[Company Watch] The Fall of Pegs Cash and What’s Next

We have in an early article analysed Frax Finance, a dual asset backed stablecoin. The innovative part of Frax Finance is having a widely accepted stablecoin, like USDC, and its platform token, FXS, jointly as its collateral. The ratio between USDC and FXS backing one dollar of FRAX is determined by how long FRAX is above or under the peg of $1.

We have concluded in that article that such multi-asset backed stablecoins are valid up to the strength of the platform tokens.

Not too long after our hypothesis, Pegs Cash, Frax Finance’s fork, has fallen and thus gave us some idea the risks involved in such a design.

Pegs Cash is almost identical to Frax, but with a more aggressive mining reward system. At its peak, the pair of PEGS, its platform token and PUSD, its stablecoin, can deliver 3000% to 4000% yield. Arguably, this is one of the few ways that an anonymous new fork could appeal to the investors. Sushi did the same to Uniswap and Swerve did so to Curve.

Pegs Cash, like Frax Finance, stabilizes its coin with the following arrangement:

• Mint PUSD (with USDC and PEGS) when it’s above $1
• Redeem PUSD (for USDC and PEGS) when its below $1

In theory it works, as PUSD is programmed by small contract to be a portion of USDC + a portion of PEGS; and when the market prices mis-match, it presents arbitrage opportunities that incentives traders to profit and restore the price to $1.

However, the design of this system depends on a few factors:

• There should be no or little transaction costs. If the gas price is too high, traders might not want to balance immediately, or the profit of restoring a peg is less than the cost of gas.
• There should always be sufficient liquidity of USDC and PEGS to support the traders’ actions to balance the peg.
• Traders should act independently and do not get involved in price speculation of PEGS.

In reality, what happened is below:

Price of PUSD/USDC in Uniswap

Price of PEGS/PUSD in Uniswap

PUSD went off-peg after the price of PEGS collapsed from its peak of $20 to a few cents within 24 hours. What happened is the following:

1. As investors saw PUSD went slightly below $1 and nobody traded, as the gas price was prohibitively high due to a falling BTC on that day (300 to 500 gwei).
2. PUSD continued to drop and at the price level of $0.95 PUSD/USDC and even below, there would be margins for traders to arbitrage by redeeming PUSD for USDC and PEGS. At that moment, the collateral ration was about 93%.
3. As traders arbitrage, a lot of PEGS were minted, increasing the supply from 300k to a few million. This put tremendous selling pressure on PEGS — considering that at a daily issuence of 34k was already a 2000% APY, and a few millions of PEGS were minted.
4. Investors started to panic sell PEGS and its price declined rapidly (the decline actually started about 24 hours to 36 hours before the unpegging of PUSD, as liquidity providers cashed out mining rewards).
5. The panic sell of PEGS cast some doubts over the entire community and traders (who arbitrage by buying PUSD and selling USDC and PEGS) hesitated, as a falling price of PEGS might have wiped out the arbitraging profits, if traders are doing this manually and not via small contracts.
6. As traders slowed down, PUSD price was bumpy with the range of $0.90 to $0.96. In the telegram group, investors started to question a falling PEGS and a shaky PUSD.
7. On the other hand, the Recollateralisation feature (allowing investors to top up the reserve of USDC when there’s a shortfall, for a small incentive of 0.75%) is not working. Firstly, the smart contract used a time-weighted average price of calculating how much PEGS can be exchanged for USDC, and in a falling market, exchanging USDC for PEGS was simply a bad idea. Secondly, gas was too expensive to justify the 0.75% incentive. So no one topped-up the USDC reserve.
8. After a few hours, as more traders redeem PUSD, the reserve of USDC was drained. In the span of a few minutes, investors rushed to Uniswap to cash out PUSD for USDC. And the price of PUSD collapsed. A crypto version of run-on-the-bank happened.

The Pegs Cash team had issued a short article on what happened and what’s next. The team, despite being anonymous, did not have malicious intentions. They simply did not understand monetary economics, and played around an innovative design, amplifying its risks. Despite failing to make a gain (from their unsold 20% of PEGS), the team was not investors and risked no capital. Even there’s another trial for Pegs Cash 2.0, as the team proposed, the transferred of wealth had already taken place, from those who bought PEGS and PUSD and its peak to those who cashed out to them. It’s irreversible and the team had nothing to compensate, even if they feel obliged to.

Would Frax Finance be vulnerable in a same situation? Theoretically what happened to Pegs Cash can happen to any dual asset backed stablecoin. As our hypothesis, this type of stablecoin is as strong as its platform token. The USDC bit of the collateral is only relevant when investors actually are willing to top up the reserves when it’s done — and there are many reasons why investors might not want to, especially in an extreme market situation.

What can Frax Finance and others do, to make its stablecoin more stable, more robust? There are many ways, proven in the history of monetary policies, e.g. a hard price floor, a special reserve, a circuit breaker. However, the more human involvement in the process, the less decentralised the stablecoin is; and this would fail the project, a decentralised stablecoin, in principle.

After all, stablecoins are still in its infancy, so let’s be patient with their progress.

(Serenity Team, 23 Jan 2021, Twitter: https://twitter.com/SerenityFund)