The average person would describe cryptocurrency as highly volatile. And while this is true for many, there are coins designed to reduce volatility or stability commonly referred to as stablecoins. Stablecoins, particularly those pegged to the US Dollar, have dramatically risen in popularity thanks to the utility they provide to users and smart contracts alike. Users tend to gravitate to the narrative of USD pegged stablecoins as a familiar unit of account. However, history has shown that stablecoins pegged to the value of a specific asset or basket of assets don’t always hold their peg. And when they do go off peg, it can quickly diminish the reputation of a stablecoin built on the premise of always being $1.
Limiting a stablecoin to always equaling $1 also limits the mechanisms available to a community to bring the stablecoin back on peg. This can lead to added complexity like introducing new collateral types and subsequently undesired risk in lieu of what many would argue is the simpler mechanism: negative interest rates. In the end, many stablecoins resort to centralized custodians to hold USD in a bank somewhere or governance systems that require lots of participation to maintain relative stability.
Reflexer’s RAI returns crypto to its roots drawing inspiration from the early days of stablecoins to offer crypto-native stability. RAI is an ETH backed, non pegged stable asset known as a reflex index whose monetary policy is managed by an on-chain, autonomous controller. Reflexer launched on mainnet on Feb 17, 2021.
RAI allows you to trustlessly leverage your ETH
For reasons we’ll cover in the next section, the function of RAI may be familiar to those with an understanding of MakerDAO’s DAI. DeFi users can borrow RAI via Reflexer by depositing ETH as collateral into what’s called a Safe. Borrowed RAI is subject to an interest rate referred to as the borrow rate. Safes must maintain a minimum collateral ratio of 145%. If a Safe position fails to maintain this collateral ratio, the Safe will incur a liquidation penalty and the protocol will sell collateral to keepers at a discounted rate to cover the debt. Note: there’s also a minimum amount of RAI that must be generated by a Safe. This ensures that in the event of liquidation the Safe has enough collateral to cover its debt and the necessary gas costs and incentives for keepers necessary to liquidate the position.
RAI boils down to this: a volatility-reduced representation of ETH. It’s designed to float similar to other currencies and not be pegged to anything. Reflexer relies on a set of protocol parameters including borrowing power and market price to determine the price RAI can be redeemed for (more on this in a bit). RAI was launched with a starting redemption price of $3.14. From this point on, RAI will continue to float while it is managed by the protocol’s on-chain controller. Actually, there’s a chance it never returns to its original redemption price at all. Market forces and Reflexer protocol user incentives influence where the redemption price of RAI floats to. At the time of writing, there are 766 active safes and 24,755,216 RAI in total. You can view the current market price, redemption price, and borrow rate along with other RAI stats here.
Inspired by the original Dai Purple Paper
Some of you may recall that the original concept of the DAI stablecoin system outlined in the “Dai Purple Paper” back in February 2018 included negative interest rates. In fact, DAI wasn’t always meant to equal $1 at all. DAI was meant to have a redemption price that would float, producing low volatility but driven by the market.
Reflexer’s RAI aims to fill this void by borrowing many of the concepts from the Dai Purple Paper. Reflex indexes like RAI are designed to reduce volatility, shielding users against major and sudden moves in the market like the events witnessed on Black Thursday. On a technical level, the system behind RAI is a modified fork of multi-collateral DAI with a few distinct changes. Some of these changes include autonomous feedback mechanisms that control user incentives, simplified variable names, more flexible collateral auctions, long term bounded governance, optional Safe insurance and more. While DAI may have strayed from its early vision leaving its hypothesis untested, Reflexer’s mainnet demo Proto RAI illustrated how an asset can create stability without a peg, relying solely on market forces and redemption price float.
The Proto RAI (PRAI) demo ran for nearly 3 months before being shut down on January 25, 2021. More than $612K worth of ETH was deposited into the demo to mint almost 52K PRAI; PRAI’s redemption price started at $2.015 and then floated between $1.937 and $2.06. During this same time period, ETH increased by 350% going from about $400 to $1400. Doing the math, this means PRAI’s redemption price fluctuated less than 4%, demonstrating how Reflexer’s reflex indexes can be a more stable representation of its collateral.
How exactly do reflex indexes create stability without pegs?
The money god wills it so. 🗿 Or at least that’s the meme the Reflexer community has adopted to refer to the set of on-chain, autonomous controllers that control RAI’s monetary policy. At this point, I think it helps to reiterate that RAI is not a pegged stablecoin, because its redemption price floats. But to fully understand what this means we need to define a few terms key pertaining to reflex indexes:
Redemption price
Redemption price is the price that the protocol wants RAI to have on the secondary market (e.g on Uniswap or Sushiswap). The redemption price is used by Safe users to mint RAI against ETH and it is also used during Global Settlement in order to allow both Safe and RAI users to redeem collateral from the system. The redemption price almost always floats and it does not target any specific peg. [insert Pennywise meme of your choice here]
Market price
This one’s a little self-explanatory. This is the price that RAI is traded at on the secondary market.
