Empty Set Dollar Stablecoin Collapse

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Empty Set

Empty set dollar was a complex algorithmic stablecoin that maintained a price around $1 until December 26th, 2020, growing to a market capitalization of $200m according to CoinMarketCap. After that point, the price appears to have crashed and is presently fractions of a penny. The protocol would automatically burn user balances to decrease the supply. However, nobody wants to hold a token that automatically loses supply.

This is a global/international case not involving a specific country.

About Empty Set

"A fully-backed, trust-minimized & community-owned stablecoin for web3."

"ESD is a stablecoin built to be the reserve currency of decentralised finance. ESD’s carefully balanced approach sidesteps the centralisation risk of USDC, USDT, & TUSD, avoids AMPL & BASED’s death spirals, the 100+ percent collateralisation requirements of sUSD & DAI, and, most importantly, it integrates perfectly with existing DeFi protocols."

"The ESD protocol expands on the pioneering work of Basis.io, which voluntarily shut down before launch due to regulatory pressure on the team. ESD has launched with an anonymous team to minimise pressure it may face down the road and the protocol includes a novel new mechanism in place of Basis’ seigniorage shares."

"Empty Set Dollar is an algorithmic stablecoin that serves as the reserve currency of Decentralized Finance." "It uses an algorithmic approach to maintaining price stability around a 1 USDC target. This approach relies on a tuned incentivization mechanism to reward actors who promote stability within the protocol."

"Empty Set’s stablecoin (DSU) has been developed to be collateral for web3 applications. The protocol’s low amount of dependancies and simple design make it suited for truely decentralized applications."

"DSU is designed to be simple & reliable. Users can mint & redeem DSU on-demand with stable collateral." "To operate Empty Set relies on two well established & throughly audited protocols: Compound & USDC." "Empty Set operates with a 100% or higher collateral. This ensures the DSU is always collateralised."

"A key tenant of web3 is decentralization, in all forms. Empty Set is able to issue a stablecoin against collateral with different trust guarantees and maintain the decentralization of its stablecoin."

"This allows for collateral with strong redemption guarantees to be used, while ensuring DSU and the protocols built on top of it are truely decentralized." "ESD is censorship resistant because it was developed by an anonymous team. This prevents regulatory bodies, or governmental agencies from really being able to pressure the protocol. With the STABLE Act potentially on the horizon in the USA, having a protocol that is free from government regulation is imperative. "

"For centralised stablecoins, like USDC, TUSD or USDT, they maintain their peg by providing a way for their tokens to be redeemable for the fiat dollars they represent. Similarly they expand the token supply when a user requests their fiat to be tokenised, and contract it when users request to burn their tokens for fiat. This is the safest and simplest way to run a digital dollar equivalent, as long as the centralised counter-party stays in business and doesn’t block your address."

"Another popular approach is to use Collateralised Debt Positions (CDPs) to issue a stablecoin whose worth is based on the redeemable value of the underlying assets (collateral). DAI and sUSD let users deposit assets into a ‘vault’ which in turn generates an amount of stablecoins that relates to a predetermined percentage of the value of the assets held within the vault. The value of the underlying assets are constantly monitored to ensure their value doesn’t fall below a specific threshold and if they do the vault is liquidated to ensure that the stablecoin is always able to be redeemed. This approach can succeed, however, it can be affected by heavy price fluctuations in the underlying assets and it requires assets to be locked in a CDP for the life of the issued stablecoins. Moreover, in most cases over collateralization is necessary to create a buffer in case of such high price fluctuations, which is inherently an inefficient use of assets."

