A Terrible Feight - The Daily Gwei #218

You've met with a terrible feight, haven't you?

Disclosure for today’s piece: I participated in Fei Protocol’s seed round as a small angel investor.

The talk of crypto Twitter over the weekend was all about Fei - a new algorithmic stablecoin that aims to keep its peg by using mechanisms called “protocol controlled value” (PCV) and “direct incentives”. The reason for the buzz around this project is because it had an open sale where people could contribute ETH which would then be put into an ETH/FEI pool on Uniswap and then people could redeem their FEI for ETH and they would also be entitled to some TRIBE (the governance token). But what ended up happening was a most unfortunate turn of events.

First, let’s go over how Fei is actually meant to work (aka how it keeps its peg to 1 USD). Essentially what Fei Protocol does is utilize PCV to either sell or buy back supply as needed to maintain the peg - the protocol can do this because it keeps a reserve as collateral (which is currently ~$1.3 billion worth of ETH). In addition to this, Fei also uses something called “direct incentives” to disincentivize people from trading against the protocol. In plain English, the direct incentives mechanism kicks in when Fei is above or below peg - if it’s below, then a burn mechanism kicks in which gets exponentially worse the further the price of Fei is from its peg. For example, if you want to sell Fei at its current price of $0.96 then you will be taking a ~30% haircut on that sale due to the burn mechanism.

What people have to do now is either wait for the PCV to kick in and start re-weighting Fei to $1 (using its reserves) or hope that a surge in demand for Fei pushes it closer to its peg. Though the kicker here is that the demand and supply side for Fei are currently in extreme imbalance - put simply, there are too many sellers and not enough buyers which means getting Fei back to its peg of $1 without PCV is a difficult task. This is because every time Fei inches closer to its peg, there are people waiting to sell it back down in order to exit their positions. I don’t think this will last forever (and PCV will help to speed this process up) but it’s currently a vicious cycle that the protocol finds itself in.

Soft-pegged/synthetic stablecoins (like Fei and Dai) heavily rely on the demand-side to keep their peg of $1 - if the demand is too low (and supply is too high), then they will lose their pegs to the downside until demand picks up again. Fiat-backed stablecoins (like USDC and GUSD) don’t really suffer from this issue because they are fully backed by USD sitting in a bank account. So in order to have a functioning synthetic stablecoin, the demand side is absolutely critical. For Fei, this would include getting integrated into every other DeFi app as soon as possible which would encourage people to actually buy Fei to put it to use. Right now, the only thing people can do with their Fei is either hold it, sell it at a loss or trade it for the TRIBE token.

So, how could all of this have been avoided? Well, I think that the entire thing (the sale and the launch) should’ve been run in a more careful and controlled way. Firstly, the sale should’ve been capped at a modest amount instead of being uncapped. Secondly, the protocol should’ve been launched onto mainnet before the TRIBE token went live so that people didn’t feel the fomo to crowd into the sale. Thirdly, there should’ve been a “disaster recovery plan” put in place to get Fei back to peg as quickly as possible in the event that the current situation played out. And lastly, the team should’ve notified Uniswap about FEI’s mechanics in advance so that the Uniswap front-end interface displayed a note about the burn mechanism when trading FEI for ETH when FEI is under its peg.

To end this piece on a positive note, I don’t think this is a death knell for Fei nor do I think it means that its mechanisms have outright failed. Novel mechanisms are difficult to get right and you really only know how they’re going to play out once a protocol is launched into the wild. And to be honest, this is a pretty amazing battle-test for Fei right now because it is testing all of its mechanisms at once in such a visceral and public way.

After all, Ethereum is a platform for all types of wild and whacky experiments - most will fail but some will go on to change the world - and we all have the pleasure of watching it play out!

Have a great day everyone,
Anthony Sassano

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All information presented above is for educational purposes only and should not be taken as investment advice.