The UST crash has certainly cast a lot of fear over the stablecoin market, especially the algorithmic stablecoin sector. However, the crypto world never seems to stop evolving. As a result, it has made some progress.

DYAD is a new algorithmic stablecoin that is expected to launch before the end of the year or early next year. It takes certain ideas from Ampleforth and DAI and connects them together in an interesting way by including NFTs. We shall break down its components in this article. But, first and foremost, these are its essential characteristics:

It only accepts ETH as collateral.
It is based on unchangeable smart contracts. There is no governance mechanism or governance token.
It can only be generated by holders of a restricted number of 10,000 dNFTs (DYAD NFTs).

How DYAD works

Let's begin with minting. If you hold one of the 10,000 dNFTs, you have the ability to mint fresh DYAD whenever you choose.

DYAD enters the circulating supply in two stages. The first stage is for NFT holders to put ETH into an "ETH collateral vault." 1 DYAD is minted for every $1 of ETH received.

However, the freshly minted DYAD is not yet in circulation. It is located in the "DYAD damping vault." The NFT that created DYAD has been designated as its sole owner. Only the bearer of that NFT has the ability to remove it from the damping vault. NFTs maintain track of their proportionate share of the damping vault. As a result, another approach to consider DYAD in a damping vault is as an NFT's DYAD balance.

This balance is dynamic and fluctuates in response to the price of ETH; it increases when the price rises and contracts when the price falls. The protocol handles contraction and expansion seamlessly. This enables the DYAD damping vault to reflect the USD value of ETH in the collateral vault, independent of the price of ETH. As the damping vault expands or contracts, NFT holders will perceive a rise or reduction in their DYAD balances.

Only the NFT holder has the ability to release DYAD into circulation. When an NFT holder decides to withdraw DYAD from their NFT balance (or, more correctly, from the damping vault, which each NFT holds a part of), the DYAD is sent straight to the NFT holder's address. It may then be freely transferred like an ERC20 token. As a result, withdrawn DYAD may be viewed as exiting the NFT and joining circulation. As a result, the DYAD balance of the NFT decreases.

DAYD mechanism

Source: DYAD whitepaper

Once DYAD is in circulation, the protocol can no longer extend or shrink its supply. As a result, DYAD may be utilized as a stablecoin in DeFi, payments, and other applications.

It should be noted that while some of the total DYAD is in circulation, the protocol is unable to execute its expansion and contraction duties over circulating DYAD. To compensate for this, the protocol aggressively grows and contracts the DYAD in the damping vault, with the purpose of ensuring that the overall DYAD supply (damping + circulation) equals the ETH collateral vault (measured by USD). As a result, the more DYAD that circulates, the larger the swings in NFTs' DYAD balances in the damping vault.

Let's look at an example to see this in action. To keep things simple, we'll suppose there's only one NFT.

0% of DYAD in circulation
Action	NFT balance	NFT balance change	DYAD circulating	ETH collateral	ETH price	ETH pierce change
Mint	1500	0	0	1	$1500	0
ETH price down	1350	-10%	0	1	$1350	-10%

50% of DYAD in circulation
Action	ActionNFT balance	NFT balance change	DYAD circulating	ETH collateral	ETH price	ETH pierce change
Mint	1500	0	0	1	$1500	0%
Withdraw	750	0	750	1	$1500	0%
ETH price down	600	-20%	750	1	$1500	-10%

The damping vault contains all DYAD in the first case (top table). Half is released into circulation in the second scenario (bottom table). In both circumstances, the price of ETH drops by 10%. As can be seen, a 10% price drop causes a 10% contraction in the first example and a 20% contraction in the second. Take note of the underlying tradeoff here: the more an NFT holder lets their DYAD into circulation, the greater their leverage to ETH. This also implies they are more vulnerable when things go wrong.

There is a procedure safety margin that restricts the amount of DYAD that can circulate. 1.5 DYAD must be placed in the damping vault for every DYAD in circulation. If this margin is exceeded, NFTs will be unable to release DYAD into the market. Aside from that, all NFTs have complete control over how much of their DYAD balance is discharged into circulation. Every NFT holder is accountable for over-collateralizing their DYAD. NFT holders gain liquidity by releasing DYAD into circulation; they may use it, sell it, or redeem it for ETH.

This, however, implies that they are taking on a leveraged ETH position through their participation in the damping vault, and hence are taking on a larger risk. If the protocol requests that an NFT destroy more DYAD than it has in its balance, that NFT falls insolvent. We'll talk about how the protocol behaves in this scenario, but there's one more thing we need to discuss before getting the entire picture.

