In this episode, we delve into the workings of Gyroscope, a decentralized stablecoin designed to manage various risks within the stablecoin ecosystem. Ariah Klages-Mundt, co-founder of Gyroscope, discusses its origins, the innovative mechanisms for minting and redeeming GYD, and how Gyroscope uses oracles and a diversified reserve strategy to maintain stability. He also introduces sGYD, a yield-bearing variant, and explores the potential expansion of Gyroscope’s reserve with new stablecoins and non-stable assets, aiming to set a new standard in DeFi.

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EP-23 Gyroscope: Navigating the Complex World of Stablecoins WuBlockchain Podcast 1:10:12

Opening & Introduction

I’m Ariah Klages-Mundt, co-founder of Gyroscope, a decentralized stablecoin designed for maximum liquidity and resilience. With a background in financial technology and a PhD in complex systems, I’ve focused on modeling stablecoin systems and identifying risks, such as those that affected MakerDAO during Black Thursday. My early research explored the complexities of financial networks, which led me into DeFi and the development of stablecoin models starting in 2018. A key study on “deleveraging spirals” in MakerDAO was validated in 2020, underscoring the importance of resilient design in decentralized finance.

The Evolution of Stablecoins and Industry Overview

I was one of the early critics of Terra, recognizing early on that their design had fundamental flaws. When you simplify Terra’s design, you’ll find that it essentially operated like a Ponzi scheme. New funds were used to pay off earlier investors, leaving nothing in the system to maintain stability or allow for redemptions when needed.

One interesting aspect of our research was the term we coined: “endogenous collateral stablecoin.” This term has since been widely used to describe systems like Terra. The concept of endogenous collateral is that the assets backing the system are directly tied to the system’s value. These assets are only valuable because the system itself has value, creating a circular and ultimately unstable foundation. This concept has even been referenced in U.S. stablecoin regulation draft bills, highlighting its relevance in understanding and regulating these types of stablecoins.

Stablecoins are often seen as a key use case gaining significant traction in the crypto space. From my perspective, I agree with this view, especially when considering the needs and behaviors of crypto users. While leverage trading is a major attraction for some, a substantial portion of users seek access to financial services they might not otherwise have or prefer to maintain custody of their assets. This is where stablecoins play a crucial role.

Many users don’t want exposure solely to volatile assets like ETH or Bitcoin; instead, they want access to more stable assets, particularly dollars, which is why stablecoins are so important. These digital currencies allow users to conduct financial transactions with the stability of the dollar within the crypto ecosystem. Although the focus is currently on dollars, we may eventually see stablecoins expand to represent other currencies.

In terms of different types of stablecoins, they can broadly be categorized into two types: non-custodial and custodial. Non-custodial stablecoins, like DAI, are decentralized and don’t rely on a central authority to manage their backing. Instead, they use mechanisms like over-collateralization and smart contracts to maintain their peg. On the other hand, custodial stablecoins, such as USDC and Tether, are backed by reserves held by a central entity, making them more centralized.

Each type of stablecoin faces its own challenges. Custodial stablecoins, while reliable and backed by tangible assets, are subject to regulatory scrutiny and centralization risks. Non-custodial stablecoins, while more aligned with the decentralized ethos of crypto, often struggle to maintain their peg during volatile market conditions and face challenges in scalability.

Looking forward, the industry will likely continue to see both types of stablecoins coexist, each catering to different needs and risk profiles. While custodial stablecoins currently dominate due to their perceived stability and liquidity, there is still room for algorithmic and decentralized stablecoins to grow, particularly as the technology matures and they prove their resilience in the market.

Risk Management of Stablecoins and Gyroscope’s Approach — Is There a Single Best Stablecoin?

When discussing stablecoins, I want to focus on the risks associated with them. As a user, it’s crucial to understand the risks associated with different types of stablecoins. These risks might seem complex, but they are an inherent feature of financial systems. If a stablecoin seems simple, it might be because it’s overlooking the complexities behind it.

We can analyze risks from both centralized and decentralized perspectives. Centralized stablecoins, like USDC and USDT, primarily face risks related to the issuer. These issuers, similar to banks, have significant discretion over whether they will service you, which can be affected by jurisdiction or documentation issues, influencing your ability to mint or redeem stablecoins. Additionally, regulatory risks are not to be overlooked, especially in an uncertain or rapidly changing environment.

Decentralized stablecoins, such as DAI and similar projects, face risks primarily centered on on-chain mechanisms and smart contracts. These systems often rely on oracles, where the multi-signature model presents a potential single point of failure. Vulnerabilities in smart contracts could also lead to exploits. Governance risks are also significant, as the evolution of these systems is controlled by decentralized autonomous organizations (DAOs), and users need to pay attention to the security of these governance layers.

