In-Depth Analysis of Flatcoins Stablecoins: Concepts, Design, and Challenges

Kapil334

This article explores "Flatcoins," which Coinbase considers algorithmic semi-stablecoins adjustable based on inflation rates. This specific use case presents an interesting control theory design challenge.

Introduction: What are Flatcoins?
Flatcoins are an emerging token economics concept where interest-bearing tokens, as a store of value, adjust their valuation over time to track changes in inflation. The established goal is to protect the purchasing power of token holders and/or specific interest groups (such as platform users).

A simple example of Flatcoin is the fictional "i-DAI": an inflation-adjusted DAI. i-DAI will be linked to a reference time, and its price will adjust in real-time based on changes in inflation, preserving the purchasing power of i-DAI holders. The table below illustrates this programmed behavior. As we will see in this article, although i-DAI is currently just a fictional story, it can become a reality by using controller-based stablecoins (CBS), which already exist in production, similar to RAI, for example.



This table illustrates the valuation difference between DAI and i-DAI (a fictional DAI adjusted for inflation). (*) The mammoth price in DAI is a fictional example used to illustrate the impact of CPI on commodities.

What is Inflation?
In economics, inflation is understood as a general increase in the prices of goods and services, leading to a decrease in the purchasing power of the currency held for valuation. In web3, inflation is often (rather confusingly) used to describe the effects of expanding token supplies, although this phenomenon is more accurately described as "dilution" in traditional economic terms. In the rest of this article, we will stick to the previous definition of inflation.

In an inflationary environment, the purchasing power of currency holders can decrease, potentially undermining trust in that currency and the entire economic system it represents. Therefore, inflation is considered a key metric for any economy, and central banks around the world have specific mandates to keep the annual inflation rate of their managed fiat currencies at lower levels (typically around 2% to 4%). However, as recent global economic experiences have shown, this is not always easy.

Given the recent inflationary pressures on the global economy, Coinbase proposes the design of "Flatcoins" that are adjusted for inflation. The established goal of Flatcoins is to "maintain stability in purchasing power while having resilience against economic uncertainties caused by the traditional financial system." Again, this is not an easy task—let's take a closer look at some of the inherent challenges in Flatcoins' design.

Flatcoin Design Challenges
Flatcoins present a unique design proposition, and as such, they entail several challenges that need to be addressed both individually and collectively. We will delve into the details of some of these challenges later in this article. The core challenge is accurately perceiving inflation and devising appropriate incentive mechanisms.

Specifically, inflation operates, like many concepts in economics, within the paradigm of complex adaptive systems. This means there are numerous dynamic interactions among different factors and variables, including unpredictable human behaviors affecting both the causes and effects of inflation. This poses a challenge to Flatcoins' design, and any implementation will need to consider many factors, including but not limited to:

1. Low time granularity of the inflation index.
2. Difficulty in spatial-temporal adjustments of sensor measurements.
3. Complexity of sensor fusion and effective controller design.
4. Challenges in driving the Flatcoin economic transformation through appropriate incentive mechanisms.

Feasible Flatcoins Design: Controller-Based Semi-Stablecoins
A promising approach to building Flatcoins is to reuse some of the most successful stablecoins currently deployed. These stablecoins are based on the concept of using controllers to perceive price changes and re-adjust participant incentives, thus causing the value of held tokens to tend toward a reference value.

This is where Controller-Based Stablecoins (CBS) come into play, with RAI being an example of such tokens. RAI draws inspiration from similar theoretical and practical problems—RAI adopts controllers, in part, because research has shown that central banks' historical behavior in controlling inflation can be well-described using PID controllers. Theoretical research by Hawkings et al. in 2014 and empirical research by Shepherd et al. in 2019 both support this idea.

Given the stability exhibited by RAI as a controller-based stablecoin, we will study RAI as a case study and introduce the components of a feasible Flatcoins design based on CBS.

RAI as a Case Study
RAI is a CBS that tends to track the value of the U.S. dollar by using unsupervised PI controllers to guide economic incentive mechanisms and a price oracle to "perceive" the RAI/USD price in real time.

In terms of user experience, RAI allows users to collateralize with ETH and take out overcollateralized loans in RAI. The outstanding debt is denominated in RAI, and its interest rate (or redemption rate, known as the Redemption Rate in the RAI ecosystem) is defined by the implemented PI controller. The amount of loan available is determined by the so-called redemption price, which often closely tracks the RAI market price, with differences typically around 1%.

The logic for adjusting interest rates is based on the difference between the market price of RAI (priced in RAI per USD) and the redemption price of RAI (also priced in RAI per USD). Rates tend to rise when the redemption price is higher than the market price and decrease (even becoming negative!) when it's lower.

Even without being pegged and using volatile assets (ETH) as collateral, RAI's price remains fairly stable due to its countercyclical incentives. The market price is determined by buyers and sellers of RAI in the secondary market, hence having volatility, while the redemption price is determined by the PI controller, offering damping. Therefore, when there's a significant discrepancy between the two prices, rational users have an incentive to arbitrage.

Specifically, when the market price is higher than the redemption price, it makes sense to take out RAI loans, sell them in the secondary market for profit, wait for both prices to converge, and then buy RAI back from the secondary market to repay the debt at a neutral position. This is particularly convenient if the market price remains persistently higher than the redemption price, as the redemption rate may turn negative, resulting in arbitrage profits and interest profits. In any case, profiting from the system often keeps the market price of RAI tokens stable.

