Beware Of Flatcoins, Crypto’s Inflation Busting Fad

These coins are designed to protect stablecoin holders from inflation. But they are complicated and it’s not clear whether they will actually work.

Stablecoins are digital tokens created to mirror the value of hard currencies like the U.S. dollar. They are critical for liquidity in the $1.2 trillion crypto market because investors need a steady, predictable place to park cash, in part because bitcoin, which will swing as much as 10% in a single day, has largely failed as a store of value. There are $120 billion in stablecoins outstanding. Unfortunately, their history is anything but stable.

In May 2022, TerraUSD, a stablecoin dreamed up by a Stanford-educated South Korean programmer named Do Kwon, famously collapsed because its value was based on an algorithm that proved to be unreliable in the face of an asset run. More than $45 billion in market value evaporated in a single day setting off a crypto market plunge. After being on the lam for nearly a year, Do Kwon was recently arrested in Montenegro. Then, there is the world’s largest stablecoin issuer Tether, which has $80 billion outstanding, but has long avoided even the most basic disclosures (like where it is located) and has been in trouble with regulators numerous times. On several occasions Tether’s U.S. dollar coin (USDC) has “broken the buck” and dipped below $1.00 in value.

Even the most regulatory compliant and transparent stablecoin, Circle’s USD Coin (USDC), which has $30 billion outstanding, has disappointed investors. When Silicon Valley Bank collapsed on March 10, USDC’s Boston-based issuer Circle admitted to having $3.3 billion on deposit at the bank, mostly uninsured. The price of USDC lost its peg, nosediving to $0.88 cents on March 11.

But stablecoins are still essential for serious players in the digital asset world, and hope springs eternal in crypto, so a new product has hit the market called promising an inflation-adjusted version of stablecoins. Dubbed “flatcoins” these new tokens are designed to to maintain purchasing power parity with a basket of goods by keeping up with inflation.

So far only about $100 million in flatcoins have been minted but with inflation stubbornly stuck at 4.6%, demand for these novel tokens is growing. Already Coinbase is actively looking to seed flatcoins on its new Ethereum Layer 2 blockchain Base.

“We are fascinated by the deep thought we’re seeing in decentralized stablecoin design and are particularly interested in ‘flatcoins’ – stablecoins that track the rate of inflation, enabling users to have stability in purchasing power while also having resiliency from the economic uncertainty caused by the legacy financial system,” wrote Coinbase in a recent post.

Flatcoins are the brainchild of former Coinbase Chief Technology Officer Balaji Srinivasan and an Iranian born programer Sam Kazemian, who came up with a stablecoin protocol named Frax in 2021, and an inflation tracking index called Frax Price Index (FPI).

“The term flatcoin was basically meant to signify by me and Balaji that it stays flat to a standard of living, ” says Kazemian who notes that his new flatcoin would be partially backed by collateral like USDC, and partially “stabilized” algorithmically.

Here are the basics mechanics of the new inflation-protected stablecoins. The first thing the Frax programmers set out to do is identify a targeted standard of living to track. Kazemian built a feed with a blockchain data provider called Chainlink to publish each month’s CPI from the Federal Reserve’s Bureau of Labor and Statistics (BLS) onto the Ethereum blockchain. With the current 12-month trailing inflation rate at 5%, Frax has a set of smart contracts programmed to automatically conduct algorithmic trading with a goal of profiting enough to match the monthly inflation print sent from Chainlink.

The Frax Price Index vs. Consumer Price Index

Below is the trailing 12 month record of flatcoin, FPI against the CPI. Its tracking mechanism is based on smart contracts, algorithms and DeFi yields.

In theory, this would mean that if a single tether or USDC is still worth $1.00, in a 5% inflation world an FPI would be redeemable for $1.05 of collateral. In order to earn the necessary amounts to cover the inflation premium, Kazemian’s team invests collateral in DeFi lending protocols such as Aave and Convex, which primarily focus on stablecoin markets. These DeFi protocols earn yield for letting borrowers access their tokens. These returns then become available for FPI minters to withdraw. However, FPI is run by a Decentralized Autonomous Organization, which could make changes to its risk parameters in the future.

If this sounds complicated and risky, it is, especially relative to simply owning a stablecoin…