic stablecoins draw on the design of Basecoin, which is highly rational; at the same time, they incorporate the experiences of liquidity mining and elastic stablecoins, forming a relatively complete 'currency' adjustment mechanism based on market supply and demand changes, which is more similar to the 'currency' function envisioned by Satoshi. Which specific algorithmic stablecoin will become the leader in the future still needs to await market selection; however, from the development trajectory of DeFi, first-mover advantage remains very important. If later entrants merely imitate or make 'micro-innovations', their value will be relatively limited, and the risks of user participation will also be relatively high.

How Will Algorithmic Stablecoins Develop in the Future?

Algorithmic stablecoins are still in the early stages of development, and it is difficult to predict how they will evolve in the future, but based on recent observations, some predictions can be made.

We believe that the future anchor point of algorithmic stablecoins may deviate from one dollar. Emin Gün Sirer, the founder of the Avalanche protocol, tweeted yesterday that algorithmic stablecoins may indeed have an anchor point, but this value does not necessarily have to be 1 dollar. He also cited the example of DSD, which currently trades at 0.38 dollars, indicating that there are not enough DeFi participants to raise its price to 1 dollar. When DSD rises above 0.38 dollars, these participants may feel they have made enough profit and sell when they believe DSD is above the entry level of others.

This phenomenon arises from the presence of a complete 'currency' adjustment mechanism within algorithmic stablecoins, which is essentially determined by market supply and demand. Therefore, the dollar price in the algorithmic stablecoin system serves more as a reference price, and algorithmic stablecoins do not necessarily have to be anchored to the dollar price. Currently, the scale of algorithmic stablecoins is still small, and their volatility is relatively high; however, observations indicate that as the scale of algorithmic stablecoins expands, their volatility is decreasing.

As algorithmic stablecoins become more widely adopted, a more accurate anchor point will emerge, and at that point, the volatility of algorithmic stablecoins will significantly decrease, making them more commonly encountered in the crypto market, leading to the maturation of a complete 'currency' system. At that time, algorithmic stablecoins, DeFi, Bitcoin, and other crypto assets will combine to form a complete crypto economy.

Additionally, we believe that there may also emerge algorithmic stablecoins anchored to a basket of fiat currencies in the future. This is partly due to the decline of the dollar and the emergence of diverse competition among currencies in traditional financial markets, where a basket of currencies can better reflect the monetary value of assets; on the other hand, the 'currency' in the crypto market naturally has no borders, aligning with global assets, and thus does not necessarily have to be anchored to the dollar. If it can be more diversified, it will better adapt to the future diversified development of the crypto market.

Algorithmic stablecoins are still in the experimental stage, and achieving significant and stable development requires broad and long-term consensus.

From the user's perspective, early participation may yield high profits but also comes with high risks. For example, tokens within the algorithmic stablecoin system generally exhibit high premiums, and significant declines may occur in the future; in addition, the security and applicability of contracts also need to be tested by the market, so investors should participate cautiously.