Redemption rate
This is the rate at which RAI is being devalued or revalued. The process of devaluing/revaluing RAI consists in the redemption rate changing the redemption price.
Global settlement
Settlement refers to the process of shutting down a reflex index and allowing both Safe and RAI users to redeem collateral from the system. Settlement uses the redemption price (not the market price) to calculate how much collateral can be redeemed by each user.
Borrowing power
Borrowing power is how many reflex indexes like RAI can be borrowed against one unit of collateral. Each time the system receives a price feed update for its accepted collateral types, the feed data is divided by the redemption price and then divided again by the liquidation ratio in order to calculate the borrowing power. So for example, if ETH’s price is 100 USD, the liquidation ratio is 145%, and the current index redemption price is 1 USD, the borrowing power for ETH is approximately equal to 100 / 1 / 1.45 = 68.96 USD.
Let’s dive into a few examples to see what RAI looks like in practice:
When the market price of RAI is greater than the redemption price for a sustained period of time, the redemption rate becomes negative. A negative redemption rate lowers the redemption price. This results in users’ borrowing power being increased as RAI becomes cheaper inside the protocol. The redemption price continues to lower until the market price reaches it. In other words, this process creates a strong incentive for users to sell their RAI or even leverage their collateral to generate more sooner rather than later.
Now, imagine this process in reverse. When the market price of RAI falls below the redemption price for a long enough period of time, the redemption rate becomes positive. This in turn lowers users’ borrowing power which then causes more users to buy RAI to pay down debt or buy it with the expectation that the market price will follow the redemption price. Likewise, this process continues until the difference between the market and redemption price is reduced to 0.
There are a few interesting caveats to Reflexer worth noting including the fact that the system’s desired steady state may not reduce the redemption rate to 0%. There may be a non-zero redemption rate where the redemption price and market price remain relatively close to one another. Additionally, the system can collect stability fees even when the redemption rate is negative. When a reflex index is being repriced because of the redemption rate, the amount of stability fees collected (denominated in the reflex index) doesn’t change.
Reflexer’s Ungovernance
If you haven’t picked up on it yet, Reflexer protocol highly prioritizes trustlessness and in pursuit of that end: governance minimization. Reflexer has laid out a multi-stage process at the end of which governance will not control or be able to upgrade most core contracts and many Reflexer protocol parameters will be set autonomously by other external contracts. Before this process could begin, the following conditions would need to be met first:
- Governance must not add or plan to add any more collateral types
- All infrastructure for governance minimization must have been audited and tested in production
- Finally, the system must accrue enough surplus in its main treasury so that it can afford to pay for oracle, PID, state management etc costs for at least 6 months.
The list of components to which can be minimized and automated to varying degrees is far too long for us to cover here, but please refer to Reflexer’s Governance Minimization Guide to learn more. A key takeaway is that the first of 3 Governance Minimization Levels is expected to be reached within 14 months after launch (approx. April 2022).
What does this mean for the average user? The behavior of RAI and other reflex indexes will be more predictable with defined parameters. Furthermore, developers looking to incorporate reflex indexes into their protocol or smart contract will be able to trust that its behavior won’t change undesirably.
Interesting possibilities enabled by reflex indexes
Reflexer’s redemption rate mechanism when put in the hands of DeFi developers could be utilized in all sorts of ways. A prime example being a unique money market design that takes advantage of RAI’s changing redemption rate to offer users better interest rates or speculate on the expected market price of RAI in the future. When viewed as an intrinsic interest rate for RAI, you can start to see how the redemption rate can be incorporated into a whole range of products and services from options to portfolio management strategies. Yield aggregators in particular would benefit from unfiltered access to borrowing power allowing them to remove deposit caps or simply be more capital efficient. RAI’s low volatility also lends itself well to being used as collateral for synthetic asset tokens.
Closing thoughts
Reflexer offers crypto-native stability while taking an approach previously left unexplored by the DeFi ecosystem. RAI answers the call for an ETH-backed asset with low volatility which many DeFi users have been calling for since the transition away from single-collateral DAI. Beyond individual users, Reflexer’s goal towards “ungoverned,” unfiltered access to borrowing power could prove to be a useful resource to future DeFi protocols. You could say these are uncharted waters in what might be a blue ocean.
Reflexer went live on mainnet on February 17, 2021. Got a question or just itching to discuss the future of RAI? Join the discussion happening in the Reflexer community Discord or follow Reflexer on Twitter.
Disclosure: This post is part of our paid promotional DeFi Pulse Drop series; We’ve partnered with Reflexer to help educate and inform the community about reflex indexes. As always, we’re committed to providing the entire community with quality, objective information, and any opinions we express are our own.
