The Coupon System of Stablecoins Needs A Disruption to Survive

Over the past month, the coupon system in algorithmic stablecoins have quickly lost traction and trust across the DeFi community. ESD has built up massive debt during its contraction cycle and lost investors as evidenced by its significant drop of market liquidity, while DSD is experiencing a tough time entering a new expansion phase with early coupons already expiring.

Meanwhile, new forks went into contraction and have remained there because the coupons ecosystem have lost the firepower to bring the price back above the peg price. All this has resulted in investor fears towards burning tokens and buying coupons. What’s more, DeFi influencers and veterans seemed to shy away from stablecoins because of what they apparently deem as failed concepts.

Most of you probably have this gut feeling that coupons are a high-risk game and that risk-adjusted profits are not sufficient enough to buy coupons. What has followed was a wave of artificial “solutions” from different stablecoin projects to overcome the intrinsic weaknesses of the coupon system: adjust upwards coupon premia, modify expiry dates, OTC auctions for coupon, or draconian controls on liquidity to prevent the physical act of selling (https://algostable.medium.com/why-algo-stable-bonds-dont-work-cb218eb2e59e).

But you have to be skeptical about solutions offered when no one has yet offered a convincing diagnosis of the problem at hand. By looking at all the coupon system of the stablecoins, we made the following conclusion: The current coupon system is not fair.

Note: The VTD project team has a solid background experience in finance. Part of the team currently work in the financial industry and have experience trading financial instruments. The team has tried to keep this article as understandable as possible for everyone, so please excuse some gross oversimplifications here and there.

Coupons are Not Debt, but Rather a Long Call Option

In order to better understand what we intend to do; we have to start with the basics of the option markets. A call option is a contract that lets you to buy or sell an asset at a pre-determined price in the future. In other words, it’s a way of betting that the price is going up or down. The more it goes up or down, the more money you make. Let’s apply this logic to coupons.

A coupon is very close to a plain-vanilla long call option with one difference — you lock up your coupons until the token price goes beyond the peg price (into expansion) such that it is not tradeable (that’s the idea, despite the recently established OTC markets that are rather unattractive, in our view). A coupon has the following parameters in the option language (we are just using the standard ESD coupon as reference):

1. Strike price of $1 — at the peg price of $1, coupons become redeemable and investors can make profits.
2. A duration of 90 epochs — after 90 epochs the coupon expires and become worthless.
3. A coupon premium of 55% — this means something that is potentially worth $1.55 is trading for 1 token. If the token is $0.5, it means this option is priced at $0.33 (remember this value for later).

The strike price is the most important parameter in the option markets, in our view. Investors can only gain profits if the price of the asset is higher than the strike price. Because the peg for almost every stablecoin so far has been $1 and not variable, buying a coupon means investors need to assign a probability to the token price going beyond $1.

So when the token is at 95c — and the distance-to-peg is smaller than at a price of 50c — the coupon becomes much more attractive, because the probability of the token price moving above its peg is relatively high. A coupon in the option world would show the following chart pattern:

The second important parameter is the duration or time until expiration. Next to its intrinsic value (probability of going above 1$), there is a time value for coupons. The longer the duration, the more chances it could go into the money and become profitable. This is partly why nobody likes buying coupons at the start of a contraction, because investors know a typical contraction takes many epochs, and the longer they wait before they buy, the higher the probability that the system will go into expansion before the coupon expires.

You probably have an intuitive feel for this, if you have held coupons for a while, your coupons are somehow less valuable. This is the time value of a coupon which gradually declines as it moves closer to its expiry date (see chart below).

Finally, the coupon premium is just another way of showing the coupon price. The higher the premium, the cheaper the coupon. This gives more incentives for investors to buy coupons as potential profits increase in the future.

Now with all these explained, what if we price a coupon similar to an option by using all the given parameters and estimates of a few more based on historical data (volatility, risk-free rate etc.)? We think this is a proper assessment because a coupon has the same risk-return characteristics as in case of a long call option. By doing this, VTD argues that the current coupon system of stablecoins is not fair.

All Current Coupons are Overpriced!

In the following we make use of the Black-Scholes Option Pricing Formula, one of the best-know option pricing formula that is heavily used in financial markets. We use the ESD price and parameters as of Jan. 19th, 2020 to showcase our approach: A spot price of $0.5, a strike price of $1, a duration of 30 days (90 epochs), an estimated volatility of 200~300%, and a risk-free rate which equals ‘AAA’-rated fixed-income government bonds. The Black-Scholes Formula generates a coupon price of $0.07 by using the option price formula.

The coupon is selling for around 33c (remember this value from earlier in this article?), while a fair value would something be close to 7c given the option-alike features. Even if the Black-Scholes-Formula cannot be applied in full, we are strongly convinced that the price for a coupon should not be 4x higher than its estimated fair value.

The conclusion here is straightforward: It’s not about buy or sell pressures, lock-ups or liquidity, whales or retail investors. It’s simply the fact that buying a coupon is a bet that the token will go up to a $1, and many of you have had this gnawing feeling that burning coupons in exchange for coupons is not a good deal. What’s more, investors suffer from opportunity costs by burning otherwise sellable tokens. This is why the current coupon pricing is flawed and outdated, in our view.

VTD Will Soon Deliver an Update to Coupon Pricing

Because VTD has switched to dynamic peg from a fixed peg, the coupon system of the VTD ecosystem will also change fundamentally. The distance-to-peg is significantly lower than other stablecoins because of the momentum price. The momentum price is the relevant price parameter for switching from debt to expansion cycles. Depending on supply and demand dynamics, coupons can be extremely cheap in the VTD ecosystem as the likelihood of moving into the expansion cycle is significantly higher than for a fixed-peg token. As we said before, the current way of pricing coupons is outdated and not fair.

This bring us to VIP5: If coupons are just call options, let’s make them more like call options!