FEI Protocol Valuation and the Stablecoins Market Opportunity
Please note that this letter is not intended as financial advice.
According to the Cambridge University study, Stablecoins are one of the most promising trends in crypto.
Stablecoins that are pegged with US Dollars are the most important in the field. They are the base of the crypto finance ecosystem and are heavily used in lending protocols as Compound (see the last article).
The USD stablecoin has some advantages over fiat currency. It is programmable and runs on a global public infrastructure that operates 24/7/365, which makes them available for everyone in the world. For some developing countries with weak currencies, the ability to buy USD easily is even more compelling.
When we analyze the evolution of Stablecoins, we see USD Tether as the first one, but which has its risks. As a centralized Stablecoin, it is more susceptible to regulatory and counterparty risks. Then, we can see more regulated and centralized stablecoins emerging. A promising one was USDCoin, a partnership between Coinbase and Circle. Although it did a great job in mitigating the regulatory and counterparty risk, the future of the regulatory burden is uncertain as it becomes more widely used.
So here comes the era of decentralized stablecoins. The ones that do not depend on centralized entities to have their value pegged with dollars. The dominant decentralized stablecoin today is DAI, but it has scalability issues due to capital inefficiency.
In this article, we are going to talk about a new one, the FEI Protocol.
FEI Protocol
The vision of the FEI protocol is to build a decentralized, fair, liquid, scalable stablecoin, which is called FEI.
They use a "liquidity-collateralized" model, in which FEI is collateralized by protocol-owned liquidity.
FEI Protocol works as a crypto central bank creating direct incentives for traders to maintain the peg with USD and owning reserves, called Protocol Controlled Value (PCV), to intervene in the market if necessary.
The incentives apply to trades when the spot price is below the peg (1 FEI < 1 USD), charging a “penalty” for sellers and rewarding buyers at this level.
The side above the peg (1 FEI > 1 USD) is taken care of by the arbitrage loop with the bonding curve. Arbitrageurs can buy on the bonding curve from FEI Protocol and sell on secondary markets.
To buy in the bonding curve, the user gives ETH and receives FEI. This curve approaches and fixes at the $1 peg. The incoming ETH integrated the Protocol Controlled Value (PCV) and is deployed to create a liquid secondary market where users can sell FEI back into ETH.
The main goal of PCV is to provide stability and that's why it will initially be allocated 100% to a Uniswap pool denominated in ETH/FEI.
As the protocol mechanism gains trust from the market and expectations start to play a more important role, part of the PCV could have more use cases. It is inefficient to hold an excess of collateral for every single position if only a subset will ever liquidate.
As a reserve from a central bank, it can be used in different ways that help to grow the value of the reserve in the long term preserving the intervening power and increasing the value for token holders. For example, it could generate yield via a Compound, Aave, or Yearn deposit, and maintain balances in governance tokens of integrating platforms.
It is a different kind of central bank, as it is governed by a Decentralized Autonomous Organization (DAO). The Fei DAO uses the same code as the Compound DAO, which is well established and understood within the DeFi ecosystem. TRIBE will be the governance token that gives voting power to users. Although FEI aims to be governance minimized and FEI will primarily be stabilized algorithmically, TRIBE holders will govern several things:
Adding new bonding curves and adjusting existing ones
Adjusting the allocation of PCV
Adjusting or changing protocol parameters such as its direct incentives mechanisms
Investing in FEI Protocol is like investing in a mix of a crypto central bank and a liquidity insurance company.
Following the business model of an insurance company, it receives the money from users wanting to buy FEI and the protocol only needs to spend it in specific cases to ensure liquidity is provided. It is one of the best business models and is even greater when money raised is invested wisely.
Let's analyze Fei Protocol under our valuation framework.
Value Drivers
Integration with DeFi: such as lending protocols as Compound and Aave. It is good that Compound and Aave founders are participating in the discussion about this project since this initial phase.
