Original title: Flatcoins: Inflation-Adjusted Stablecoins
Original article by: Jeff Emmett, Danilo Lessa Bernardineli, Jamsheed Shorish, Michael Zargham
Edited by Leia, TEDAO
Introduction: What is Flatcoin?
Flatcoin is an emerging token economics concept that can be used as a store of value token that adjusts its value as inflation changes. The explicit goal of Flatcoin is to preserve the purchasing power of token holders and/or specific interest groups (such as platform users).
Take a simple example - the fictional "i-DAI", which is an InflationCorrected DAI. The anchor of i-DAI will be attached to a reference point in time, and as inflation changes, its price will adjust in real time to maintain the purchasing power of i-DAI holders. The following table shows this typical behavior. As we will see in this article, although i-DAI is currently only a fictional concept, the concept of i-DAI can be realized through a controller-based stablecoin (hereinafter referred to as "CBS"), and there are already examples like RAI (a new algorithmic stablecoin launched by Reflexer Labs).
Table showing the difference in value between DAI and a fictitious i-DAI. (*) The Big Mac Price Index in DAI is a fictitious example used to illustrate the impact of CPI on commodities.
What is inflation?
In economics, inflation is a general increase in prices that results in a decrease in purchasing power for holders of the currency used to denote prices. In the web3 space, inflation is defined differently, often (rather confusingly) describing the effects of growing token supply, though in traditional economics terms, this phenomenon would more accurately be called “dilution.” In this article, we’ll stick with the traditional definition of inflation.
In an inflationary environment, currency holders may experience a loss in purchasing power, which can undermine trust in the currency and the economic system as a whole. For this reason, inflation is considered a key measure of any economic system, and central banks around the world have a clear mandate to target a low annual inflation rate (usually between 2% and 4%) for the fiat currencies they manage. However, as recent experience in the current global economy has shown, this is not a simple task.
In light of the recent high inflationary pressures facing the global economy, Coinbase has proposed designing an inflation-adjusted “Flatcoin.” The stated goal of Flatcoin is to “maintain stable purchasing power while also being resilient to economic uncertainty caused by the traditional financial system.” However, it is important to reiterate that this is not an easy task — let’s explore some of the challenges inherent in Flatcoin’s design.
Flatcoin Design Challenges
Flatcoin is a unique design proposition that includes several challenges that need to be solved, which can be solved independently or simultaneously. We will explore these challenges in detail below. Among them, the core challenges are to accurately sense inflation and create appropriate incentive mechanisms.
Specifically, inflation, like many concepts in economics, operates in a complex adaptive system. This means that there are a large number of dynamic interactions of different factors and variables, including unpredictable human behavior, that affect the causes and consequences of inflation. This poses a challenge in Flatcoin design, and the implementation of any design needs to focus on and consider many factors, including but not limited to:
Low time granularity of inflation index
Difficulties in measuring spatiotemporal regulation of sensors
The Complexity of Sensor Fusion and Effective Controller Design
The challenge of implementing Flatcoin economic changes through appropriate incentives
A possible Flatcoin design: a controller-based semi-stablecoin
A promising approach to building Flatcoin is to borrow and adopt the ideas and technologies of the most successful stablecoins currently available. These successful stablecoins use the concept of a controller that can "sense" price changes and readjust the incentives of participants so that the value of the tokens held tends to track the reference value.
Such controller-based stablecoins are called Controller-Based Stablecoins (CBS), of which RAI is an example that has been put into practical use. RAI is inspired by similar theoretical and practical considerations. One of the reasons for RAI to adopt a controller is that it has been shown that the historical behavior of central banks in controlling inflation can be well described by a PID controller (consisting of a proportional unit P, an integral unit I, and a differential unit D). This has been demonstrated in theoretical studies by Hawkings et al. in 2014 and in empirical studies by Shepherd et al. in 2019.
Given the stability demonstrated by RAI as a CBS, we will next use RAI as a case study and introduce a feasible CBS-based Flatcoin design structure.
