NB: Purpose of this post is to share a new concept and collect feedback prior to moving to a proposal.
Executive Summary
Decentralized stablecoin protocols assume increasing levels of bad debt risk when expanding as a single, monolithic protocol to new chains. In addition to mounting bad debt risk, monolithic expansion results in increasing operating costs, sub-optimal lending capacity, and reduced competitiveness. A new stablecoin federation approach enables more competitive cross-chain expansion, eliminates most chain-specific bad debt risk, and allows more customized approaches to specific markets in exchange for majority ownership in one or more sub-DAO’s.
Background
Two ongoing challenges for debt-backed stablecoin scalability are cross-chain risk management and peg management.
Cross-chain risk management for decentralized stablecoin lending protocols (sometimes referred to as collateralized debt positions or CDP’s) is challenging, but expanding stablecoin lending to new L1 or L2 chains magnifies the challenge. Considering the risks that can lead to bad debt when operating on just a single chain, the appearance of new L1 and L2 options for stablecoins presents real dilemmas since the revenue opportunities can be so attractive.
Peg management during adverse market events is a similar challenge. Stablecoin holders often sell in high volumes in order to convert to fiat or other assets and the resulting downward price pressure is managed according to available peg stability tools on hand. Compared to centralized stablecoins, which carry their own risks of censorship and centralized custody, the risk and peg management for decentralized stables is generally more challenging and impacts scalability.
Three Key Observations
- Competitors cooperate. Inverse maintains valuable coordination with rival stablecoin and lending protocols around liquidity incentives, new liquidity pairs, and in some cases when adding competitor assets as collateral on FiRM. While seemingly counterintuitive - why help a competitor? - inter-protocol collaboration is common.
- But competitors won’t save your peg during a severe market correction. When things get rough a stablecoin must fend for itself. DOLA Feds are amazing liquidity tools but when paired with a “passive” stablecoin like USDC where there is currently no formal partner collaboration, pools can become imbalanced which may affect peg stability.
- Bad debt is an extra burden. Operating a stablecoin project with bad debt is like mountaineering with a 100-pound backpack. You can still reach the summit, but the pace is way slower.
The Pressure For Cross-chain Growth Is High
The increase in the number of Ethereum L2’s in particular is hard to miss and the benefits are clear: control your own L2 product roadmap, capture your own L2 transaction revenue, and print your own emissions tokens to fund ecosystem incentives. As L2’s emerge with incentives earmarked for stablecoin lending protocols, the pressure for stablecoin lenders to expand cross-chain in the pursuit of new profits and market share only grows.
In addition to cross-chain growth incentives, within-industry competition leads to subsidized or discounted borrowing costs, where protocols operate a lending market at a loss in order to establish awareness, baseline TVL, or grab initial market share on a new L2. This price competition leads to further risk, liquidity, and growth dilemmas for decentralized stablecoin projects, including Inverse.
In sum, while debt-backed, decentralized stablecoin lending on a single chain carries risk, cross-chain lending further magnifies that risk.
The Cross-Chain Risk Stack
For projects that engage in cross-chain lending, we can visualize risk starting with a 10-layer “risk stack”:
- Chain risk. Risk related to the underlying integrity or safety of a blockchain protocol like Ethereum or higher-level L2 protocols like Optimism or Arbitrum.
- Smart contract risk. This is risk related to smart contracts deployed on top of a given chain.
- Collateral risk. This is the risk that the value of a staked collateral asset abruptly going to zero triggers a liquidation or bad debt event.
- Oracle risk. This is the risk of a price oracle feed being manipulated or otherwise compromised.
- Liquidity risk. This is the risk that liquidity required to execute liquidations is too thin, thereby risking bad debt from the inability to liquidate an underwater loan. Liquidity risk also extends to the ability for a stablecoin protocol to defend its peg. Liquidity risk for Inverse also encompasses risk of extending DOLA liquidity feds onto new chains and partner protocols.
- Bridge risk. This is risk from a native or third party bridge being attacked and parked or “wrapped” assets being stolen or otherwise made illiquid.
- Partner risk. This is the risk that a third party asset in a liquidity pool is compromised and triggers bad debt for an AMM Fed.
- Governance risk. This is the risk of a compromise of a relevant multisig or governance mechanism.
- Brand risk. This is the risk of harm to a protocol’s brand via a failure in any layer or node in the risk stack, including a protocol’s association or partnership with third party brands.
- Other risk. This category covers miscellaneous, unforeseen, or systemic risks not expressed in other layers of the risk stack.
The risk stack is extended horizontally with cross-chain lending. Here’s a hypothetical monolithic risk stack for a decentralized stablecoin protocol that lends across Ethereum mainnet and five Ethereum L2’s:
Monolithic stablecoin lending protocols (including Inverse) who expand lending across chains magnify the risk of bad debt as total protocol bad debt risk is not isolated to a single chain (or column, in this illustration) but rather extends “horizontally” where a single failure in any node in the matrix can lead to bad debt for the entire protocol across all chains.
