Editor | Wu Blockchain about Blockchain
In this episode, we take a deep dive into the workings of Gyroscope, a decentralized stablecoin designed to manage various risks in the stablecoin ecosystem. Ariah Klages-Mundt, co-founder of Gyroscope, shares the origins of Gyroscope, GYD's innovative minting and redemption mechanism, and how Gyroscope uses oracles and a diversified reserve strategy to maintain stability. He also introduces sGYD, a variant with yield, and explores the potential for Gyroscope's reserves to expand to new stablecoins and non-stable assets, aiming to set a new standard for DeFi.
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Opening and Introduction
I’m Ariah Klages-Mundt, co-founder of Gyroscope, a decentralized stablecoin designed for maximum liquidity and resilience. With a background in fintech and a PhD in complex systems, I focus on modeling stablecoin systems and identifying risks, such as those that impacted MakerDAO during Black Thursday. My early research explored the complexity of financial networks, which led me into the DeFi space and developing stablecoin models since 2018. A critical study of MakerDAO’s “deleveraging spiral” was validated in 2020, highlighting the importance of resilient design in decentralized finance.
The evolution of stablecoins
I was one of Terra's early critics, recognizing early on that their design was fundamentally flawed. Simplifying Terra's design, you can see that it's essentially a Ponzi scheme. New funds are used to pay back early investors, leaving no funds in the system for stability or redemption when needed.
An interesting aspect of our research is a term we coined: “endogenously collateralized stablecoins”. This term is now widely used to describe systems like Terra. The concept of endogenous collateralization is that the assets backing the system are directly tied to the value of the system. These assets have value only because the system itself has value, forming a circular and ultimately unstable foundation. This concept is even mentioned in the draft US stablecoin regulation, highlighting its importance in understanding and regulating these types of stablecoins.
Stablecoins are often cited as one of the key use cases within the crypto space that stand a significant chance of growth. From my perspective, I agree with this sentiment, especially when considering the needs and behaviors of crypto users. While leveraged trading is a major attraction for some, there is a significant segment of users who want access to financial services that they may not otherwise have access to, or prefer custody of their own assets. This is where stablecoins play a key role.
Many users do not want to be exposed to highly volatile assets like ETH or Bitcoin; instead, they want to have access to more stable assets, especially the U.S. dollar, which is why stablecoins are so important. These digital currencies allow users to conduct financial transactions in the crypto ecosystem with the stability of the U.S. dollar. While the current focus is on the U.S. dollar, we may eventually see stablecoins expand to represent other currencies.
In terms of different types of stablecoins, they can be broadly divided into two categories: non-custodial and custodial. Non-custodial stablecoins like DAI are decentralized and do not rely on a central authority to manage their backing. Instead, they use mechanisms like overcollateralization and smart contracts to maintain their peg. On the other hand, custodial stablecoins like USDC and Tether are backed by reserves held by a central entity, making them more centralized.
Each type of stablecoin has its own challenges. Custodial stablecoins, while reliable and backed by real assets, face regulatory scrutiny and centralization risks. Non-custodial stablecoins, while more in line with the decentralized ethos of crypto, often struggle to maintain their pegs during market volatility and face scalability challenges.
Going forward, the industry is likely to continue to see both categories of stablecoins coexist, each catering to different needs and risk preferences. While custodial stablecoins currently dominate due to their perceived greater stability and liquidity, algorithmic and decentralized stablecoins still have room to grow, especially as the technology matures and they prove their resilience in the market.
Is there a best stablecoin?
When discussing stablecoins, I want to focus on the risks associated with them. As a user, it is critical to understand the risks of different types of stablecoins. These risks may seem complex, but they are actually inherent to the financial system. If a stablecoin looks simple, it may be because it ignores the complexity behind it.
We can analyze risks from two perspectives: centralization and decentralization. Centralized stablecoins, such as USDC and USDT, are primarily exposed to risks from issuers. These issuers are similar to banks and have great discretion over user services, which may affect users’ ability to mint or redeem stablecoins due to jurisdiction or documentation issues. In addition, regulatory risks cannot be ignored, especially in an uncertain environment or when regulations are constantly changing.
For decentralized stablecoins, such as DAI and other similar projects, the risks are mainly concentrated on the on-chain mechanisms and smart contracts. These systems usually rely on oracles, and the multi-signature model of oracles is a potential single point of failure. Vulnerabilities in smart contracts may also lead to the exploitation of the system. In addition, the governance risks of decentralized autonomous organizations (DAOs) are also significant, because the evolution of the system is controlled by these organizations, and users need to pay attention to the security of these governance levels.