Listing in exchanges and supported by crypto wallets: it will be more accessible to mainstream users as it is listed in the exchanges and available in the wallets (eg.: Ledger and Trezor). As the trading pairs of crypto tokens/FEI become more available, FEI will be more liquid and useful.
FEI Stability: with proven stability more investors can start to trust it and will deserve part of their portfolio destined to Stablecoins.
Adding Bonding Curves: as FEI Protocol adds more bonding curves for FEI, it enables direct exchange of FEI with more crypto tokens, ensuring the liquidity for that.
Risks
Transaction costs: as it is initially built above the Ethereum network, it can suffer from scaling difficulties and high fees. This risk can be mitigated with future expansion to other networks or in case we have upgrades in the Ethereum network.
PCV volatility and Peg Reweights mechanism:
In the event of extended periods below the peg, when direct incentives are not enough, the Fei Protocol can reweight the Uniswap price back to the peg. It achieves this by executing the following atomic trade: 1. Withdraw all protocol owned liquidity, 2. Buy FEI with the withdrawn ETH to bring price up to peg. 3. Resupply remaining PCV as liquidity. 4. Burn the excess FEI.
The volatility of PCV could make this intervention more difficult. Initially, all PCV is held as ETH. If ETH drops in value, the FEI protocol would have less intervening power in case it is needed to do FEI reweight. The liquidity ratio or the collateralization is defined as PCV /FEI and the volatility in PCV directly affects the liquidity ratio. As we said before, it does not need to be a 1-1 relation, because only a subset will want to liquidate.
In an extreme situation, the community could inflate TRIBE and use this capital to restore stability.
Also, new bonding curves can be added to the protocol. It would diversify the PCV, mitigating the PCV volatility risk.
Competition: there is competition from decentralized projects as Frax and EUSD and from centralized ones as USDCoin and Tether. As the project is open-source, others can copy its code. In the next section, I talk about what could be the competitive advantages for FEI Protocol. Anyway, I see the best stablecoins will coexist in the crypto space. The market opportunity is huge for only one player.
Regulation: If governments prohibit centralized exchanges to list FEI, it will be more difficult for mainstream users to access this stablecoin.
Competitive Advantages
As more users come and FEI is more integrated with other crypto finance projects, it creates a network effect (more users, more value of the network). It also means more PCV and liquidity, which brings more safety to the protocol and capital to grow.
These are important moats protecting from new entrants.
Strong community and governance around the project are key and make it more difficult to replicate. In crypto, you easily copy the code, but not the community.
Moreover, the power of habit in using FEI is another important entry barrier. This will be even stronger when FEI as a stablecoin could be used frequently.
As time passes, the Lindy effect will be important to the stablecoins that succeed in maintaining the peg with dollars.
Team and Community
The team has experience in the blockchain industry and the project has relevant investors that can help in the integration with other protocols and companies. They raised $19 million from Andreessen Horowitz (a16z), Framework Ventures, Coinbase Ventures and AngelList founder Naval Ravikant, ParaFi Capital and Variant Fund, among others.
Price
To mitigate frontrunning and unequal early tokens distributions, Fei Protocol will include a “Genesis Period.” Genesis begins on March 22, 2021. It will last three days, ending on March 25, 2021. The Genesis Period will be a time period in which early adopters can pool their ETH for FEI.
Members of the Genesis Group earn a shared pro-rata percentage of the first bonding curve transaction. The aggregate quantity of ETH at this stage will determine the quantity of FEI generated at Genesis, and in turn, will affect the quantity of FEI users receive and the price. The maximum price that Genesis Group members could pay is $1.01 per FEI due to the 1% buffer.
As an additional reward, the Genesis Group also earns TRIBE, the governance token for FEI Protocol. Unlike FEI, the quantity of TRIBE the Genesis Group receives is static and set to 10% of the TRIBE total initial supply. This allocation is distributed pro-rata (based on ETH) to all participants in the Genesis Group.
