Tokenized Locking in an Algorithmic Backed Protocol

When compared to other options, the idea of locking funds in any way costs the user, but it benefits both the user and the system in terms of stability.

So, in theory, any MoE (Medium of Exchange) that struggles with stability should embrace locking and try to take advantage of the balancing benefits that come with it. As tokenized MoEs usually struggle with sensitivity issues in price and trust, you would expect at least some added benefits to help dilute the issues they face. Tokenized staking with various maturities is already a part of the ecosystem, however, it is less evident amongst stablecoins.

Stablecoins are also a space that could benefit from a maturity-based model in the future.

To visualize this point in practice, we can speculate on how lock periods could be introduced into an asset-backed protocol algorithm a.k.a stablecoins. The reason why these protocols act as good structures is that they are usually purely decentralized with an open-source formula, scalable solutions and often work on an incentivized arbitrage model.

There is a lot of debate around the model of liability guarantee amongst stablecoin issuers and the most effective use-case example. The providers need a function that guarantees their coin will always be worth a USD, EUR or GBP at 1:1 etc. There are many different variations of SC pegs and various stability mechanisms, yet the core models that work are collateral-led and supply-led.

Although locking could benefit both models, it is more likely to work in supply-led coins, as the stability dynamics are more customizable, whereas collateral coins are usually bound by only one policy lever – its backed asset.

As mentioned, the purpose of a stablecoin makes locking vastly more effective.

The principal cost of locking involves the inability to capture higher market yield when it arises after the lock-in. Yet, the consensus around stablecoins is that they will eventually offer an alternative to holding cash or cash equivalents, meaning that the lock-in costs could become rather trivial. If there is a market for the coin and goods and services are accepted on it, then there is less of a need to convert it back to fiat.

Therefore, Stablecoins are a good fit for locking.

However, the locking model would need to add additional incentives to the protocol savings rate (given the rate available to lock the SC elsewhere), that makes users happy to give up a premium in the rate, whilst also protecting users from the negative effects of liquidation if the price of collateral falls. This is not to say they would be protected from liquidation per say but makes sure the users have always been compensated if the system works as it should.

An asset-backed algorithmic protocol is effectively trying to get the perfect balance between stabilizing its collateral-to-debt ratio (E.g 1.5/1) and not overly burdening users with unforeseen liquidation. Liquidation models are complex and designed well yet are often weighted towards excessive and swift collateral auctions, leaving many without the right to collateral adjustment in the first place.

The idea of locking can therefore adjust the system’s relationship with price volatility, reducing collateral value volatility, thus reducing the occurrence of liquidations.

For instance, If the supply algorithm could be adjusted on a time basis allowing the chance for the market to reposition the value to the correct C/D ratio over a set period, the system could eliminate the risk of mass protocol liquidation. The protocol could be allowed to become undercollateralized under certain conditions, as coin redemption would be unavailable. Traditional banks and shadow depositaries use this structure in a softer way, by creating friction between a user and their funds, creating a softer layer of locking (e.g ATM limits).

If the market were to stay in a period of downward pressure, then the current liquidation process could take place, however, the system would have had a chance to re-balance. You are essentially taking away the effect of higher daily volatile collateral prices on vaults, opening the doors to more types of collateral, in exchange for the lock.

This would also make the liquidation auction process much more scalable and orderly. Instead of auction keeper bots (who scan the system for unsafe vaults) randomly searching for ‘unsafe vaults’, whereby the C/D ratio is too low, there would be designated auctions each day for different lock maturities. If a vault is still undercollateralized at maturity, then the auction would decide a price to liquidate the vault. Therefore, market pressure would have less of a say on the dynamics of an auction.

The auction bots that drive the auction prices for collateral would also be more incentivized to get a better price for the initial depositor and owner of the vault, as competition between vaults would potentially be higher, with set auction times.

Further, a user has greater clarity regarding their own perceptions of the C/D ratio. For instance, in the current system, a user may overcollateralize to protect the vault, making less use of funds. However, with a 21-day lock, the user can better visualize when they need to rebalance the ratio to protect against the price movement of the collateral.

However, the biggest flaw this model helps solve surrounds the systems utility coin’s effectiveness, when faced with extreme market selling pressure. A potential flaw with the design of these protocols is that it relies on utility coin (UC) holders to absorb extreme pressures from the market when the system is in trouble. It’s the light boats of a sinking ship.

In theory, the benefits from the coin in good times are meant to balance the coin in bad times, meaning that UC coin demand will usually hold in times of stress. However, the correlation between the UC and the rest of the system is too high for this logic to be plausible. Further, the benefits of being a UC holder are price appreciation and interest payments from any interest/stability fund pool- (amongst governance rights). If the SC is being sold off quickly, the interest buffer pool will drop proportionately in value, whilst the price of UC will devalue. The reality is, that if the market Is uninterested in the stablecoin, it will also be uninterested in the utility coin.

If the protocol has different maturity locks, then the pressure on the UC holders will be proportionate to the stages of each lock unloosing, reducing the burden, rather than the whole market selling at the same time.

Yet, a downside to this theory is that it could reduce the impact of part of the pegging mechanism, to do with the arbitrage buying and selling of the SC. Algorithmic coins keep their peg via incentivized profiting from points above and below the peg. If you limit the selling ability of the coin due to locks, it may become harder to reduce upward price pressure.

Another problem is an article embedded in the new EU Markets in Crypto-assets Directive, which states that the issuer must grant token holders the right to SC redemption “at all times” against the issuer. This makes locking problematic if these laws come into force, however, it is to be seen how the law would interpret a user entering into a contract to give up this right, in favour of locking benefits.

A side note to these issues is to incentivize the system to split between locking and non-locking, keeping liquidity high, thus keeping the market dynamics of incentivized buying and selling and utilizing the benefits of increased stability in locks.