The risks of economic design are also an important consideration. For example, systems like Terra have failed due to poor design, and DAI has experienced similar problems. These risks are real and can have serious consequences.
Therefore, when ranking stablecoins, one should not simply pick a single best option. Different users have different risk preferences, and a stablecoin that suits one person may not suit another. For example, although Tether is considered less transparent than USDC, it remains popular due to different risk priorities of users outside the United States.
In this context, Gyroscope attempts to address these risks by building a more robust solution. The core function of Gyroscope is to act as a risk management layer for stablecoins, which is backed by a variety of assets, mainly other stablecoins, and more assets may be added in the future. This diverse asset base allows Gyroscope to effectively manage risks.
Gyroscope is built in a modular way, leveraging existing infrastructure in the DeFi space and adding additional layers of security where needed. For example, we use Chainlink oracles as the primary source of price information and have added additional security mechanisms to cross-check the accuracy of the information to prevent problems before they occur.
In summary, Gyroscope accepts the complexity of the stablecoin system and manages various risks by combining existing infrastructure and additional security mechanisms to provide a stable and reliable product.
The role of oracles in Gyroscope
Any decentralized stablecoin that runs on-chain requires an oracle to determine the value of its asset relative to a target, typically USD. Since USD does not exist on-chain, the system needs a way to get off-chain information about its value. This is where oracles come in — they bring this critical off-chain data to ensure the stablecoin mechanism works properly.
For Gyroscope, oracles play a crucial role in the user flow, especially when minting or redeeming stablecoins. The system must know the value of the collateral provided to maintain security and effectively peg to USD. Although some on-chain sources, such as decentralized exchanges (DEXs), may also provide pricing information, they also have their own issues that require careful consideration. However, since Gyroscope and other decentralized stablecoins are targeting something that exists off-chain, oracles are still a necessary component to bridge this gap.
How to understand Gyroscope’s self-proclaimed “all-weather stablecoin” feature?
Gyroscope's main mechanism is based on a model where a reserve of stablecoins with different risk exposures is held and managed. Basically, this means that the protocol holds a set of reserves of assets that it owns and controls. This reserve acts as the balance sheet of the protocol, and the minting and redemption mechanisms are how this balance sheet is expanded or contracted through these mechanisms.
When minting new stablecoins, users provide assets to the system, which evaluates which assets it is willing to accept without becoming too risky. These assets then become part of the reserve, backing newly minted stablecoins. Conversely, during redemptions, the system determines which assets it can release while maintaining a balanced exposure between different risks. Users can redeem their stablecoins with these assets as long as it does not negatively impact the overall exposure of the protocol.
In the event that an asset in the reserve (such as USDT) is unpegged, the protocol must manage risk to ensure that Gyroscope's stablecoin GYD remains as stable as possible. The protocol has built-in safety mechanisms to prevent excessive exposure to any single asset before a crisis occurs. However, if the unpegged asset is still part of the reserve, the system will use arbitrage mechanisms to manage redemptions and minting to control exposure to the unpegged asset while ensuring the overall stability of GYD.
The key to this process lies in the interaction between the primary and secondary markets. If GYD is unpegged in the secondary market, the arbitrage mechanism may be activated, depending on the system's assessment of the situation. The protocol must strike a balance between maintaining a healthy reserve and allowing redemptions and maintaining stability, even in the event of market shocks.
In summary, Gyroscope’s minting and redemption mechanisms are designed to carefully manage the protocol’s reserve assets, ensuring that the system can handle shocks and remain stable across a diverse risk spectrum.
How does Gyroscope strike the balance between providing benefits and managing risk?
In establishing the GYD reserve, we took a conservative approach, leveraging existing stablecoins that met certain criteria, such as having sufficient liquidity, the ability to maintain a peg, and a proven risk record that allowed us to assess the risk. Although there are some established players in the stablecoin space, it is still relatively new, and many emerging stablecoins have not yet reached the liquidity or on-chain usage requirements necessary to be safely included in our reserves.
However, as these new stablecoins gain traction and reach a threshold where they can become part of a conservative reserve, this is expected to change. The more stablecoins we can safely include, the safer and more diversified the reserve will be. The reserve we are launching today should be seen as a starting point, designed to expand as more stablecoins become viable options.
For our initial reserves, we focused on the major players in the stablecoin space, aiming to create a segregated risk structure. This approach ensures that we take the right amount of risk in different categories without concentrating these risks in a single exposure.
