A lot of people think our system is an algorithmic system, but the truth is that the FxDAO peg system shares more characteristics with the old Gold standard than algorithmic coins. Let's talk about it.
Our protocol issues synthetic currencies as debt, this debt is backed by your position in XLMs and if at some point you want your collateral back you need to pay your debt, and that's basically it... Well, yeah this is the basic logic behind the protocol but this doesn't explain what keeps the value of the currency, so let's first think about two cases:
- A synthetic currency from the protocol starts going down in price on the market without reason (protocol is healthy and there is enough collateral), well in this situation you as an arbitrager can buy that cheap currency paying in collateral, and redeem it later from the protocol so you get the real value in the form of collateral, at this point you made a profit because of the difference in the price.
- In the other case, a synthetic currency from the protocol starts going up in price on the market without reason, in such situation you lock collateral in the protocol and then you sell that issued synthetic coin on the market, at this point you also make a profit because of the price difference.
This arbitrage process is what keeps prices stable because there is always an incentive to keep it at the real price. it's similar to what people do between exchanges, let's say Bitcoin is being sold at a 5% discount in exchange A compared to exchange B. As an arbitrager go to exchange A and buy that Bitcoin so you can sell it later on exchange B and make a profit... Just like in our protocol, this keeps prices efficient.
Controlled issuance and redemption
Knowing the basic logic behind you might say "Well Terra USD also based its price on arbitrage, how is FxDAO different?"... And that's a good question, the key difference is the controlled issuance and redemption of the debt.
When dealing with an algorithmic currency the debt asset is created and burned at issuance and redemption (just like in our protocol), BUT in such system the collateral asset is also controlled by the protocol while in our case the collateral (XLMs) is not controlled by the protocol and can not be issued nor burned by the protocol.
Just like in the days of the Gold standard countries couldn't (at least in theory) issue more debt (paper money) than what they were able to backed by gold (the collateral), FxDAO can not (and in this case enforced by a smart contract) issue more debt than the collateral.
What about the price stability of the collateral?
We don't live in an ideal world and prices change a lot (especially in the crypto space), in order to keep the protocol healthy (more collateral value than debt value) we need to be able to liquidate bad debt.
Think about a broker who allows you to short a stock, and for this example let's think the stock you're shorting is GME. Suddenly the price starts skyrocketing because a lot of people are buying it, and your broker now calls you and tells you "You need to put in more collateral or we will liquidate your position"... FxDAO does the same for debt-issued, if the value of the collateral is going down the protocol opens vaults under a collateral ratio for liquidations unless the owners put more collateral.
But who can liquidate those vaults? The answer is simple: everybody. The liquidation process is open to anybody who is willing to pay the debt, this alone doesn't give any incentive, and because of that the protocol opens vaults for liquidation above 110% of its debt ratio so liquidators can profit up to 10% of the liquidation amount.
Checkout the documentation
If you want to know more about each part of the protocol you can read about the liquidation, borrowing and redeeming process in our documentation here