Economic design risks are another important consideration. For example, systems like Terra failed due to poor design, and DAI has also experienced similar issues. These risks are real and can have serious consequences.

Therefore, when ranking stablecoins, it’s not as simple as choosing one as the best. Different users have different risk preferences, and what’s suitable for one person may not be suitable for another. For example, despite Tether being considered less transparent than USDC, it remains popular outside the U.S. due to different risk priorities among users.

In this context, Gyroscope aims to address these risks by building a stronger solution. Gyroscope’s core function is to serve as a risk management layer for a stablecoin, backed by a diversified set of assets, primarily other stablecoins, with the potential to include more assets in the future. This diversified asset base allows Gyroscope to effectively manage risks.

Gyroscope is built in a modular way, leveraging existing infrastructure in the DeFi space and adding additional layers of safety where needed. For instance, we use Chainlink oracles as the primary source of price information and add extra safety mechanisms to cross-check the accuracy of the information, preventing issues before they occur.

In summary, Gyroscope embraces the complexities of stablecoin systems and manages various risks by combining existing infrastructure with additional safety mechanisms, providing a stable and reliable product.

The Role of Oracles in Gyroscope

Any decentralized stablecoin operating on-chain requires an oracle to determine the value of its assets relative to its target, typically USD. Since USD doesn’t exist on-chain, the system needs a way to gather off-chain information about its value. This is where oracles come into play — they bring in this crucial off-chain data, ensuring that the stablecoin mechanism functions properly.

For Gyroscope, the oracle is essential in the user flow, particularly when minting or redeeming stablecoins. The system must know the value of the collateral being provided to maintain security and effectively target USD. Although some on-chain sources, such as decentralized exchanges (DEXs), could potentially provide pricing information, they come with their own set of issues that need to be carefully considered. However, since Gyroscope and other decentralized stablecoins target something that exists off-chain, oracles remain a necessary component to bridge that gap.

What Makes Gyroscope an “All Weather” Stablecoin?

The primary mechanism for Gyroscope is a reserve-backed model. Essentially, this means that the protocol holds a reserve of assets, which it owns and controls. This reserve acts as the balance sheet of the protocol, and the minting and redemption mechanisms are the ways through which this balance sheet is expanded or contracted.

When minting new stablecoins, users provide assets to the system, which evaluates what assets it is willing to take on without becoming too risky. These assets then become part of the reserve, backing the newly minted stablecoins. Conversely, during redemption, the system determines which assets it can release while maintaining a balanced exposure across different risks. Users can redeem their stablecoins for these assets, as long as it doesn’t negatively impact the protocol’s overall exposure.

In situations where an asset in the reserve, such as USDT, becomes depegged, the protocol must manage the risk to ensure that Gyroscope’s stablecoin, GYD, remains as stable as possible. The protocol has built-in safety mechanisms to prevent excessive exposure to any single asset before a crisis occurs. However, if a depegged asset is still part of the reserve, the system uses an arbitrage mechanism to manage redemptions and minting in a way that controls the exposure to the depegged asset while ensuring the overall stability of GYD.

The key to this process is the interplay between primary and secondary markets. If GYD trades off-peg in secondary markets, the arbitrage mechanism may kick in, depending on how the system evaluates the situation. The protocol must balance the need to maintain a healthy reserve with the need to allow redemptions and maintain stability, even in the face of market shocks.

In summary, Gyroscope’s minting and redemption mechanisms are designed to carefully manage the protocol’s reserve assets, ensuring that the system can handle shocks and maintain stability across a diversified risk spectrum.

The Balance of Offering High Yield and Controlling Risks

When setting up the GYD reserve, we took a conservative approach, utilizing existing stablecoins that met certain criteria, such as sufficient liquidity, a proven ability to maintain their peg, and an established track record that allows us to evaluate risk. Although the stablecoin space has some established players, it is still relatively new, with many emerging stablecoins that have not yet met the necessary liquidity or on-chain usage requirements to be safely included in our reserve.

However, this is expected to change as these new stablecoins gain traction and meet the thresholds needed to be part of a conservative reserve. The more stablecoins we can safely include in the reserve, the safer and more diversified it becomes. The reserve we launched today should be viewed as a starting point, with the intention to expand as more stablecoins become viable options.

For our initial reserve, we focused on the major players in the stablecoin space, aiming to create a segregated risk structure. This approach ensures that we take on a balanced amount of risk across different categories without letting these risks converge into a single, concentrated exposure.