Yet beyond risk management, monolithic stablecoin protocols must also govern:
- all product,
- all liquidity,
- all community, and
- all marketing across
- all chains and ecosystems via
- a single DAO typically governed by
- a single governance token.
Revisiting The Monolithic Stablecoin Approach
Based on the above, it is worth revisiting this monolithic approach to stablecoin scaling for multiple reasons:
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A rapid emergence of new chains and ecosystems. As stated above, we are seeing a surge in Ethereum L2’s and new L1’s or sidechains, often well-capitalized. The number of new chains built on the Optimism stack alone is noteworthy. (https://twitter.com/stacy_muur/status/1698720913842180113?s=20). New chains attract new tokens and new token wealth, which leads to new demand for leverage. Yet as monolithic stablecoin protocols expand lending on new chains, bad debt risk per dollar of lending does not remain constant, but rather increases.
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Cross-chain lending = Higher OPEX. In order to compete, monolithic stablecoin lending protocols ultimately require their stablecoin holders to “bet” with them that their cross-chain expansion activities will not materially increase bad debt. If holders take the bet, they should on average demand a risk premium for holding the stablecoin, forcing the protocol to spend greater sums on liquidity incentives which impacts profitability and/or tokenholder returns. Paradoxically then, as cross-chain lending by a monolithic stablecoin protocol grows, the profitability for the protocol per dollar loaned, all things being equal, decreases.
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Emergence of new asset classes as collateral. The use of real world assets like yield-bearing centralized stablecoins, tokenized treasuries, or tokenized real estate as collateral represents attractive growth opportunities that may conflict with a protocol’s decentralization mission or risk profile, but which are otherwise viable collateral candidates. As new asset classes emerge, monolithic protocols must convince their voters to assume risks associated with those asset classes.
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Emergence of novel collateral designs. Derivative products like cvxCRV represent compelling but higher-risk revenue opportunities that show promise as collateral but bring liquidation and other risks.
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Bad debt. Cross-chain expansion presents potential new bad debt liabilities for a protocol that may be difficult to digest given the presence of existing bad debt.
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Capital requirements. Cross-chain expansion typically requires capital to fund product development, liquidity operations, audits, etc. This leads to inevitable resource allocation tradeoffs for a monolithic protocol which may slow cross-chain expansion.
Current Anti-monolithic Movements in DeFi
Two recent events in DAO organization, governance, and capital structures point to a trend towards non-monolithic structures.
- MakerDAO Endgame plan
This plan (recommended reading) evolves the current MakerDAO into a series of sub- or meta-DAOs with individual governance tokens and is intended to solve for org inefficiencies for an $1B mcap DAO but fundamentally the plan is rooted in DAI’s growth challenges. For example, the proposal specifically calls for the creation of a Meta-DAO to address opportunities with RWA’s.
- Velodrome/Aerodrome
Not a stablecoin project, but Velodrome’s Aerodrome spinoff is designed to exploit a new DEX opportunity on Base but using a new protocol and governance token that is 40% owned by veVELO holders. Aerodrome is a clone of Velodrome and shares the same team with Velodrome along with some new contributors.
The Aerodrome approach avoids the risks and complications of using a common governance token for ve3,3 emissions across chains, unlike the approach taken by other cross-chain DEX protocols. Also allows Aerodrome to raise capital independently on a promising chain (Base) at a valuation that is significantly current Velodrome valuation. AERO/USDbC - Aerodrome Price on Aerodrome (Base) | GeckoTerminal
A Proposed Next Step for Inverse: an Inverse Federation
If we were to imagine an alternative approach to monolithic governance and growth for Inverse, the approach would:
- Address the cross-chain expansion dilemma described above, while
- Reduce DOLA bad debt and/or its operational impact
- Improve DOLA peg stability
- Improve Inverse’s competitive situation; and
- Improve returns to INV stakers
One non-monolithic approach, an Inverse Federation, borrows from real-world growth strategies (e.g. corporate spinouts) as well as web3 approaches from MakerDAO and Velodrome to create a series of debt-backed stablecoin projects built around rights-based borrowing which are majority owned by the genesis DAO, Inverse Finance.
What Is An Inverse Federation?
In the federated model, in place of monolithic cross-chain expansion, individual “sub-DAO’s” with individual governance tokens are launched on new chains which are majority-owned by INV holders. Each sub-DAO:
- Brings rights-based borrowing to users on its chain. In most respects, sub-DAO’s are launched as Inverse/FiRM clones.
- Re-uses FiRM and other code, allowing our vision of rights-based borrowing to proliferate throughout the web3 universe in a way that accrues value back to Inverse.