"The most recent approach is to use a price feed to determine the total supply of the token. The logic goes: If the token is priced above its peg then more tokens should be created and distributed to token holders to inflate away the value of each token. Similarly when the price is below the peg the supply should contract to make the token more scarce and more valuable. The price feed is sampled at a specific interval (24hrs for AMPL) and the supply is changed (this is referred to as a ‘Rebase’). An equilibrium should be reached where the demand for the stablecoin matches the supply and the peg stays stable. Projects like AMPL, $BASED and ESD use price oracles to dictate supply, but crucially the methods to affect the supply differ. Both AMPL and $BASED use a mechanism which increases and decreases the amount of tokens in each user’s wallet each time a rebase happens, while not actually affecting the underlying value of the tokens."

"In contrast to standard rebasing tokens, in ESD rebases are voluntary. Users who choose to bond their ESD or lock their liquidity tokens in the DAO will receive the newly created ESD in the case of a positive rebase. For a negative rebase, protocol debt is issued which token holders can elect to purchase by burning their ESD for coupons that are redeemable for ESD at the next positive rebase. When purchasing debt for coupons: the greater amount of protocol debt, the greater amount of ESD they can be redeemed for. This incentivises holders to burn ESD, contracting the supply, as protocol debt increases."

"The protocol forces the token back to the peg of $1 based on the time weighted average price (TWAP) over an epoch (measure of time). If ESD TWAP > 1, expansion rewards go to bonded ESD holders. That expansion (inflation) increases supply devaluing the token. If ESD TWAP < 1, contraction occurs and coupons are sold at a premium. The coupon premium value grows with each epoch that passes if the TWAP continues to stay below peg. When the premium is enticing enough token holders may burn ESD in exchange for coupons for future ESD. The risk: coupons expire after X epochs (currently 90 epoch expiry.) The reward: coupons are redeemed when TWAP >1 for enough epochs to clear debt through expansion. ESD has been through multiple debt and expansion cycles. Expansions and debt cycles have lasted weeks, and they’ve also only lasted days or hours."

"As outlined in EIP-7 by AlexL, there are fundamental issues with the current ESD couponing mechanism. Simply put, the risk/reward ratio is not sufficiently attractive to entice speculators to buy and burn ESD for coupons. A stablecoin must maintain its target when sellers emerge, and effective hawkish tools are needed to stabilize the price during periods of weakness."

"V2 was inspired by [an] article written by prominent members of the ESD community. This spurred a successful treasury proposal to create a team to further research and create the code needed to implement V2. The first milestone for that team is fast approaching as their design is to be presented to the community on January 18th. In the community call from 1/8/21, they let us know they are on track. It’s important to remember, whatever their conclusions, and however they hope to change the protocol, that change will have to be presented to the community, and voted on by bonded ESD holders."

"The new system will be partially collateralized, rather than uncollateralized. This provides for a robust stability mechanism that is ~10x more capital efficient than current trustless collateralized stablecoins." "ESD supply is expanded by minting and selling ESD on the market when the system is above target. This will be done by a public incentivized function callable by anyone. The proceeds of this sale will be used to fund the reserves, and any excess will be distributed to DAO members."

Description From American Institute For Economic Research

The American Institute for Economic Research published a description of the Empty Set Dollar stablecoin.

An algorithmic stablecoin system begins life by generating a number of digital tokens, or stablecoins, out of thin air. If the stablecoin trades above $1, then the system automatically creates new stablecoins until the price falls back to $1. That’s the easy part.

If the stablecoin falls below $1, things are a bit trickier. To restore the peg, an algorithmic stablecoin system must reduce the supply of stablecoins. Empty Set Dollar (ESD), the largest of the algorithmic stablecoin systems, does so by encouraging users to exchange their ESD stablecoins for coupons. These coupons lock up ESD stablecoins for a period of time. In theory, as more funds shift into coupons, enough ESD stablecoins will be removed from circulation that their price rises back up to $1.

To encourage users to buy coupons, the Empty Set Dollar system sets an enticing exchange rate between ESD stablecoins and coupons, say 1 ESD stablecoin to 1.1 coupons. So if you own 10 ESD stablecoins, and their price falls below the $1 peg, the system will let you convert your 10 ESD stablecoins into 11 coupons. When (or if) the price of ESD stablecoins rises back above $1, you’ll be able to reconvert your coupons into 11 ESD stablecoins. Voila, your 10 ESD stablecoins have become 11, for a 10% profit.