Experience point accrual mechanism

To grasp the concept of XP (experience points), let’s consider a situation in which all DYAD is in the damping vault and not circulating. The damping vault is utilized by several NFTs.

If we assume that the NFT's portion of the damping vault remains constant in this circumstance, all NFTs will bear 100% price exposure to ETH regardless of price direction. In other words, if the price of ETH rises by 10%, all NFTs' balances rise by 10%, and conversely on the downside (just like with Ampleforth).

However, in DYAD, NFT's part of the damping vault is not consistent. Every time there is an expansion or contraction, certain NFTs' portion of the damping vault grows at the expense of others.

Experience points, or XP, a unique attribute, are used to decide this. According to their DYAD balance, NFTs with high XP points gain more DYAD during their rise and lose less DYAD during their fall. Therefore, NFTs compete to get the most XP.

When NFTs aid contractions, they get experience points. Simply put, the NFT gains XP whenever the price of ETH drops, and the protocol must burn DYAD from an NFT's balance in the damping vault. Top-ranked NFTs on the XP leaderboard have super abilities. They benefit from having a bigger positive ETH exposure and a smaller negative ETH exposure.

The NFT at the pinnacle of the XP leaderboard, for instance, has 3x leveraged ETH exposure when ETH rises and 0.5x leveraged ETH exposure when ETH falls. This is a magical position that is superior to simply holding ETH, irrespective of price direction. These NFTs that are farther down in the XP rankings suffer as a result of this capability. Positions for NFTs with little XP are worse than simply holding ETH. According to the leaderboard, NFTs in the top 20% have better price exposure than ETH, and NFTs in the bottom 80% have inferior price exposure.

Another way to look at this is to acknowledge that being in the bottom 80% has a cost. Why would anyone want to work in a position that is geared to outperform ETH? The solution has to do with XP accumulation.

The XP accrual curve defines how effective an NFT is at accruing XP. NFTs with a lower XP leaderboard rank accumulate XP more effectively than those with a higher XP leaderboard rank. This is established by an XP accrual algorithm in which the lowest-ranked NFT receives the most XP gain per DYAD burnt. This rate decreases as an NFT rises in the rankings, suggesting that the top ranked NFTs have the lowest XP per DYAD accrual rate.

lower rank nft accrue xp better

Source: DYAD manifesto

This paves the way for some intriguing NFT market behaviors. For example, an NFT holder may acquire a low-XP NFT and battle their way up to a higher level before selling it. A thriving DYAD economy would therefore provide a steady stream of lower-rank NFTs fighting their way to the top of the leaderboard by accumulating XP more efficiently. This method is broken down into steps as follows:

Purchase NFT with a low XP rating
Deposit ETH to create a new DYAD
Gain XP when the price of ETH varies
Ascend the XP ranks
Profitably sell the NFT

As previously stated, there is a cost to using this technique. Investing in one of the lowest 80% of NFTs is equivalent to investing in ETH. This is considered the carrying cost. To profit, the revenue from the preceding strategy must exceed the carrying cost. The two key elements that determine income are ETH volatility and the amount of cash infused. Higher volatility, along with high deposits, is likely to accelerate the ranking of an NFT and reduce the carrying costs before the NFT may be sold for a profit.

The solution to insolvency

So, we've finally arrived. What arises when the protocol requires more DYAD in the damping vault than an NFT has?

First, we will go through the design mentioned in the whitepaper, as well as the rationale for it. Then we will try to find flaws in this design and recommend ways to enhance it. It should be noted that, according to team discussions, the specific implementation of how to manage insolvent NFTs is the least developed component of the design and might potentially deviate from the idea given in the paper.

NFTs in debt would not be liquidated immediately under the concept outlined in the litepaper. Instead, insolvent NFTs would retain a burn liability. Insolvent NFTs would continue to accumulate debt in the form of unburned DYAD while the protocol burns DYAD in the damping vault. The NFT would be incinerated if its debt exceeded 0.01% of the ETH in the collateral vault. Its debt would subsequently be distributed to the remaining NFTs.

Importantly, NFTs with debt no longer earn experience points or qualify for mints. The goal is to swiftly compel the NFT holder to select between the two possibilities listed below: either sell the NFT on the secondary market (because all NFTs are necessary for DYAD minting, they are all presumed to have some residual value) or raise more funds to pay down the debt.

This is not, in my opinion, the ideal strategy for solving the issue for a variety of reasons. It is challenging for an NFT holder to rationally consider the effects of socialized losses. An NFT holder's chosen passive income plan can be affected by an unforeseen socialized loss. More significantly, we think that any potential debt should be avoided at all costs.