The stablecoins we currently include include USDC, USDT, DAI, and Liquity's LUSD and CurveUSD. USDC and USDT represent centralized risk factors, but have different risk profiles, and including both in the reserve is very valuable to help mitigate the risks within this centralized asset class. On the decentralized side, LUSD and CurveUSD are the most decentralized stablecoins that meet our liquidity requirements and cover decentralized risk factors.
However, DAI exhibits a mixed risk category. Although it initially relied on decentralized mechanisms through its CDP system, a large portion of its current backing comes from real-world assets (RWA), placing it in the centralized stablecoin category. DAI straddles both centralized and decentralized risk factors, so it is important to separate its risks from other risks.
Looking ahead, we are eager to expand the reserve with new stablecoins that can provide additional diversification. However, these stablecoins need to reach a level of maturity and stability that can be safely included without compromising the integrity of the reserve.
Yield-generating stablecoin: sGYD
From a user perspective, the risks of holding stablecoins are important, but the utility of these stablecoins, especially in terms of generating yield, is equally important. Users seeking higher yields may be attracted to new stablecoins without a proven track record, while other users may prefer stablecoins like Tether for specific use cases, such as purchasing large amounts of Bitcoin. Gyroscope's GYD aims to balance these considerations by providing a stablecoin that not only effectively manages risk but also provides competitive yield opportunities.
Currently, GYD has established a record of liquidity and stability, which is critical to attracting risk-conscious users who need to see proven performance before adopting new stablecoins. GYD is designed to target these users by providing a stable and resilient option, not specifically for the high-risk high-reward scenario of typical "degen" users, but for those who prioritize security and stability.
GYD is particularly useful for users who want to hold stable assets between investments or act as a liquidity provider (LP) in automated market makers (AMMs). As an LP asset, GYD is advantageous because it offers a diversified risk profile. For example, by pairing GYD with other assets in a liquidity pool, users can gain returns while reducing the risk that a single asset depegging event can affect their entire portfolio. This is in contrast to situations like the USDC depegging crisis, where users exposed to a single pool could see their entire position affected.
Additionally, Gyroscope recently launched the yield-generating sGYD, which operates similarly to other yield-generating tokens such as sDAI, but is based on the GYD system. The GYD system generates revenue through various sources including yield generated by reserve assets and exchange fees in AMM pools composed of reserve assets. The sGYD mechanism allows users to stake GYD and earn part of the yield, which is considered one of the best risk-adjusted returns available in DeFi due to GYD's diversified and balanced risk exposure.
The income behind sGYD mainly comes from the income of reserve assets, which are deployed in various strategies to generate returns for the protocol. Through sGYD, these returns can be shared with users, providing a stable and attractive income option and benefiting from the underlying stability and risk management of the GYD system.
Future Development and V2 Mechanics
Currently, GYD's main reserves are deployed in sDAI, earning the DAI Savings Rate, and gaining exposure through USDC in AAVE. These deployments are part of the system's launch phase and provide liquidity for GYD. As GYD expands, reserves will be further diversified, expanding exposure to various risk factors. This evolution will continue as the protocol grows and adapts to new opportunities and challenges.
In addition to the current deployment, we envision that GYD will evolve in the same way that DAI or USDS (renamed) operate today. For example, DAI has two main issuance mechanisms: the original CDP (collateralized debt position) mechanism, which allows users to mint DAI by leveraging their excess collateral position, and the Pegged Stability Module (PSM), which allows users to mint DAI one-to-one against USDC.
Gyroscope has implemented what we believe to be a more robust version of PSM. This mechanism is designed to automatically manage the exposure taken by the protocol, making it a more resilient system. In addition, there is a slot in the GYD protocol for incorporating a leverage mechanism, where users can mint GYD through overcollateralized positions using existing infrastructure that is known for handling such processes efficiently.
Additionally, we are developing Gyroscope’s V2 mechanism, which aims to improve the efficiency of liquidity management between decentralized assets, especially between decentralized stablecoins. This new mechanism will leverage Gyroscope’s existing liquidity pools (ECLPs) and introduce new features inspired by central bank strategies for generating liquidity between currencies. While I can’t go into all the details right now, this upcoming development will provide an innovative way to create stablecoin liquidity and marks an important step in the evolution of Gyroscope.
Looking ahead, GYD and its future mechanisms are designed to provide decentralized stability while competing directly with centralized stablecoins on reliability, liquidity, and track record. The V2 mechanism will further achieve this goal by unlocking new competitive advantages inherent in decentralized assets, allowing Gyroscope to push the boundaries of what is possible in the stablecoin space. This is an exciting time for Gyroscope and the broader DeFi community as we continue to innovate and expand the utility and appeal of decentralized stablecoins.