For the reverse scenario (redemption price higher than market price), profitable actions include buying as much RAI as possible from the secondary market and holding it until prices converge, or using it to close any open RAI positions. Both actions encourage the system toward price convergence in the market.

The advantage of the controller behind RAI is that all these incentives triggered by the controller are driven by an external benchmark, namely the RAI/USD price obtained through an external oracle. RAI does not directly depend on holding any USD reserves or liquidity pools to achieve its price stability.

For designing Flatcoins, the RAI design represents a natural starting point to build an MVP and requires two things: 1) an inflation oracle and 2) an appropriately adjusted controller for measuring inflation.

More Resources on RAI:
- Reflexer Finance
- Summon the Money God. Applying Control Theory to... | by BlockScience | Reflexer | Medium
- Workshop #1: RAI Workshop — Modeling for the God of Money
- GitHub — BlockScience/reflexer: Reflexer Labs, RAI
- GitHub — BlockScience/reflexer-digital-twin: Toolkit for automated routine testing and future predictions of GEB deployments, based on cadCAD.

Challenges of Decentralized Control
After identifying key components of a CBS-based Flatcoin as the inflation oracle and the properly adjusted controller, we can proceed to refine the challenges around these two aspects.

Due to the spatial, temporal, and compositional nature of inflation (as described later in this article), fully measuring inflation is fundamentally a challenge for decentralized control system design.

From a control theory perspective, the Flatcoin design challenge can be understood as follows:
- There exists a geographically distributed "factory" or market for goods and services that emits price signals for different goods at different times and places.
- The first step is to design a set of sensors that pick up relevant signals (at the right frequencies and from the appropriate locations) and fuse them together at appropriate temporal and spatial scales.
- These signals can then be input into a controller to be processed into a sufficiently


A programmatic diagram of the control system and its components.

The "factory" refers to the controlled physical or mathematical system. This can be a mechanical system, a circuit, or even a biological system. Initially, the term "factory" referred to factories and production facilities equipped with thermostats and other sensors for temperature control.

Sensors are devices that measure aspects of plant behavior or the environment, such as temperature, pressure, or component positions. In this case, sensors need to capture price changes in relevant goods and services at appropriate locations to calculate and adjust changes in inflation.

Actuators are devices that influence the future behavior of the factory, such as motors, valves, heaters, or economic incentive mechanisms to ensure that token prices evolve appropriately after inflation adjustments.

The controller is the brain of the control system, processing information from sensors and using that information to adjust the behavior of actuators to achieve the desired outcome. Controllers calculate the appropriate actions to be taken based on the current state of the system and the desired results, using algorithms and mathematical models to help manage the system's performance.

Sensors, actuators, and controllers together form the fundamental building blocks of a factory control system, which can be used to regulate and automate various processes, even in systems with unpredictable human interactions.

Exploring the Challenges of Flatcoin's Inflation Adjustment in Depth
Any token designed to track the inflation rate to mitigate its impact on purchasing power must address some challenges related to which "sensors" and information sources to use. These challenges include questions like, "Where is inflation happening?" or "For whom?" and "Which goods and services?"


Display price changes of different goods listed in the U.S. Consumer Price Index (CPI) and compare them with the black official CPI index. (Source)

As economist Blair Fix brilliantly explains, inflation is not just "one thing." While inflation indices such as the GDP deflator or the Consumer and Producer Price Indices (CPI and PPI respectively) exist, these indicators vary significantly from one another and depend on other criteria (e.g., geographic location, industry, or sector). Indices also often suffer from a lack of granularity in time; most indices are updated at most monthly, while changes in purchasing power may have a direct impact on daily life, such as grocery or gasoline purchases.

The design of Flatcoins (as the name implies) aims to keep purchasing power "flat" in the face of price changes, so its expected scope and impact must be carefully considered before implementation. Tokens adjusted for inflation may have to cope with high price volatility in certain geographic regions or sectors, such as hyperinflation, while adjusting for low volatility and lack of inflation in other areas.

Furthermore, selecting which inflation index to use is challenging because even within nations, regions, or metropolitan areas, inflation can vary significantly. Standardized inflation indices like the Consumer Price Index do not account for differences in purchasing power among groups composed of different professions, investments, socioeconomic statuses, or demographics.

Finally, from an implementation perspective, accurate and timely measurement of inflation, given the sensitivity of such tokens to potential manipulation, presents a particularly challenging oracle problem, adding complexity to the design challenge. Since the actuators of the Flatcoin system will depend on the reliability (and "tamper-proof" nature) of the oracle subsystem, their design is far from simple.

Towards the Production of Flatcoins: Proposing the Way Forward
The spatiotemporal difficulty of this specific issue makes it worthwhile to address some open design problems from the perspective of creating appropriate incentives for token economies regulated by control theory methods.

In the spirit of agile methodology, we suggest starting with a proof of concept (PoC) design and pilot implementation with minimal functionality to meet the initial design objectives. As design challenges iterate, the design features of the PoC can be upgraded to more complex implementations after further specification and prioritization.

A starting point is to first limit the spatial aspect of inflation. A simple and recommended proof of concept (PoC) design is to begin with regional index Flatcoins from single currency markets and scalar price indices, although such a straightforward design may face various arbitrage challenges.

On a longer design timescale, a global composite index inflation token will address these arbitrage difficulties, offering a more robust use case, but will require further conceptualization and design to address the numerous challenges outlined in this article. With the deployment and evaluation of the first PoC, more requirements and capabilities can be identified and developed for sensors, controllers, and actuators incrementally.