RAI as a case study
RAI is a controller-based stablecoin that keeps its value consistent with that of USD through the use of economic incentives guided by an unsupervised PI controller and an oracle that is able to "sense" the RAI/USD price at any point in time.
From a user experience perspective, RAI allows users to use ETH as collateral to obtain an overcollateralized loan denominated in RAI. The outstanding debt is denominated in RAI, and the interest rate on that debt (or the redemption rate in the RAI ecosystem) is defined by the implemented PI controller. The amount of the loan available is determined by the so-called redemption price, which in practice tends to be closely tied to the RAI market price - the difference is usually around 1%.
The logic of the interest rate adjustment is based on the difference between the RAI market price (denominated in RAI/USD) and the RAI redemption price (also denominated in RAI/USD). When the redemption price is higher than the market price, the interest rate tends to rise. When it is lower than the market price, the interest rate tends to fall (or even become negative!).
Why can the price of RAI remain relatively stable? Even without anchoring, even with a more volatile asset (ETH) as collateral, this is because RAI has a counter-cyclical incentive mechanism. The market price is determined by the secondary market of RAI buyers and sellers, so it fluctuates more; while the redemption price is determined by the PI controller, so it is more controllable and stable. Therefore, when the difference between the two is large, rational users will have the motivation to arbitrage.
Specifically, when the market price is higher than the redemption price, it is profitable to take RAI loans and sell them to the secondary market until the two prices converge, and then buy RAI from the secondary market to repay the debt and achieve a neutral position. This practice is especially convenient when the market price is higher than the redemption price for a long time, because the redemption rate may become very low, resulting in arbitrage profits and interest rate profits. In any case, profiting from the system helps the RAI token market price remain stable.
As for the opposite case (i.e. the redemption price is higher than the market price), the profitable action would be to buy as much RAI as possible from the secondary market and hold it until the price converges, or use it to close any open RAI positions. The first action tends to reduce the number of RAI tokens in circulation on the market, and the second action destroys RAI. Both actions will cause the system to converge to the market price.
The beauty of the controller behind RAI is that all of these incentives directed by the controller are driven by an external benchmark, the RAI/USD price obtained through an external oracle. RAI does not directly rely on having any USD inventory or liquidity pool to achieve price stability.
For designing Flatcoins, the design of RAI represented a natural starting point for building an MVP (minimum viable product), requiring two elements:
1) Inflation oracle;
2) A moderately regulated controller to measure inflation.
If you need more resources about RAI, you can check out the following links:
Reflexer Finance：https://reflexer.finance/
https://medium.com/reflexer-labs/summoning-the-money-god-2a3f3564a5f2
https://www.youtube.com/watch?v=dQRvDV5IILw
https://github.com/BlockScience/reflexer
https://github.com/BlockScience/reflexer-digital-twin
Distributed Control Challenges
As mentioned earlier, building a Flatcoin requires a moderately regulated controller and an inflation oracle. Now, let’s look at the challenges faced in both aspects.
Because inflation involves spatial, temporal, and compositional properties (explained in detail below), comprehensively measuring inflation is a fundamental challenge in the design of distributed control systems.
From a control theory perspective, the Flatcoin design challenges can be understood as:
(1) There is a geographically distributed “plant,” i.e., a market for goods and services, which sends price signals to different goods at different times and in different places.
(2) The first step is to design a set of sensors that collect the relevant signals (at the right frequencies and in the right locations) and combine them together at the appropriate time and space scales.
(3) These signals can then be fed into a controller and processed into a sufficiently rich model of the world to estimate the market interventions needed to make the value of Flatcoin evolve as desired.
(4) Finally, the system needs to have actuators that can provide incentives to drive the secondary market to adjust the value of Flatcoin to keep it consistent with inflation.
In the next section, we will explore some basics of control theory to further analyze the design problem.
