Introduction to Ergo’s SigmaUSD stablecoin risk and reward mechanism
Ergo launched its stable coin, SigmaUSD, a few days ago. At time of writing, 4.4M$ are already in the reserves and the amount is steadily growing.
Many people struggle to understand how it works, and even more to get a good appreciation of the potential rewards and risks.
During the first month, the Reserve Ratio (Total Reserves/Liabilities) is not capped, however, afterwards, it will be kept between 400 and 800%. Under 400% you won’t be able to redeem the reserve coins for ERGs, above 800% you are not able to mint new reserve coins.
The stablecoin
Let’s start with the simplest side: the SigmaUSD stable coin.
It’s pretty simple to understand: you get a stable coin. However, the question you can ask is: Is it 100% stable ? The answer is no.
When you purchase SigmaUSD with Ergo, you get a SigmaUSD coin that can be redeemed for an equivalent stable USD value paid back in Ergo. In case your initial ERGs are not enough, you will get additional ERGs from the Reserve. But as the price of ERG goes down, you need more and more ERGs to cover a perfect stability; so at some point, there isn’t enough ERGs in the Reserve anymore. In a very simple 2-step scenario, this point would be reached if ERGs price decreases by the reserve ratio.
Stability is not guaranteed but covered until a decrease of the underlying asset by the reserve ratio. For example, if the reserve ratio is 800%, the price would have to be divided by 8 before the value of 1 SigmaUSD would drop below 1 USD.
Below can be observed the difference in Profit & Loss profile depending on the Reserve Ratio.
If there would be a need for a higher Reserve Ratio, a second layer of insurance could be bought separately (but at the same time) in the future for a certain price (like an insurance policy), and would be probably be using another uncorrelated asset (for example a tokenised asset) for risk decoupling (thus implying a lower cost of insurance compared to the impossible increase of the Reserve Ratio to infinity).
The Reserve coin
Buyers of Reserve coins (SigmaRSV or SigRSV) provide the service of stability to stablecoin users. In order to do so, they can’t redeem their SigmaRSV for ERG as long the Reserve Ratio is below 400% because stablecoin users have priority to redeem their stablecoins into a stable USD equivalent value paid in ERGs from the Reserve (and taken from the profit of SigmaRSV holders).
The smart contract also won’t allow for purchase of SigmaRSV once a Reserve Ratio of 800% is reached in order to avoid diluting too much the risk (and the reward).
In exchange to this risk taking, SigmaRSV holders are rewarded if the price of Ergo increases. They are also rewarded by the fees collected by the smart contract.
The following explanation will focus on the Profit and Loss profile when the price of Ergo fluctuates and exclude the fees component. These rewards or penalties are expressed in the price of SigmaRSV, calculated by the smart contract as (Equity / Number of coins in circulation).
This means that when the “Current price” of SigmaRSV is 0.001, in the smart contract balance sheet, ERG assets cover all ERG liabilities without profit. When SigRSV > 0.001 ERG, you can decuct that the assets in the contract are greater than the liabilities and that there is a profit. This price is the entry and exit price of the smart contract. Meaning that you take profit when exiting, and when new participants enter into the contract, the value of the profit is taken into account in the dilution calculation, so past profits stay yours.
Current price of SigmaRSV as of time of writing this article:
As the Reserve Ratio will fluctuate between 400% and 800%, we will examine the Profit & Loss profile in these 2 scenarios.
- Reserve ratio of 400%: a ratio of 4 ERGs (1 ERG received from SigmaUSD holder + 3 ERGs in Reserve received from SigmaRSV holder) to cover 1 ERG paid from the stable coin user.
- Reserve ratio of 800%: a ratio of 8 ERGs (1 ERG received from SigmaUSD holder + 7 ERGs in Reserve received from SigmaRSV holder) to cover 1 ERG paid from the stable coin user.
When the risk is diluted by a higher number of participants at 800%, the rewards are also diluted and the Profit & Loss is more similar to holding plain vanilla ERG. However, when the Reserve Ratio is approaching 400%, the incentive to join the contract and mint more SigmaRSV is higher, and the risk higher too.
