The post-COVID-19 era has brought the issue of inflation to the fore, leading to growing interest within the web3 space in the creation of flatcoins, a close “cousin” to stablecoins designed to mitigate inflation risk.
Many existing flatcoins, like Terra’s stablecoin TerraUSD (UST), are algorithmically backed and therefore serve as a stark reminder of the risks associated with algorithmic backing, as evidenced by the collapse of LUNA and UST. So, while the idea behind flatcoins may sound appealing, it raises significant conceptual and design concerns. Ultimately, the success of flatcoins will depend on the ability of developers to deliver on their promise.
To date, flatcoin white papers – including the one offered by Coinbase – do not appear to deliver on their promise, at least in their current state. In particular, the token economic designs of some projects are likely to pose an even higher risk than contemporary stablecoin designs.
Conceptual issues
Examining potential use cases for flatcoins is indeed crucial. Although often presented as an asset that can help users preserve their purchasing power in a context of inflation and economic uncertainty, this idea could be misleading.
Stablecoins are digitized versions of fiat currencies, and their value as a medium of exchange and unit of account is the same as fiat currencies. In contrast, flatcoins are indices of the purchasing power of a fiat currency obtained through oracles that collect data on economic indicators such as the consumer price index (CPI).
Related: CBDCs will lead to absolute government control
As a result, the unit value of flatcoins will deviate from the fiat currency they track over time as long as inflation is not zero. Therefore, the existence of flatcoins hinges on the assumption that fiat currencies or their digitized forms are the mediums of exchange and units of account.
In other words, there will not be a situation where flatcoins are better than stablecoins or fiat currencies as mediums of exchange and units of account, because the existence of flatcoins depends on the superiority of currencies. fiduciary and stablecoins in these roles.
Inflation-linked assets already exist
Flatcoins are financial instruments that expose investors to inflation rates, making them a derivative of inflation. Asset classes that expose investors to inflation risk have been around for a long time.
For example, Treasury Inflation-Protected Securities (TIPS) have been used since 1997 to manage inflation risks associated with fixed-rate bonds. Retail investors can easily access TIPS and gain exposure to inflation through exchange-traded funds (ETFs) in their brokerage accounts.
The availability of these established inflation-linked asset classes through ETFs means that institutional and retail investors can easily manage their inflation exposure. The potential value proposition of flatcoins as an investment vehicle for inflation hedging may be limited.
Despite some criticism of flatcoins, they have the potential to add value to the economy. The real innovation of flatcoins lies in their integration of traditional financial instruments into the blockchain. Flatcoins are a digitization of an existing asset class, similar to how stablecoins digitize fiat currencies. This innovation can enable more efficient financial transactions and create competition with traditional financial intermediaries such as TIPS ETFs, which could lead to greater efficiency and lower costs in financial markets. However, it is essential to recognize that the existence of flatcoins is not the salvation of the macroeconomic challenges we face today.
Design issues
Previous discussions revolved around the potential uses and innovations of flatcoins. However, it is essential to note that the current development of an inflation-linked stablecoin is still in its infancy and faces significant challenges.
A few projects are currently underway that develop CPI-pegged flatcoins, but these projects rely on mechanisms similar to stablecoins. Some existing flatcoin designs, such as Reflexer’s Frax Price Index Share (FPIS) and Rai Reflex Index (RAI), algorithmically adjust the flatcoin supply to maintain peg to a specific purchasing power-related index, similar how algorithmic stablecoins maintain their pegs to fiat currencies.
However, algorithmic stablecoins have proven to be a risky class of design, as extreme market conditions can cause a downward spiral similar to a bank run, as seen in the case of the Terra collapse.
For example, Frax Finance’s white paper on the peg mechanism of its Frax Price Index (FPI) states:
“During periods when the AMO yield is lower than the CPI rate, a TWAMM AMO will sell FPIS tokens for FRAX stablecoins to maintain the CR at 100% at all times.”
To simplify, it states that the protocol will sell index tokens for the Frax Finance stablecoin if the yield of the CPI index falls below its true value. However, this design poses a common vulnerability in algorithmic stablecoins. If the protocol runs out of Frax Price Index Share (FPIS) reserve tokens, Terra-like execution is likely to occur.
Additionally, since inflation rarely turns negative, consistent sales of FPIS tokens will be required to maintain the 100% collateral ratio, making this design even more run-sensitive than other algorithmic stablecoin designs.
The trade-off of relying on anything other than algorithmic adjustment is reliance on centralized authorities. Stablecoin projects that use fiat currency as collateral rely on trust in the project to maintain US dollar escrow. In contrast, those dependent on oversized crypto assets are subject to market risks. Unfortunately, flatcoin projects have yet to provide a solution to this problem.
Another critical obstacle to developing an effective purchasing power index with flatcoins is the accuracy of the data provided by oracle protocols. Relying solely on publicly available CPI data published by the Bureau of Labor Statistics would limit the true potential of flatcoins. Projects such as Chainlink and (mine) IoTeX’s W3bstream have the potential to provide real-time data that could make accurate and timely IPC data possible.
Related: The world could face a bleak future thanks to CBDCs
The success of flatcoins will depend on the continued innovation of oracle teams. A decentralized flatcoin index could significantly improve existing investment instruments for hedging inflation risk if creators can obtain real-time IPC data.
Risks and uncertainties
Widespread adoption of flatcoins and similar cryptocurrencies hinges on their ability to overcome the challenges and risks inherent in stable designs.
As flatcoins and other inflation-linked cryptocurrencies emerge, it is crucial to assess their impact on the broader financial ecosystem. Do they provide a more stable and decentralized alternative to traditional currencies, or are they just another investment vehicle?
Investors, users, and regulators need to carefully consider new developments in the digital asset space. Understanding the true nature and potential of these cryptocurrencies is key to determining whether they will become dominant in the financial landscape or remain an intriguing yet niche investment option.
The emergence of Flatcoins highlights the continued pursuit of stability and decentralization in the field of digital assets. Although this new financial instrument introduces an innovative approach, it carries additional risks and uncertainties. Investors, users, and regulators can better navigate the future of inflation-linked cryptocurrencies by keeping a critical eye on these developments.
Peter Han holds a doctorate. in finance from the University of Illinois at Urbana-Champaign, focusing on financial intermediation and fintech, in addition to a master’s degree in financial engineering. He holds a bachelor’s degree in English and a bachelor’s degree in mathematics from Tianjin University of China. He worked for PwC in Beijing before joining IoTeX, where his work focuses on tokenomics-related research aimed at improving the design of IoTeX tokenomics.
This article is for general informational purposes and is not intended to be and should not be considered legal or investment advice. The views, thoughts and opinions expressed herein are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.