Understanding control theory in complex adaptive systems
Defining the Environment
In control theory, the "boundary" or environment of a system must be clearly defined. A model can be built that understands the world within that boundary well enough to make controllable decisions within the system. Below we will explore the various parts of a control system.
Plants refer to physical or mathematical systems that are controlled. This can be mechanical systems, electrical circuit systems, or even biological systems. Plants originally referred to factories and production plants, which were equipped with thermostats and other sensors to regulate temperature control.
Sensors are devices that measure some aspect of a system’s behavior or environment, such as temperature, pressure, or component position. Here, the sensors need to capture changes in the prices of relevant goods and services in order to calculate and adjust for changes in inflation.
Actuators are devices that influence the future behavior of a system, such as motors, valves, heaters, or economic incentives, to ensure that the price of a token adjusts appropriately with inflation.
Controllers are the brains of a control system, processing information from sensors and using that information to adjust the behavior of actuators to achieve desired outcomes. Controllers calculate appropriate actions based on the system's current state and desired outcomes, and use algorithms and mathematical models to help manage the system's performance.
Sensors, actuators, and controllers together form the basic building blocks of control systems and can be used to regulate and automate a wide variety of processes, even in systems with unpredictable human interactions.
A Deeper Look at the Flatcoin Challenge
Difficulty of inflation adjustment
Any token designed to track inflation rates to mitigate its impact on purchasing power will have to answer some tough questions about which “sensors” and information sources to use, such as: “Where is inflation occurring?”, “Who is it affecting?”, and “What goods and services are affected?”.
Graph showing the evolution of prices for different goods listed on the US Consumer Price Index (CPI), compared to the official CPI index (black line) (Source: Blair Fix)
As economist Blair Fix vividly describes, inflation is not just “one” phenomenon. Of course, there are inflation indices, such as the GDP deflator or the CPI and PPI (Producer Price Index), but there is a lot of variation between these indicators and in terms of other criteria, such as geographic location, industry or sector. In addition, the time granularity of these indices is also low, with most updated only monthly, while changes in purchasing power can have immediate effects in daily life (such as supermarket shopping or gasoline purchases).
Flatcoin, as its name suggests, is a token whose purchasing power remains "stable". The design of Flatcoin must carefully consider the scope and coverage of its intended use before implementation. A token that adjusts according to the inflation rate may face situations with high price volatility, such as high inflation in certain regions or industries, which may last for a long time. At the same time, such a token also needs to adapt to situations in other regions or industries where price volatility is very low or even no inflation.
In addition, choosing which inflation measure to use is challenging because inflation can vary widely even at the national, regional, or metropolitan level. Standardized inflation measures, such as the CPI, do not take into account differences in purchasing power across occupations, investments, and socioeconomic or demographic groups.
Finally, from an implementation perspective, accurately and timely measuring inflation adds complexity to the design, as the token is susceptible to potential manipulation. Since the actuators of the Flatcoin system will rely on the reliability (and “trustworthiness”) of the oracle subsystem, their design is also not trivial.
Next step: How to promote the implementation of Flatcoin
The spatial and temporal aspects of this problem are difficult, and from a control theoretic perspective there are many interesting open design problems to tackle in order to create a token economy regulated by an appropriate incentive algorithm.
In the spirit of agile methods, we recommend a minimal PoC (proof of concept) design and pilot implementation to achieve a design goal that meets initial requirements. The PoC can be designed to be upgradeable to incrementally address more specific and prioritized design challenges in iterations.
One starting point is to first limit the spatial component of inflation. A simple and recommended PoC design is to start with a regional index Flatcoin and a scalar price index within a single currency market, but this simple design may face various arbitrage challenges.
On longer design timescales, a global compound index inflation token would be able to solve these arbitrage problems and therefore have a more robust use case, but this would obviously require more conceptualization and design to address the various challenges presented in this paper. As the first PoC is deployed and evaluated, additional requirements and feasibility can be proposed to gradually conduct research and development of sensors, controllers and actuators to achieve a truly effective global scale Flatcoin that will cover a diverse, multi-space index.