- Has its own governance, stablecoin, and borrowing rights tokens. Value accrues to INV holders and/or the Inverse treasury through majority ownership of each sub-DAO. Revenues are remitted to sub-DAO governance token holders via TBR streaming, as occurs today with DBR streaming.
- Supports DOLA liquidity pools. Inverse and the sub-DAO will coordinate liquidity incentives for DOLA pools on the sub-DAO’s chain. Separately, Inverse and a sub-DAO may mutually supply liquidity pools using feds, providing extra supply for either DAO to use for purposes of peg management in a downturn.
- Reduces lending risk on new chains for INV holders since lending on new chains is executed solely by sub-DAOs. Any bad debt accrued by the sub-DAO never transfers to Inverse or DOLA holders.
- May have customized risk policies. For example, a sub-DAO can be created that focuses exclusively on RWA’s as collateral, while Inverse as a DAO today might not vote to embrace more than a modest amount of RWA as collateral.
- Shares contributors. To minimize opex for each sub-DAO and minimize time to market, Inverse contributors provide assistance in launching and ramping up the sub-DAO, with additional contributors added as necessary. For example, risk management is tightly coordinated between Inverse and sub-DAO’s to maximize overall outcomes.
How Do Inverse Federation Members Work Together?
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Co-incentivized pools. Inverse federation members work together to co-incentivize liquidity pools where practical.
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AMM fed coordination. It may be advantageous for Inverse and a sub-DAO to mutually supply a liquidity pool via AMM feds, providing additional fed “ammo” when contractions are necessary which can be coordinated between federation members. For example, on Base a sub-DAO could activate a fed for its own stablecoin and Inverse could activate one (cross-chain) for DOLA. Each would supply its own stablecoin, hold the LP token, and coordinate expansions and contractions, while sharing swap fees.
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Reduction in DOLA bad debt. As a majority tokenholder in each sub-DAO, the Inverse treasury (along with INV stakers) receives a TBD % of each sub-DAO’s tokens which can generate token borrowing rights revenue which can be harvested to repay DOLA bad debt. Inverse treasury holdings of vesting sub-DAO governance tokens represents an additional source of revenue for retiring bad DOLA debt.
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Marketing collaboration. Federation members can amplify the marketing messages of other federation members, share marketing resources, hold joint events, provide incentives to try a federation member’s new product, etc.
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Contributor sharing. Federation members also share contributor resources, can negotiate jointly with suppliers, can share audit costs, etc.
Benefits of Launching The Inverse Federation
Turbocharging the INV Flywheel. For INV holders, the Inverse Federation becomes a source of additional yield streaming as not only do INV stakers receive DBR’s but they also receive new borrowing rights tokens from each sub-DAO. INV stakers also receive a vested airdrop of sub-DAO governance tokens. This additional real yield for INV stakers boosts demand for the INV governance token, reduces liquidity costs, and enables greater levels of DOLA borrowing.
Faster Value Accrual for INV stakers. Federation sub-DAO’s launch with no bad debt, incur no bridging risk, raise capital independently, and can operate with greater agility. By capturing a majority of the profits from multiple sub-DAO’s, INV holders accrue more profits more quickly than with the current growth model of deploying FiRM to a new chain every 6-12 months.
Value Accrual for the Inverse treasury. Federation sub-DAO’s allocate a % of their governance tokens on a vested basis to the Inverse treasury which can receive TBR streaming, be farmed, or swapped to reduce bad DOLA debt.
Risk mitigation. Importantly, sub-DAO’s absorb 100% of bad debt lending risk on new chains. Inverse retains bad debt liability for DOLA AMM feds deployed on new chains, if and when deployed. Non-mainnet lending bad debt risk is transferred to the sub-DAO.
Time to market. A federation approach allows for more rapid expansion of rights-based borrowing across chains, experimentation with new asset classes, heterogeneous risk management policies, liquidation mechanisms, etc. than would be possible with a monolithic DAO. To-date, Inverse has been (rightly) cautious about cross-chain lending expansion and a federated model allows for more rapid deployments.
Removes friction in the lending ecosystem. Unlike centralized stablecoins, which can mint canonical versions of their stablecoins on individual chains commensurate with their centralized backing, many decentralized stablecoins today mint exclusively on a single chain and rely on bridges to enable a cross-chain presence. Holders of the stablecoin therefore assume bridging, depeg, and lending risk on the new chain, creating higher costs for borrowers on the new chain and impeding growth of the stablecoin on the new chain. A federated approach instead provides a stand-alone rights-based lending protocol with an independent stablecoin for users on the new chain, avoiding bridging and related risks and costs. A federated approach captures the full rights-based borrowing revenue opportunity available on a new chain and does not rely on high-volatility variable rate lenders to assume lending risk on new chains.
