Cryptocurrencies, like Bitcoin, are often too volatile for everyday use. Stablecoins, digital coins linked to steady assets like the US dollar, make using crypto for daily payments more practical. Prof. Min DAI, Chair Professor in Applied Statistics and Financial Mathematics at the Department of Applied Mathematics, and Director of The Research Centre for Blockchain Technology at The Hong Kong Polytechnic University, presents a robust stablecoin design using option pricing theory and smart contracts on Ethereum. The dual-class structure delivers fixed-income and stablecoin options, effectively separates speculation from real usage and demonstrates resilience to extreme market event.
Over the past decade, the cryptocurrency market has experienced explosive growth, evolving from a niche innovation into a global financial phenomenon. However, the prices of cryptocurrencies remain highly volatile, limiting their effectiveness as reliable means of payment or stores of value. In response, stablecoins have rapidly emerged as a crucial solution, offering price stability and fostering broader adoption within the digital economy.
By using the option pricing theory and the Ethereum (ETH) platform that allows the running of smart contracts, Prof. DAI and his research team have spearheaded a pioneering study on the design of fixed-income-like stablecoins. This research integrates rigorous mathematical modelling with economic theory to address the challenge of achieving price stability in decentralised currencies.
Broadly, stablecoins can be categorised into two main types. The first type, exemplified by USDT and USDC, is fiat-collateralised. The second major category is crypto-collateralised stablecoins, with DAI being the most prominent example.
While these models promise improved capital efficiency and flexibility, their long-term stability is highly dependent on the robustness of their hedging strategies and the prevailing market conditions, introducing new layers of risk that must be carefully managed.
To tackle these challenges, Prof. Dai's research team has proposed a novel stablecoin architecture inspired by option pricing theory and implemented via smart contracts. The core innovation lies in a dual-class structure combined with automated upward and downward reset mechanisms. This structure not only enhances capital efficiency by allowing more flexible use of collateral, but also enables dynamic risk allocation through automated upward and downward reset mechanisms. These automated resets help isolate risk, enhance resilience, and ensure the stablecoin's value remains robust even during extreme market movements.
The team’s analysis based on numerical tests confirms that the dual-class structure and reset mechanisms provide strong stability and resilience, outperforming traditional stablecoins like DAI, especially during extreme market events.
The dual-class structure presents a compelling and forward-thinking framework for achieving price stability in the highly volatile cryptocurrency landscape. By integrating risk tranching, automated upward and downward resets, and smart contract-based governance, this system not only isolates market risk but also significantly improves capital efficiency. The design enables differentiated exposure for investors, allowing conservative participants to enjoy fixed-income-like returns while risk-tolerant users pursue leveraged gains. This innovative architecture addresses key shortcomings of traditional stablecoins, such as their opacity and rigidity, and offers a scalable, transparent and decentralised solution that aligns with the evolving needs of modern financial ecosystems.
Source: Innovation Digest Issue 5