This distribution helps to establish the most dedicated community members (those that supply ETH to the PCV) as the Fei DAO’s initial voting members as TRIBE holders.
The Genesis Group completion will kick off an Initial DeFi Offering (IDO) of the TRIBE token. The listing will be on Uniswap, denominated in FEI and TRIBE. It is available immediately at Genesis Period completion. The IDO will receive 20% of the initial TRIBE supply. The FEI for the IDO is minted by the protocol. The circulating FEI and TRIBE from the Genesis Group can be used in the IDO for efficient price discovery.
Genesis Group has the option to buy TRIBE before others in the IDO. They have the option to use the FEI bought in Genesis to buy TRIBE tokens at the same price of the IDO (this is the pre-swap). It is possible to choose how much of the Genesis FEI you want to use to buy TRIBE from 0 to 100%.
By doing this pre-swap you ensure the amount of TRIBE you want, do not have to compete with bots and pay less gas costs. It will be offered 200,000,000 TRIBE in the IDO and the pre-swapped TRIBE will be taken from this amount.
Fei Protocol users will follow their risk preferences when pre-swapping and can adopt many strategies in the Genesis period.
The Community/Team-Grants/Investors TRIBE token distribution is 80/15/5. The community liquidity is instant, while investors have a 4-year linear time-lock and the team has 5 years back-weighted time-lock. Team members receive in each of the 5 years 10%, 15%, 20%, 25%, and 30%, respectively. Almost half of this allocation is earmarked for future core team members.
The Genesis Group and IDO, while designed to be fair in a proportional way, still favor users with more capital. To mitigate this and enable more users to own TRIBE tokens, 10% is allocated to staking and 40% is controlled by the DAO.
The FEI-TRIBE liquidity mining incentives will commence in the coming days after Genesis. The initial liquidity mining incentives will be designed to promote widespread use and adoption of FEI as well as to further support the decentralization of the Fei Protocol. This will promote decentralized governance as well as the stability and safety of the platform.
The staking rewards will follow a linearly decreasing schedule over two years. If you stake FEI you will earn during these 2 years. It is good for TRIBE holders because it enhances liquidity and also incentivizes participation in FEI governance. Users can deposit FEI and receive a pro-rata percentage of the TRIBE drip into the pool.
It is worth noting that TRIBE is not capped and can be inflated by the community if needed. This may be of interest to the community for numerous reasons, including creating enhancements such as a backstopping feature for deflating in black swan scenarios.
In summary, the main value metrics to follow are: FEI Marketcap and Volume (to track its usage), PCV / FEI (protocol security and stability), TRIBE circulating / PCV and TRIBE FDV/PCV (tracking price to value), TRIBE Circulating and Fully Diluted Marketcap (to compare with competing projects).
The value metrics at launch will depend on the ETH value raised and the mean of pre-swap (pre-commit) from Genesis Group. You can see some sensitivity analysis below:
If pre-commit is high, protocol security will be higher (PCV/FEI) and with more space to grow the FEI marketcap. So it is fair that TRIBE FDV/PCV and TRIBE Circulating/PCV ratios are higher. The amount of ETH raised does not impact those ratios.
If ETH amount raised is higher, protocol security will be higher (PCV/FEI) and it will be better to integrate with other crypto projects. On the other hand, will have less space to grow (but it is still a huge market opportunity in stablecoins).
If pre-commit is high and ETH amount raised is high, protocol security and potential integrations will be higher, with space to grow. So it is fair that TRIBE FDV/PCV and TRIBE Circulating/PCV ratios are higher. In my opinion, the not so good scenario would be a high pre-commit with a low ETH amount raised (FEI mktcap below $ 90 millions) .
In conclusion, it is a very interesting project that mixes characteristics from a central bank and an insurance company and addresses a very huge market opportunity, the stablecoins. Strong community and partnerships with other players will be key to its success.