Got that? A coupon, in short, can be thought of as a promise to pay even more ESD stablecoins in the future, conditional on locking up one’s ESD stablecoins now, but only if and when the $1 peg has been restored.

The further that the price of ESD stablecoins falls below $1, the more enticing the system-set conversion rate into coupons gets. Put differently, the more that it fails, the more the algorithmic stablecoin system tries to harness forces to repair itself.

"This meant that when the price of Empty Set Dollar rose above $1, then the protocol would mint more stablecoins to increase supply. The protocol would burn coins from wallets when the price fell below $1."

"This all sounds good in theory, but what about in practice? Luckily for us, algorithmic stablecoins aren’t just ideas jotted down on paper. ESD debuted last September and is providing real data on how these things function."

"Both algorithmic stablecoins have proven to be popular. At their peaks in late December 2020, ESD and DSD had respectively issued $550 million and $300 million worth of stablecoins into circulation."

"This actually worked pretty well until the end of December 2020. At that point, the value of the stablecoin fell below $0.90 and the peg simply could not be reached again." "Empty Set Dollar stablecoin [fell] from its $1 peg to less than $0.01 within months."

"How close did their prices hew to $1? For the first few months, the pegging mechanisms seemed to work. When ESD or DSD rose above $1, new coins were created, driving their prices back down. And periods of sub-$1 prices were successfully fixed, too, with the aforementioned coupon freezing mechanism pushing them back up to $1."

"However, since late December the price of ESD has gradually fallen to 23 cents. DSD stablecoins have fallen to 24 cents. There is little indication that either will ever return to $1. The value of ESD is presented in Figure 1. The value and volume of DSD is presented in Figure 2."

"A likely explanation is that people do not like to see the amount of coins in their wallet decrease. That caused distrust in the protocol, which resulted in selling pressure that the protocol could not correct by simply shrinking the supply."

"To summarize, Empty Set Dollar was a stablecoin that did not use collateral to defend its peg. Instead, it controlled the supply to maintain the peg, which worked until faith in the stablecoin was lost. At that point, the stablecoin became worthless and has not recovered."

This is a global/international case not involving a specific country.

The background of the exchange platform, service, or individuals involved, as it would have been seen or understood at the time of the events.

Include:

• Known history of when and how the service was started.
• What problems does the company or service claim to solve?
• What marketing materials were used by the firm or business?
• Audits performed, and excerpts that may have been included.
• Business registration documents shown (fake or legitimate).
• How were people recruited to participate?
• Public warnings and announcements prior to the event.

Don't Include:

• Any wording which directly states or implies that the business is/was illegitimate, or that a vulnerability existed.
• Anything that wasn't reasonably knowable at the time of the event.

There could be more than one section here. If the same platform is involved with multiple incidents, then it can be linked to a main article page.

The Reality

This sections is included if a case involved deception or information that was unknown at the time. Examples include:

• When the service was actually started (if different than the "official story").
• Who actually ran a service and their own personal history.
• How the service was structured behind the scenes. (For example, there was no "trading bot".)
• Details of what audits reported and how vulnerabilities were missed during auditing.

What Happened

The specific events of the loss and how it came about. What actually happened to cause the loss and some of the events leading up to it.