Improves the health of DOLA. In a federated model, all DOLA lending on FiRM on Ethereum mainnet, all DOLA liquidity incentives including cross-chain incentives, and all INV staking incentives remain intact. All Inverse bad debt payments continue as planned or accelerate due to remittances from sub-DAO’s and/or INV price appreciation due to implementation of the federation model. Little or no capital outflow from Inverse is required to launch a sub-DAO.
More experimentation. A stablecoin federation allows for innovation and experimentation on a smaller scale by a single federation member that has a smaller risk footprint, all things being equal, than the same experiment conducted by a monolithic protocol. For example, a decentralized stablecoin backed by real-world assets, which are subject to censorship, theft, and other pitfalls of centralized assets. Thinking of the stablecoin federation as a portfolio of stablecoin governance tokens, a single federation member that experiments and fails in its RWA-backed stablecoin experiment amounts to a portfolio loss for the genesis DAO (e.g. Inverse), but not a catastrophic one.
Flexibility. Sub-DAO’s may be formed based one or more attributes that are distinct from Inverse and FiRM today:
- New chains (e.g. Arbitrum, Base, opBNB, etc.)
- New collateral asset classes (e.g. treasury securities, real estate, etc.)
- New risk management policies (e.g. single collateral asset lending protocol, ultra-conservative risk management, etc.)
- Targeted user segments (e.g. specific geo, regulated markets that require KYC, “bleeding edge” markets requiring multi-year ramp up)
- New products. While not the intention of the federation model, sub-DAO’s may choose, with governance OK, to expand into new products that are distinct from those of Inverse. For example, Nour’s recent concept, Grace, is an example of a product concept that could form the basis for a new sub-DAO but with its own governance token.
- Legal entity. Sub-DAO’s may be formed with a legal entity that is best suited to the mission of the sub-DAO, or governance may elect to forego a legal entity.
Lean operations. Sub-DAO’s fork Inverse code, share Inverse full time contributor resources, and share non-recurring expenses like audit or bug bounty expenses. This allows sub-DAO’s to be launched with modest upfront capital requirements and modest ongoing operating expenses. It is assumed that each sub-DAO will raise its own startup capital or take a small loan from Inverse Finance.
Optionality. The federation vision does not preclude Inverse from launching on any chain in competition with a sub-DAO. For example, the DAO is currently moving toward a deployment of FiRM on OP which will proceed as planned. Inverse can elect to launch lending operations on any chain at any time.
Potential Challenges With A Federation Model
Liquidity. Sub-DAO’s will ultimately be required to support three tokens - governance, stablecoin, and borrowing rights. Third party DEX NFT’s, co-incentivized pools with DOLA, grant-based incentives (e.g. OP grants), and outside capital help provide baseline liquidity incentives however there is still potential to require inflation of the sub-DAO’s governance token to support liquidity operations. Worth noting that as with INV stakers today, one path for protecting governance token holders from dilution is to replicate INV anti-dilution rewards at the sub-DAO level. In addition, liquidity may be built in stages beginning with the launch of the sub-DAO governance token and, after building a sub-DAO treasury and other pre-requisites to launching lending operations, building sub-DAO stablecoin liquidity operations. In all cases, sub-DAO stablecoins may be paired with DOLA to minimize launch-stage liquidity costs.
Awareness. Launching a new stablecoin requires awareness building in a competitive stablecoin marketplace. Awareness can be built via partners, community members, or even direct marketing spend, but a core hypothesis of this proposal is that one or more new stablecoins launched by the Inverse Federation can achieve sufficient levels of awareness and adoption to enable sustained operations of the sub-DAO.
Capital. Launch costs for a sub-DAO are minimized due to the sharing of existing Inverse contributors, code, and other infrastructure. An assumption is that sub-DAO’s, each with a fresh governance token, will find capital raising to be easier than for a similar capital raise for Inverse.
Contributors. Building effective sub-DAO contributor teams is essential to the execution of the federation vision. While current Inverse contributors are an experienced resource, the scalability of this proposed resource sharing remains untested. There is also a risk that as new sub-DAO’s are launched it may distract current Inverse contributors from their core Inverse responsibilities. We can expect that as more sub-DAO’s are launched, Inverse contributors will refine the process and build something akin to “Inverse in a box” for sub-DAO’s to use as a template.
Conclusion
Transitioning Inverse from a monolithic to a federated stablecoin lending model offers a compelling set of benefits with modest and manageable downside. Launching a federation also brings minimal incremental risk to DOLA or FiRM on mainnet, and in the case of DOLA, a federation has potential to improve DOLA’s peg stability and treasury operations revenues. The move to a federation model can be done in steps starting with a single sub-DAO on a new chain, but the long-term implications for Inverse as the genesis DAO of the federation are exciting and full of opportunities for innovation and growth.
