Recently, developers of the invite-only Zero web app removed the redemptions page, making it so that only expert users with knowledge of how to interact directly with the Zero smart contracts (or run the open source web app themselves) are able to redeem ZUSD for BTC. Since I collaborate closely with the developers and have been closely following the issues and conversations leading up to this, I thought it’d be helpful to share context here and explain the background and reasoning for this change, what options exist for ZUSD holders who do not know how to interact directly with the Zero smart contracts or run the web app themselves, and what other changes Zero users can look forward to in the near future.
Zero is first and foremost a stablecoin protocol. The purpose of Zero is to create a BTC-backed stablecoin called ZUSD that is pegged to USD. The mechanism the protocol uses for issuing the stablecoin is a collateralized line of credit system, where users can put up BTC collateral and issue themselves (or “borrow”) ZUSD on-demand, at 0% interest, with a collateral-to-loan ratio as low as 110%. The only cost Zero charges for borrowing ZUSD is a one-time origination fee, which in normal mode starts at 0.5% and increases based on the recent volume of redemptions (more on redemptions later).
As mentioned, the purpose of Zero is to create a BTC-backed stablecoin pegged to USD. If the value of 1 ZUSD wavers too high above or below 1 USD for too long, this would damage confidence in the stablecoin and holders would flee to stronger stablecoins or maybe even back to legacy fiat currencies. This would hurt the network effects of ZUSD as a currency, and overall the Zero and Sovryn ecosystems would suffer.
Several mechanisms have been devised over the years that aim to secure a cryptoasset-backed stablecoin peg. Some stablecoin protocols, such as Maker, use a variable interest rate. If the peg breaks downward, interest rates increase to soak up the stablecoin supply; if the peg breaks upward, interest rates decrease to induce borrowing, which releases supply onto the market. Other stablecoin protocols, such as Terra, have experimented with a multi-asset system. The first asset acts as the stablecoin, the issuance of which is incentivized whenever the peg breaks upward, and the second asset is a kind of “bond” or “seignorage share” that is used to buy stablecoin supply off the market when the peg breaks downward. Some multi-asset stablecoin protocols, such as Basis Cash, are designed to have a stablecoin asset, a bond asset, and a seignorage share asset.
These two popular stability mechanisms, interest rates and bonds/seignorage shares, are not the only mechanisms proposed but are the two most common. We saw last year how the Terra experiment ended. Terra suffered the same fate as every previous attempt to build an under-collateralized stablecoin: a permanently broken peg (Basis Cash preceded Terra and met the same fate; ironically, it appears both were created by the same person). Maker, on the other hand, is one of the longest-running and most successful stablecoin protocols, but has made two significant compromises that differ from Zero: the first is the use of interest rates, and the second is the acceptance of fiat stablecoins such as USDC as collateral. These are both compromises that the Zero community has so far been unwilling to make (and I would advocate Zero stay that way).
Instead of interest rates or bonds, Zero has its own mechanisms for defending its USD peg, inherited from the Liquity protocol that Zero is based on. If the price of 1 ZUSD breaks upward beyond 1.10 USD for an extended period of time, borrowers can take advantage of Zero’s low collateralization requirements to issue ZUSD at 110% collateral ratio and sell the ZUSD into the market at a profit, bringing the ZUSD price back down to 1.10 USD. If the price of 1 ZUSD breaks downward below 1 USD for an extended period of time, borrowers can use the redemption feature to redeem 1 ZUSD for 1 USD worth of BTC, minus a redemption fee, then sell the BTC for ZUSD at a profit, rinse and repeat until the price of 1 ZUSD is brought back up to 1 USD. With these mechanisms, Zero is able to maintain a peg of between 1 USD and 1.10 USD per ZUSD, and under normal conditions 1 USD may prove to be the “Schelling point” that the market coordinates around.
The BTC used to service redemption requests comes out of the collateral of lines of credit, starting with the lowest collateralized line of credit and working up to the highest collateralized line of credit. For every 1 USD worth of BTC redeemed, 1 ZUSD of debt is paid off on the affected lines of credit. Once a redemption fully pays off a line of credit’s debt, the line of credit is closed and the extra BTC collateral that remains becomes available for the owner to reclaim.