Key Event Timeline - Empty Set Dollar Stablecoin Collapse

Date	Event	Description
October 25th, 2020 12:00:21 AM MDT	CrypherHunter Description Live	The empty set dollar explanation on the CypherHunter website comes live.
November 2nd, 2020 8:01:00 AM MST	DYOR Crypto Wiki Article Started	An article on the Empty Set Dollar is first published to the DYOR Crypto Wiki.
December 3rd, 2020 5:52:30 PM MST	A New Hope For Algorithmic Stablecoins	A Medium article describes the Empty Set Dollar as "An New Hope For Algorithmic Stablecoins".
December 26th, 2020	Main Event	Expand this into a brief description of what happened and the impact. If multiple lines are necessary, add them here.
December 29th, 2020 3:43:00 PM MST	TraderDefi Tweet	TraderDefi mentions empty set dollar and dynamic set dollar in their Tweets about the tools they've developed to predict the market price. TBD more review. Should this be included?
February 1st, 2021 7:01:00 AM MST	American Institute For Economic Research Analysis	The American Institute for Economic Research publishes an analysis of the Empty Set Dollar stablecoin as the price has lost it's peg and started to fall.
July 23rd, 2021 7:51:56 AM MDT	Version 2 Launch Announced	A blog post announces the anticipated launch of version 2 of the empty set dollar protocol.
March 13th, 2022 1:52:33 PM MDT	Referenced in Beanstalk Finance Blog Post	The empty set dollar project is referenced multiple times in the Beanstalk Farms blog post. TBD fill in with more details.

Technical Details

This section includes specific detailed technical analysis of any security breaches which happened. What specific software vulnerabilities contributed to the problem and how were they exploited?

Jack And Jill Collapse Analogy

The American Institute for Economic Research published an explanation of what happened in fairly layman terms using Jack and Jill.

The success of an algorithmic stablecoin is reliant on a careful dance between two types of participants. Jack likes stability, and so he has a preference for stablecoins. Jill likes to speculate, and prefers high-return opportunities like coupons.

The relationship between the two is circular. Jack’s decision to hold ESD stablecoins is contingent on whether he trusts that Jill will buy coupons when the peg breaks. But Jill’s decision to buy coupons is contingent on whether she trusts Jack to use the ESD stablecoin system.

As long as the two participants stay positive, their mutual expectations can keep the system moored to $1. But if, for any reason, Jack and Jill’s self-referential beliefs in each other begin to deteriorate, the stablecoin price will irrevocably collapse. Jack won’t use stablecoins because he doesn’t think that Jill will support the system by buying coupons. Jill won’t support the system because she doesn’t think Jack will use the system’s stablecoins.

Total Amount Lost

The total amount lost has been estimated at $200,000 USD.

How much was lost and how was it calculated? If there are conflicting reports, which are accurate and where does the discrepancy lie?

Immediate Reactions

How did the various parties involved (firm, platform, management, and/or affected individual(s)) deal with the events? Were services shut down? Were announcements made? Were groups formed?

Ultimate Outcome

What was the end result? Was any investigation done? Were any individuals prosecuted? Was there a lawsuit? Was any tracing done?

American Institute for Economic Research

The American Institute for Economic Research summarized the failure.

Efforts to create stability without collateral are ambitious. The evidence that Empty Set Dollar and Dynamic Set Dollar have provided over the last few months suggests they are too ambitious. An algorithmic stablecoin only works so long as its users’ self-referential beliefs persist.

Total Amount Recovered

The total amount recovered has been estimated at $2,000 USD.

What funds were recovered? What funds were reimbursed for those affected users?

Ongoing Developments

What parts of this case are still remaining to be concluded?

General Prevention Policies

Algorithmic stablecoins are an experimental technology that may not actually be possible to survive a "bank run" scenario where users want to leave en-masse.

Individual Prevention Policies

No specific policies for individual prevention have yet been identified in this case.

For the full list of how to protect your funds as an individual, check our Prevention Policies for Individuals guide.

Platform Prevention Policies

Policies for platforms to take to prevent this situation have not yet been selected in this case.

For the full list of how to protect your funds as a financial service, check our Prevention Policies for Platforms guide.

Regulatory Prevention Policies

No specific regulatory policies have yet been identified in this case.

For the full list of regulatory policies that can prevent loss, check our Prevention Policies for Regulators guide.