Horses for Courses: Chainflip’s Use of Stablecoins

Any conversation regarding stablecoins can quickly descend into abstract and tribally charged arguments about centralisation and control, so it might be useful to say this straight off the bat: We are pro-decentralisation. Our mission is literally to allow users to delete centralised spot exchanges from their minds, allowing us all to never outsource custody again. For this mission to succeed, we need to offer users an amazing experience and the most competitive pricing. How we get there is an open question, but something we’ve thought about a lot.

Chainflip by default uses USD as a default pairing for all liquidity pools in the system, and USDC as the collateral for that pairing. We’ve had mixed responses to these design choices, and wanted to address them.

In particular, the risk of future regulation and the centralised nature of USDC are common complaints. To anyone who watched the House Financial Services Committee on crypto last December, the following is abundantly clear:

1. SBF alpha’d the suits by accepting the default knot setting on his new shoes, and;
2. Stablecoins are going to be a gigantic focus for the foreseeable future as regulators grapple with the implications and categorisation of these products.

In spite of this, we don’t see viable alternatives for the time being. Hopefully, this will be a useful resource for when you shill Chainflip to your friend and your friend responds with “y usdc tho, sounds ngmi and centrlzd af” or other unkind words to that effect.

So, here are the three headline reasons why we think it’s the optimal choice (in this order):

1. Liquidity
2. Stablecoin vs Native token
3. Viability of alternatives

Liquidity

Whether it’s USDT on Binance or one of the numerous coins that make up the USD family on FTX - the highest volume markets and deepest orderbooks in crypto are always paired against stablecoins. When trading one token for another, almost without exception the most efficient way to do that is to sell into USD and then buy again with USD. The market, and more specifically liquidity providers, are comfortable with the concept of holding stablecoins, and it doesn’t look like it’s going to change any time soon.

Liquidity is crucial for users who want to get in and out of a position and is the most important success factor of any exchange, decentralised or otherwise. If you wanted to launch support 100 tradable assets without a common pair, Chainflip would end up with over 6000 pools. By using a common token pairing, you only need 100 pools, which concentrates liquidity and reduces the overall amount of collateral needed to make the exchange liquid.

Consider the graphic above - On the left, you can see how we could end up with some whacky pairs that aren't often traded against each other. On the right, you can see how liquidity can be concentrated through fewer pools with more recognisable trading pairs. But what when you want to trade SOL for Bitcoin? - well let’s take a look at the order journey.

A trader would request Bitcoin, and send SOL to Chainflip. The validator network would witness the SOL hitting the Chainflip wallet on the Solana chain, exchange a user’s SOL to USDC in the SOL-USDC  liquidity pool, use the USDC to buy BTC in the BTC-USDC pool and send it to the destination address. There are some small fees along the way used to fund the system, much like paying rebates and trading fees on a centralised exchange, but that’s pretty much it. The price the user pays will be determined by the Uniswap v3 styled AMM, but that’s for another article. No matter what type of swap you want to make among assets listed on Chainflip, the swap will only go through at most two liquidity pools.

Stablecoin vs Native Token

There are some projects in the market that have opted to use a native token or a "non-stable" asset as the base pair of the DEX. High level, this serves the same purpose of increasing liquidity across the exchange by reducing the number of pairs and pools.

The second most important reason for having a stable asset as a base pair is the fact that liquidity providers (LPs) don't want to hold an asset that is volatile in price, as it contributes to impermanent loss (IL). You might hear people say that holding a stablecoin vs a single volatile asset will actually result in MORE IL. This can be true, but that's not the real magic. The magic is that LPs can easily hedge their positions in the derivatives markets against deep and liquid contracts priced in USDC. This ability to hedge effectively essentially eliminates the risk of IL. This might not seem like much, but the downstream consequences are drastic for token holders and swappers.

Chainflip has a unique AMM design that, using batching and pre-swap range order updates, changes the role of a liquidity provider from an actor risking capital to collect fees, to an actor providing something more like an arbitrage service. Liquidity providers on Chainflip are incentivised to pull liquidity from secondary markets and offer it to users. In this way, Chainflip should be thought of more as a liquidity aggregator than an AMM.

By flipping the concept of liquidity provision on its head, you don't have to get into the business of compensating LPs for the IL, often in the native token, which inflates the supply of the coin. This can be considered an invisible tax on the long term holders. Not only does the sell pressure increase on the token, but the security of the network suffers.

The more tokens that are available for securing the network vs being used to provide liquidity increases the maximum collateralisation for the network security drastically, which in turn increases the cost and deterrence of an attack on the protocol. This can also mean that more assets can be listed and added to the DEX, as the security ratio of the validator network allows for LPs to add more TVL without enticing collision or theft.

Viability of Alternatives

We at Chainflip are under no illusion that USDC is by no means the only option. The second half of 2021 changed the stablecoin landscape at a breakneck pace. Will collateralised stablecoins continue to dominate the circulating supply? Will 2022 be the year of groundbreaking innovation in algorithmic stablecoin? Will the winner be some sort of hybrid or oracle CPI model? Or maybe it’s the year of the reserve currency?

In any case, these questions remain unanswered, and for now, USDC is the obvious choice to collateralise the Chainflip USD pairs. LPs and market makers prefer it over USDT or any other stablecoin for its credibility, widespread use throughout DeFi, and multichain presence.

Users never have to touch USDC when using Chainflip. Swaps are automatically routed to their destination, so if you’re looking for UST, USDT, DAI, MIM, FEI or just about any other stablecoin on supported chains, Chainflip will find a way to put it in your wallet. This is purely a choice about what will make the most sense for LPs to store their USD collateral and will have a pretty minimal impact on the user experience in the long run.

The beautiful thing about the Chainflip architecture is that if another more decentralised stablecoin becomes the most liquid option on the market overall, changing collateralisation or adding additional options beyond USDC should be as easy as passing a governance vote and changing the contract address. Things might be a little more confusing if the future of stablecoins is being built on a non-eth native chain, but it will be possible if the demand is there. Such is the nature of custom execution environments - Chainflip can change!

If you have thoughts on this topic, come let us know in the socials.

Cheers!
Hitch