What are reserve currencies in crypto and how does it work
Most categories of projects with TVL (the total amount of funds locked in a smart contract) are clear in their name, credit protocols give a loan, bridges allow you to transfer funds between networks, decentralized exchanges allow you to change tokens within the same network. But there are also those categories of projects that cause problems with understanding. One such category is reserve currencies/protocols. In this article, we will analyze how reserve currencies work in crypto and why they are needed.
Why reserve cryptocurrencies are needed
Inflation and high volatility (in the context of cryptocurrencies) forces people to look for assets that allow them to maintain value for a long time. To protect against volatility in cryptocurrencies, stablecoins were invented, projects in which the value of a token is pegged to the dollar or some fiat currency. However, stablecoins inherit the properties of fiat money, such as inflation and dependence on the US Federal Reserve.
Reserve cryptocurrencies occupy a place in the market between stablecoins and volatile cryptoassets, supporting the course through a combination of various mechanisms such as bonding, staking, relocation, as well as the backing of a basket of stablecoins and other mechanisms. Olympus DAO (OHM) is one of the pioneers in the category of reserve cryptocurrencies. This article will be built on the example of Olympus DAO.
The mechanisms for maintaining the OHM exchange rate are similar to the work of the treasuries and reserve systems of various countries, therefore such projects are called reserve tokens. The goals of OHM are as follows:
Maintain liquidity – to make OHM easy to exchange for other crypto assets
Be a unit of account – for other assets to express their price in OHM
Maintaining Purchasing Power – To provide its holders with a stable, low volatility asset that grows in the medium to long term.
Problems with distribution of tokens
To raise funds, Olympus DAO uses bonds to understand why this is needed, consider the problems that any crypto project faces in an attempt to distribute its tokens, make them liquid and increase circulation.
Let’s say you issued a fungible token on some blockchain, what’s next? The first thing you can do is distribute tokens in exchange for PR of the project.
Second, offer the purchase of tokens at a discount. Third, offer your token to exchanges by paying various commissions and again offering a discount.
This distribution of tokens brings you into an ecosystem of people who have one goal – to get a token at a discount and sell it at the first increase in the rate. As a result, the token rate looks like this:
Also, if we assume that our token is backed by something (for example, the cryptocurrency of the blockchain on which the token was issued), then the actions described above will lead to a decrease in security, since you need to deposit funds in the DEX in order to be able to change them. Thus, some of the coins are blocked in liquidity pools.
most DEXs work through liquidity pools in which tokens must be invested and the pair for which the exchange will be made, most often this pair is the cryptocurrency on which the token is issued
Reserve tokens solve this problem by buying liquidity from cryptocurrency holders using bonds. Simplified, today you give away a stablecoin, and in a few days you receive OHM tokens at a discount (discount).
A series of articles would be needed to explain the full workings of reserve token bonds, but if you want to dive into the world of crypto bonds right now, I would advise you to start with the bond protocol documentation from Olympus DAO – https://docs.bondprotocol.finance/
If we simplify this mechanism, then it looks like this. Let’s say you have 100 units of some cryptocurrency that can be used in an OHM bond, for example, this is a DAI stablecoin. And you buy an OHM bond with that 100 DAI.
At the time of purchase, the OHM rate was 25 DAI, but thanks to the bond, you got it for 24 DAI (the same discount).
After a certain period of time (for simplicity, let’s imagine that the rate has not changed) you will be able to buy 100/24 = 4.1 OM and sell for 4.1 * 25 = 102.5. The profit was 2.5%.
Naturally, the rate may fall during this time and there will be no profit.
In this way, OHM easily and quickly raises funds to its treasury without blocking it in decentralized exchanges and without paying commissions to centralized exchanges. And also gives the opportunity to earn on this process to users.
This, of course, does not mean that reserve cryptocurrencies do not use exchanges.
But of course, bonding is not the only reserve token mechanism.
So we have bonds for our token, but what will be the incentive not to sell the token at the first price jump?
Olympus DAO offers to earn on OHM through staking. Since OHM is a token, in this case the word staking does not mean providing cryptocurrency to the validator to support the proof of stake process, but rather staking your OHM in a pool of funds in exchange for a reward.
But why would a person choose to stake a token instead of staking some kind of proof-of-stake blockchain cryptocurrency. Two mechanisms come into play here:
Range limit system
The Olympus protocol automatically performs transactions to offset the volatility in the market price of OHM in relation to its assets (all those funds raised).
Funds raised by bonding are called treasury or treasury reserves. The range capping system places treasuries in a downtrend market and sells OHM for crypto assets that could be reserves for OHM in an uptrend market to stabilize the price.
Detailed information about the range limitation system – https://docs.olympusdao.finance/main/overview/range-bound
Such a volatility compensation system, in theory, allows you to maintain the purchasing power of your assets and thus makes staking, roughly speaking, less risky.
A rebase is a change in the supply of a token – the supply expands or contracts due to changes in the price of the token.
In strict terms, rebase is part of the range limitation system, but for the sake of understanding in this article, I have separated these concepts.
In the event that new tokens are minted during rebasing, most of them are distributed among those who stake OHM. When you stake OHM, you are given sOHM, which can be considered as your receipt that you have staked a certain amount of OHM tokens. Because the protocol uses a rebase mechanism, 1 sOHM can always be exchanged for 1 OHM.
Relocation can result in a large annual percentage return, BUT
the potential growth in new OHM output will not always outpace the potential decline in price.
In the graph given by link you can clearly see how the sOHM yield changes depending on the period that is considered.
Combination of mechanisms
The mechanisms of reserve cryptocurrencies and Olympus DAO in particular are “loopbacked”, i.e. influence each other in the following way:
It is important to note that such an incentive scheme will only work if users are convinced of the profitability of buying bonds.
A spoon of tar
Critics of reserve tokens believe they are ponzi schemes, and all their mechanics are necessary to divert eyes. Criticisms include the following:
The incentive system of reserve tokens and their very purpose makes projects isolated systems that do not create money, but only redistribute what has been invested.
Through a combination of rebasing and staking mechanism, reserve tokens can promise big returns, although charts you can see that this is not always the case. The inability to maintain consistently high returns results in the following:
Look at the profitability bloggers promise when talking about the project:
Here An article that goes deep into why reserve tokens can be Ponzi schemes. I highly recommend.
It is difficult to talk about such projects, on the one hand, each mechanic clings to the other and it takes a long time to unravel the tangle, on the other hand, the mechanics themselves are quite complex and at the same time I don’t want to torment the reader with canvases of formulas and text. Hope you like it, thanks for your attention. I write similar articles for my telegram channel – https://t.me/ton_learnI will be glad to your subscription.