If we've learned anything from prior algorithmic stablecoins, it's that the architecture must allow for the worst-case situation, in which all factors work against the protocol. In the instance of DYAD, this scenario looks like this:

The price of ETH has plummeted dramatically
Many NFTs become indebted all at once
NFT holders who are insolvent do not infuse additional capital
In the secondary NFT marketplaces, there are no buyers
NFTs are being phased out
For exit liquidity, NFT holders boost the circulating DYAD supply
The damping vault's leverage grows
The damping vault's burns are magnified

Importantly, all of the aforementioned occur simultaneously. During a black swan occurrence, which is undoubtedly probable, the procedure of attempting to socialize losses may cause systemic risk, worsening the vicious cycle.

There are various approaches, each with its own set of compromises. We won't go into detail about each one, but given the reasons stated above, we believe the primary goal should be to avoid debt at all costs. A system that prohibits debt in the first place would be significantly more robust. This might be accomplished by having the protocol sell NFTs before they become indebted. That is, the protocol seizes and utilizes ETH collateral to buy back and burn DYAD from circulation. Any remaining excess can be put into a pooled insurance fund or lead to socialized gains for other NFT holders.

Some weaknesses worth considering

DYAD's strength is also its vulnerability. The DYAD economy is dependent on the bottom 80%'s willingness to compete with the top 20%. The economy would simply collapse if the bottom 80% lost their desire to climb the leaderboard. This might happen if people at the top of the leaderboard maintain their positions for a long enough period of time, causing the bottom 80% to lose trust in their ability to compete and quit.

While the XP value accrual curve looks to be an effective tool for preventing this, we believe other steps should be considered. Let's take a closer look to see why.

NFTs in the top 20% can choose from the following options:

Keep all of their DYAD in the damping vault and out of the way. Because mint entitlement is dependent on their portion of the damping vault, this is the greatest tactic for protecting their positions. It should be noted, however, that they cannot profit by storing DYAD in the damping vault.
Put their DYAD back into circulation. Once this DYAD is in circulation, they may benefit by selling it or redeeming it for ETH. It's worth noting that when they release DYAD into the system, their portion of the damping vault shrinks and they lose a few of their defensibility.
Sell their NFT.

It is worth noting that the third choice allows NFT holders to benefit while functioning in defense mode (maximizing their share of the DYAD pool). If this becomes a successful tactic for the top 20%, the affluent will grow richer and the top 20% of positions will become an oligopoly as NFT holders continue to maintain their ranks. It may eventually lead to the bottom 80% abandoning their struggle for the top 20% positions, deeming the effort unworthy given the amount of capital required.

This scenario might be avoided by enacting a regulation that makes NFTs non-transferable unless a significant percentage of their DYAD balance (say, 80%) is removed. This regulation would only apply to the top 20% of NFTs, rather than the lowest 80%. In this instance, when the top 20% realize their earnings, the lower 80% are more likely to overtake them. This should result in a more competitive environment and a stronger NFT market.

Another shortcoming is the governing system. DYAD is designed to be governance-free since it is built on immutable smart contracts. While we appreciate the concept of a governance-free protocol, we believe it would be incredibly difficult to get the algorithmic curves correct from the start without proving them in the wild with actual money.

In our view, the project would be better served by beginning with a governance structure that allows these settings to be tweaked depending on actual user behavior. However, the ultimate objective of being governance-free must be maintained.

Some bottom lines

Every algorithmic stablecoin chooses between capital efficiency and robustness in some way. The incentive framework that DYAD develops enhances over-collateralization. For the release of 1 DYAD into circulation, the protocol-wide safety margin necessitates a requirement of $2.5 capital to release 1 DYAD.

DYAD capital intensive

Source: DYAD whitepaper

The most capital-intensive stablecoin, if not the most, is likely to be DYAD, which has a minimum over-collateralization ratio of 250%. Although not all market players are burdened by over-collateralization (the top of the leaderboard can function at near 100% collateralization rates), it may become a scalability-limiting issue.

On the bright side, one of DYAD's assets is its capacity to reduce its circulating supply in the lack of demand. As Vitalik has stated, this capacity is a critical component of an ideal stablecoin.

Finally, leveraging NFTs as a backdoor to minting stablecoins and letting NFTs build their own distinct strengths based on their previous contributions to absorbing ETH volatility are also really intriguing ideas. This is expected to produce fascinating market dynamics in secondary NFT marketplaces. It is also expected to open up a new design area in which other protocols can combine their applications with DYAD NFTs. If DYAD is successful, it will usher in new stablecoin models based on NFTs.

Disclaimer:
This article is intended for and only to be used for reference purposes only. No such information provided constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific name.

DYAD: The savior of the algorithmic stablecoin sector?