Zero’s redemption feature creates a hard floor on the price of 1 ZUSD: if it dips below 1 USD (minus the redemption fee) for an extended period of time, an arbitrage opportunity is created that profit seekers can capture. In the past few months we have seen this mechanism put to the test. The good news is that Zero passed the test. The bad news is that it cost line of credit owners over half a million dollars worth of BTC collateral. This came as a surprise to some line of credit owners, but it’s worth noting that the redemption feature was, until recently, prominently located in the Zero web app, is mentioned throughout the Zero documentation in the wiki and on GitHub, and has been discussed as a risk to be aware of in media about Zero.
The primary outlet for ZUSD economic activity has been BabelFish, a stablecoin aggregator that, at its peak, held over 95% of the ZUSD supply, and still currently holds about 93% of the supply. Zero users would borrow ZUSD, use BabelFish to convert ZUSD to XUSD, then convert the XUSD to fiat stablecoins via BabelFish or to other assets such as RBTC via the Sovryn AMM.
Late last year, Zero began to experience growing pains. Many people were attracted to Zero by the interest-free line of credit, issuing millions of ZUSD. BabelFish began to run out of fiat stablecoins. This left Zero users with the Sovryn AMM as their main option for “cashing out” their ZUSD. This in turn drove up the price of assets on the Sovryn AMM relative to outside markets, creating an arbitrage opportunity. To capture the opportunity, arbitrageurs had to sell the overpriced assets for XUSD. With little to no fiat stablecoin liquidity for cashing out XUSD, the arbitrageurs had one remaining path to close the arbitrage loop: convert XUSD to ZUSD, then redeem ZUSD for BTC which could then be sold for whatever other asset was needed to close the loop.
This “ZUSD arbitrage loop” resulted in the first wave of redemptions, colored blue in the chart below. To defend the XUSD peg and eliminate the arbitrage opportunity, the BabelFish community decided to pause ZUSD deposits in January, about a month ago. For a couple of weeks, this had the desired effect: the XUSD peg recovered, the arbitrage opportunity dissipated, and Zero redemptions began to flatline. Then in February, a second wave of redemptions came, colored green in the chart:
This second redemption wave was different than the first: the XUSD peg was still holding strong, there was no arbitrage opportunity large enough to explain this volume of redemptions. Instead, it appeared that people were using the redemption mechanism as a way to cash out ZUSD, not realizing or caring about the harm this was doing to Zero lines of credit. Remember that redeeming ZUSD brings every line of credit that much closer to being redeemed, including the line of credit owned by the person doing the redemption (if they have a line of credit, that is - anyone can redeem ZUSD, even if they don’t have a line of credit).
When line of credit owners redeem ZUSD simply as a mechanism of cashing out ZUSD, it turns Zero into an ouroboros: a snake eating its own tail.
Due to the redemption fee, this kind of usage of the redemption feature isn’t profitable at scale. But for ZUSD holders who believed they had no other way to cash out, the fee was simply the cost of doing business. And if they owned a line of credit, the added risk must have been seen as acceptable.
The second wave of redemptions pushed the cumulative redemption volume to about 11% of cumulative ZUSD issuance. In total, over 1,000,000 ZUSD have been redeemed. Lines of credit with collateral ratios as high as 200% were being redeemed against. In response to this high redemption volume, the Zero developers decided to remove the redemption feature from the Zero web app. This was something that was publicly discussed as an option several times since the launch of Zero but was only recently prioritized to slow down redemptions. This change has so far had the desired effect: ZUSD redemptions have again plateaued, with no redemptions occurring since the change was implemented.
Now line of credit owners are relieved, but ZUSD holders who either were using or now want to use the redemption feature to cash out are understandably upset. The silver lining here is that while redemptions may have been the easiest way to cash out, they are not the only way to cash out, and ZUSD has other uses, too.
With BabelFish deposits paused and redemptions not as easily accessible, there are now four main ways to use ZUSD: hodling, p2p trade, stability pool deposits, and repaying line of credit debt. Let’s look at these in detail:
Hodling. ZUSD still has value, still has utility, and is still one of the safest assets to store value denominated in USD, in my opinion.