It should be interesting to see where the Reserves Ratio will stabilise once the smart contract reaches a bigger volume. My guess is that we will be close to 800%.
Frequently Asked Questions
Does a 400% Reserve Ratio mean that the entry price is better?
The Reserve Ratio gives you an idea of the quantity of risk currently in the smart contract. You can see your entry point as the intersection point in the above graphs: you see that in order to make a difference, you have to change the price of ERG, but for any Reserve Ratio, the intersection point is always the same.
The evolution of the Reserve Ratio over time after your entry has however an impact on the slope of the curve, so your risk changes all the time.
In addition, the % of fees collected by the smart contract creates value only for current holders of SigRSV, so the lower the Reserve Ratio, the less dilution of this value creation. That’s why the incentive can be viewed as higher to remain or join the smart contract when the Reserve Ratio is low. The lowest, the better in this regard.
What happens if the Reserve Ratio is under 400%?
In this case, the smart contract will prohibit:
- minting any new SigmaUSD
- SigRSV withdrawals, so beware, you won’t be able to withdraw your SigRSV at any time, there should be periods of time when SigRSV will not be available for withdrawal. But remember also that this situation gives you a very interesting position as you are entitled to a better share of the fees, as they are not splitted between too many SigRSV holders.
SigUSD users and SigRSV investors must know the rules in advance to have some visibility:
- SigUSD users know that under 400%, no one can mint new SigUSD, which protects them.
- It also protects SigRSV users from anyone minting so many SigUSD that their risk increases too much.
When the Reserve Ratio is under 400%, only 2 things are allowed:
- SigUSD users can withdraw their SigUSD and redeem them for ERG, which increases the Reserve Ratio
- SigRSV investors can buy additional SigRSV in order to increase the Reserve Ratio
What happens if the Reserve Ratio is above 800%?
In this case, you won’t be able to mint new SigUSD, because otherwise, the risk/reward profile of holding SigUSD vs. plain vanilla ERG would be too similar.
Does it make sense to wait for a price dip of ERG if I already own ERG?
If you are already invested in ERG, you are on the blue line, so if the USD value of ERG is decreasing, but only a little bit less than the USD value of SigRSV coins. So the difference in your entry price won’t be very substantial in this case. And the main question to ask yourself is also: by how much will the profit of the Reserve increase from transaction fees during this time and will the price decrease of ERG offset this profitability?
If you own FIAT and the price of ERG decreases, then you have also a better entry price in ERG, but also in SigRSV, but the difference will be approximately the same, and here too you can ask yourself is it worth it to wait or is it better to be part of the value creation that plays against you during the time you are “short”?
What gives value to SigRSV? how to calculate it?
Price of SigmaRSV = Equity / number of RSV coins in circulation
Liability in ERG = SigUSD circulating supply / ERG Price in USD
Equity + Liability = Total balance sheet
That’s for the liability side of the balance sheet.
For the asset side of the balance sheet you can use the Reserve Ratio to deduct how the origin or ERGs is splitted between stablecoin users and SigRSV holders.
Is it better to buy SigRSV when Reserves are high or low?
The amount of reserves (high or low) on the moment of entry does not improve your return, it is just an indication of how many shareholders will be sharing current profit generation until the change of the Reserve Ratio, so it is really a very short term indicator, as it can change at any time and its effect on your profit is really more a weighted average value over time when you are holding SigRSV, weighted by the profit made at each step of the value of the ratio.
Further questions
If you have any further questions, don’t hesitate to contact me on Twitter.
If you want to dig further into SigmaUSD, here are some links:
- PDF presentation on Github: https://bit.ly/3kvHiPM
- Ergo 2021 Summit stablecoin presentation: https://youtu.be/zG-rxMCDIa0?t=8281
- https://ergo101.org/videos
My Ergo Lords and Lordesses, Your lordship’s most humble, most obedient servant, Verium Fellow.
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