The post-COVID-19 era has brought the issue of inflation to the fore, leading to a growing interest within the Web3 space in creating flatcoins, a close "cousin" of stablecoins designed to mitigate inflation risk. .
Many existing flat coins, such as Terra's TerraUSD (UST) stablecoin, are algorithmically backed and thus serve as a stark reminder of the risks associated with algorithmic backing, as evidenced by the collapse of LUNA and UST. So while the idea behind flatcoins may seem appealing, it raises significant reservations conceptually and in terms of design. Ultimately, the success of flatcoins will depend on whether the developers can deliver on their promise.
To date, the flatcoin white papers, including the one offered by Coinbase, do not seem to deliver on their intended promise, at least in their current state. In particular, the cheap token designs of some projects are likely to pose even greater risk than contemporary stablecoin designs.
Conceptual level problems
Examining the potential use cases for flatcoins is really crucial. While often touted as an asset that can help users preserve their purchasing power amid inflation and economic uncertainty, this idea could be misleading.
Stablecoins are digitized versions of fiat currencies, and their value as a medium of exchange and unit of account is the same as fiat currencies. Instead, flatcoins are indices of the purchasing power of a fiat currency obtained through oracles that collect data on economic indicators such as the Consumer Price Index (CPI).
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As a result, the unit value of flatcoins will differ from the fiat currency they track over time, as long as inflation is not zero. Thus, the existence of flatcoins depends on the assumption that fiat currencies or their digitized forms are the means of exchange and units of account.
In other words, there will not be a situation where flat currencies are better than stablecoins or fiat currencies as a means of exchange and unit of account because the existence of flat currencies depends on the superiority of fiat currencies and currencies. stable in these roles.
Inflation-linked assets already exist
Flatcoins are financial instruments that expose investors to inflation rates, making them an inflation derivative. Asset classes that expose investors to inflation risk have been around for a long time.
For example, Treasury Inflation Protected Securities (TIPS) have been used since 1997 to manage inflation risks attached to fixed-rate bonds. Retail investors can easily access TIPS and gain inflation exposure through Exchange Traded Funds (ETFs) in their brokerage accounts.
The availability of these established inflation-linked asset classes through ETFs means that institutional and retail investors can easily manage their exposure to inflation. The potential value proposition of flatcoins as an investment vehicle for inflation hedging may be limited.
Despite some criticism of flatcoins, they have the potential to add value to the economy. The true innovation of flatcoins lies in their integration of traditional financial instruments into the blockchain. Flatcoins are a digitization of an existing asset class, similar to how stablecoins digitize fiat currencies. This innovation may enable more efficient financial transactions and creates competition with traditional financial intermediaries such as TIPS ETFs, which could lead to greater efficiencies and lower costs in financial markets. However, it is essential to recognize that the existence of flatcoins is not a salvation from the macroeconomic challenges we face today.
Design-level issues
The previous discussions revolved around the possible uses and innovations of flatcoins. However, it is essential to note that the current development of an inflation-linked stablecoin is still in its infancy and faces significant challenges.
There are currently some ongoing projects that are developing CPI-indexed flatcoins, but these projects are based on mechanisms similar to stablecoins. Some existing flatcoin designs, such as Reflexer's Frax Price Index Share (FPIS) and Reflexer's Rai Reflex Index (RAI), algorithmically adjust the supply of flatcoin to maintain peg to a specific purchasing power-related index, similar to how coins maintain algorithmic stables their pegs to fiat currencies.
However, algorithmic stablecoins have proven to be a risky design class, as extreme market conditions can trigger a downward spiral similar to a bank run, as seen in the case of the Terra collapse.
For example, Frax Finance's white paper on its Frax Price Index (FPI) linkage mechanism state:
โDuring times when the AMO performance is below the CPI rate, a TWAMM AMO will sell FPIS tokens for FRAX stablecoins to keep the CR at 100% at all times.โ
For simplicity, it states that the protocol will sell index tokens for the Frax Finance stablecoin if the CPI index performance falls below its true value. However, this design presents a common vulnerability in algorithmic stablecoins. If the protocol runs out of Frax Price Index Share (FPIS) reserve tokens, a Terra-like run is likely to occur.
Also, since inflation is rarely negative, constant sales of FPIS tokens will be needed to maintain the 100% guarantee rate, making this design even more susceptible to runs than other algorithmic stablecoin designs.
The trade-off for relying on something other than algorithmic fit is reliance on centralized authorities. Stablecoin projects that use fiat money as collateral rely on trust in the project to maintain the US dollar collateral. Conversely, those who rely on overcollateralized crypto assets are subject to market risks. Unfortunately, flatcoin projects have yet to provide a solution to this problem.
Another critical barrier to developing an effective purchasing power index with flatcoins lies in the accuracy of the data provided by the Oracle protocols. Relying solely on publicly available CPI data released by the Bureau of Labor Statistics would limit the true potential of flat currencies. Projects like Chainlink and (my own) IoTeX's W3bstream have the potential to provide real-time data that could make it possible to get accurate and timely CPI data.
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The success of flatcoins will depend on the continued innovation of the Oracle teams. A decentralized flatcoin index could significantly improve existing investment instruments to hedge inflation risk if creators can get real-time CPI data.
Risks and uncertainties
The widespread adoption of flatcoins and similar cryptocurrencies depends on their ability to overcome the challenges and risks inherent in stablecoin designs.
As flatcoins and other inflation-indexed cryptocurrencies emerge, it is crucial to assess their impact on the broader financial ecosystem. Do they provide a more stable and decentralized alternative to traditional currencies, or are they just another investment vehicle?
Investors, users, and regulators need to carefully scrutinize new developments in the digital asset space. Understanding the true nature and potential of these cryptocurrencies is vital in determining whether they will become dominant in the financial landscape or remain an intriguing but niche investment option.
The rise of Flatcoins highlights the ongoing search for stability and decentralization in the field of digital assets. Although this new financial instrument presents an innovative approach, it carries additional risks and uncertainties. Investors, users, and regulators can better navigate the future of inflation-indexed cryptocurrencies by keeping a critical eye on these developments.
Peter Han He has a PhD in finance from the University of Illinois Urbana-Champaign, with an emphasis in financial intermediation and fintech, as well as an MS in financial engineering. She has a BA in English and a BA in Mathematics from Tianjin University of China. She worked for PwC in Beijing before joining IoTeX, where his work focuses on tokenomics-related research aimed at improving IoTeX tokenomics design.
This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts and opinions expressed herein are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