P2P trade. There are several ways to trade ZUSD p2p. With trusted counterparties, trade can be done face to face or online. With untrusted counterparties, multisig escrow such as Bisq or Bitrated, or hold invoices using Robosats, could be used. Maybe someone in the Sovryn community is willing to make a market and earn a commission by providing liquidity for ZUSD holders. Speak up in the comments if this is you!
Stability pool deposits. This is a way to hodl ZUSD with the possibility of buying the BTC dip. Every time there’s a liquidation, stability pool depositors can earn up to 10% profit (loss is also possible, but unlikely imo due to Zero’s efficient liquidation mechanism). While waiting for other ZUSD offramps to come online, why not hang out in the stability pool?
Repaying line of credit debt. If you hold ZUSD and have a line of credit, and you are itching for liquidity, you can always go back out the way you came by repaying your line of credit debt and taking out some BTC collateral. You don’t even have to sell your BTC to get liquidity: you can take your BTC over to the Sovryn lending protocol and use it as collateral to get a loan in XUSD or any other currency on offer. You will have to pay interest, but the rates still beat many consumer loans: you can borrow DOC (another BTC-backed stablecoin) at 7.5% APY and XUSD at 12.87% APY, based on the available rates at the time of publishing this. Then once more ZUSD offramps come online, you can decide if you want to flip your loan back over to Zero for 0% interest.
I hope I’ve convinced you that, although redemptions certainly were the easiest way to offramp ZUSD in recent weeks, this was neither the only way to use ZUSD nor was it the healthiest way to use ZUSD, for all involved. If you hold ZUSD and want something to do with it, I invite you to leave a comment or DM me if you need help getting value from your ZUSD without having to use the redemption feature.
Going into speculative future land where there are no guarantees, it’s worth pointing out a couple of developments that I believe will help improve liquidity and reduce redemption rates over time.
One of these developments is the incentive algorithm that the BabelFish community is working on. This will create a system of penalties for bringing stablecoins in the aggregator out of balance relative to defined target weights, and provide rewards for bringing the aggregator back into balance. This won’t solve BabelFish’s liquidity shortage overnight but provides a mechanism for improving over time.
The second and even more impactful development that is worth mentioning is that according to the current project timeline and pace of development the Sovryn Dollar (DLLR) is mere weeks away from launching. Sovryn devs plan to launch a DLLR/RBTC AMM pool at the same time. ZUSD holders will then be able to convert their ZUSD to DLLR and participate as LPs in the AMM pool or trade DLLR for RBTC. If the timeline holds — and based on all the progress I’ve seen I believe strongly that it will — then ZUSD holders will have another offramp before the end of 2023 Q1.
I don’t want to make DLLR seem like a silver bullet that solves all of Zero’s problems, but I do want to share more about why I believe it will be a gamechanger for Zero users and ZUSD holders broadly, especially in the context of the issues discussed so far in this post.
DLLR is the stablecoin issued by the Mynt protocol. Mynt aggregates multiple BTC-backed stablecoins, which each have their own stability mechanisms and scaling capabilities, making DLLR more resilient and scalable than any individual stablecoin backing it. The first stablecoins that will be part of the Mynt aggregator are DOC and ZUSD.
The Sovryn community has been waiting for DLLR to launch to throw everything we’ve got at building out a stablecoin ecosystem. This is why Zero has been invite-only with limited utility until this time: it just wouldn’t have made sense to build up millions of dollars worth of liquidity, brand recognition, partnerships, etc etc for a stablecoin that will soon be a background component, just one of multiple stablecoins backing DLLR.
With the DLLR launch, we (all Sovryns who have been anticipating this launch) can finally put all of the ideas and plans we have for DLLR into action. All the pent up creativity about how to build a global community of HODLLRs will soon be unleashed. Imagine a vibrant and diverse economy of merchants, exchanges, market makers, savers, and shoppers using DLLR as their dollar of choice. This is our vision of the future. If we can achieve this, concerns about liquidity will be a thing of the past, and redemptions might be a rare occurrence.
I hope this post has helped you understand how we got where we are, and what the path looks like from here. Please let me know if you have any questions or feedback about the above.