The stablecoins we currently include are USDC, USDT, DAI, as well as Liquity’s LUSD and CurveUSD. USDC and USDT represent centralized risk factors, but with different risk profiles, making it valuable to include both in the reserve to help mitigate risks within this centralized asset class. On the decentralized end, LUSD and CurveUSD are the most decentralized stablecoins that meet our liquidity requirements, covering decentralized risk factors.

However, DAI presents a blended category of risk. While it originally relied on a decentralized mechanism through its CDP system, much of its current backing comes from real-world assets (RWA), placing it in the centralized stablecoin category as well. DAI straddles both centralized and decentralized risk factors, making it important to segregate its risks from the others.

Moving forward, we are eager to expand the reserve with new stablecoins that can provide additional diversification. However, these stablecoins need to reach a level of maturity and stability where they can be safely added without compromising the integrity of the reserve.

Yield-Bearing Stablecoin: sGYD

From a user perspective, the risk of holding stablecoins is important, but so is the utility of those stablecoins, especially when it comes to generating yield. Users seeking higher yields might be drawn to newer stablecoins without established track records, while others might prefer stablecoins like Tether for their specific use cases, such as buying large amounts of Bitcoin. Gyroscope’s GYD is designed to balance these considerations by providing a stablecoin that not only manages risk effectively but also offers competitive yield opportunities.

Currently, GYD has established a track record of liquidity and stability, which is crucial for attracting risk-conscious users who need to see proven performance before adopting a new stablecoin. GYD’s design targets these users by offering a stable and resilient option that isn’t necessarily geared toward high-risk, high-reward scenarios typical of “degen” users, but rather toward those who prioritize security and stability.

GYD is particularly useful for users who want a stable asset to hold between investments or as a liquidity provider (LP) in automated market makers (AMMs). As an LP asset, GYD is advantageous because it offers a diversified risk profile. For example, by pairing GYD with other assets in liquidity pools, users can earn yields while mitigating the risk of a single asset’s depeg event impacting their entire portfolio. This is in contrast to situations like the USDC depeg crisis, where users exposed to a single pool could see their entire position affected.

Moreover, Gyroscope recently launched the yield-bearing sGYD, which operates similarly to other yield-generating tokens like sDAI but is based on the GYD system. The GYD system earns revenue from various sources, including the yields generated by reserve assets and swap fees from AMM pools composed of reserve assets. The sGYD mechanism allows users to stake GYD and earn a portion of this yield, which is considered one of the best risk-adjusted yields available in DeFi due to GYD’s diversified and balanced exposure to different risks.

The yield behind sGYD is primarily derived from the earnings of the reserve assets, which are deployed in various strategies to generate returns for the protocol. These returns can be shared with users through sGYD, providing a stable and attractive yield option that benefits from the underlying stability and risk management of the GYD system.

Future Developments and V2 Mechanism

Currently, the main reserves for GYD are deployed in sDAI, earning the DAI savings rate, and in Aave, gaining exposure through USDC. These deployments are part of the initial setup to bootstrap the system and provide liquidity for GYD. As GYD scales, the reserve will diversify further, broadening exposure across various risk factors. This evolution will continue over time as the protocol grows and adapts to new opportunities and challenges.

In addition to the current deployment, we envision that GYD will evolve similarly to how DAI or USDS (following its rebrand) operates today. For instance, DAI has two primary issuance mechanisms: the original CDP (collateralized debt position) mechanism, which allows users to mint DAI by leveraging their over-collateralized positions, and the PEG Stability Module (PSM), which facilitates minting DAI one-to-one against USDC.

Gyroscope has already implemented what we believe to be a more robust version of the PSM. This mechanism is designed to automatically manage the exposures the protocol takes on, making it a more resilient system. Additionally, there’s a slot in the GYD protocol for incorporating leverage mechanisms, where users can mint GYD against over-collateralized positions, likely using existing infrastructure known for handling such processes effectively.

Moreover, we’re working on a V2 mechanism for Gyroscope, which aims to enhance the efficiency of liquidity management between decentralized assets, particularly decentralized stablecoins. This new mechanism will leverage Gyroscope’s existing liquidity pools (ECLPs) and introduce innovative features inspired by central bank strategies for generating liquidity between currencies. While I can’t dive into all the details now, this upcoming development will offer a novel approach to creating stablecoin liquidity, marking a significant step forward in the evolution of Gyroscope.

Looking ahead, GYD and its future mechanisms are designed to offer decentralized stability while competing directly with centralized stablecoins in terms of dependability, liquidity, and track record. The V2 mechanism will further this goal by unlocking new competitive advantages inherent to decentralized assets, enabling Gyroscope to push the boundaries of what’s possible in the stablecoin space. This represents an exciting time for both Gyroscope and the broader DeFi community, as we continue to innovate and expand the utility and appeal of decentralized stablecoins.

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