Seigniorage

Traditional Definition of Seigniorage (Wikipedia, with citations): “Seigniorage /ˈseɪnjərɪdʒ/, also spelled seignorage or seigneurage (from the Old French seigneuriage, “right of the lord (seigneur) to mint money”), is the difference between the value of money and the cost to produce and distribute it. The term can be applied in two ways:

• Seigniorage derived from specie (metal coins) is a tax added to the total cost of a coin (metal content and production costs) that a customer of the mint had to pay and which was sent to the sovereign of the political region.

• Seigniorage derived from notes is more indirect; it is the difference between interest earned on securities acquired in exchange for banknotes and the cost of producing and distributing the notes.

“Monetary seigniorage” is where sovereign-issued securities are exchanged for newly-printed banknotes by a central bank, allowing the sovereign to “borrow” without needing to immediately repay. Monetary seigniorage is sovereign revenue obtained through routine debt monetization, including expansion of the money supply during GDP growth, and meeting yearly inflation targets.

Seigniorage can be a convenient source of revenue for a government. By providing the government with increased purchasing power at the expense of public purchasing power, it imposes what is metaphorically known as an inflation tax on the public.”

ALGO-PEGGED TOKENS

Decentralized Seigniorage: Investors purchase a token and stake them for a share of an algorithmically pegged (algo-pegged) currency. Token emissions occur during a supply expansion, and the algo-pegged currency must be worth more than the currency’s value that it matches for emissions to continue. In other words, the algo-pegged token must maintain a pegged value greater than 1:1 of the target asset for emissions to increase. When peg drops below 1:1, the cost to produce currency decreases, and bonds are issued. Bonds are purchased with an algo-pegged currency when the currency falls below the peg. These bonds are available for redemption once the peg is greater than the 1:1.05 value of the target asset. The average person does not benefit from seigniorage yields that occur through the traditional monetary mechanics. Decentralized algo-pegged currencies give the average person access to yields previously the purview of governments and institutions.

SHARE ISSUANCE

To bootstrap liquidity, investors require incentives. Investors receive a share token by supplying an algo-pegged token with the target currency as a liquidity pair. These share tokens are the only way to receive freshly minted currency during expansion. When investors can manage their activities by compounding currency issuance into share tokens above peg and retaining algo-pegged currencies to purchase bonds below peg, a seigniorage protocol can realize stability and longevity. When a seigniorage protocol is above peg, there is a clear incentive for share stakers to realize profits to bring the algo-peg currency back to an optimal pegging with the target asset.

BOND ISSUANCE

When the issuance of an algo-pegged currency leads to investors selling their harvests, the value may fall below peg to the target asset. If this occurs, emissions from staking share tokens cease, and bonds become available for purchase on the market. Bonds can only be purchased with the algo-pegged currency, and the design removes excess algo-pegged tokens from supply by burning them in exchange for bonds. Only when the peg is back above 1:1 can bonds be redeemed at a premium in exchange for an algo-pegged token.

ALGO-PEGGED TOKEN ISSUANCE

There are several moving parts to a token maintaining an algo-peg to a target asset. Should the value of the algo-peg be greater than 1:1 of the target asset, an increasing supply of the algo-pegged token enters the market. Given that the algo-pegged asset’s value depends on the target asset when we see price appreciation in the target asset, the algo-pegged asset will follow suit. The peg is at risk when the target asset is down-trending significantly. Presumably, this is the result of investors selling out of the pegged asset to risk-off the target asset they are entitled to redeem from their supplied liquidity. However, this presents an opportunity to obtain bonds that put deflationary pressure on supply to restore an algo-peg. Once enough bonds have been purchased with the algo-pegged asset, the price finds its way back above peg, where the algo-pegged tokens are redeemed from treasury at a premium.

TIME-WEIGHTED AVERAGE PRICE (TWAP)

“Time-weighted Average Price (TWAP) is a well-known trading algorithm based on the weighted average price and defined by time criterion.”

In simplest terms, utilizing a TWAP mitigates any attempts at price manipulation to disrupt a peg. TWAP allows the pegged price to be calculated from an averaged price over time instead of the closing price at the end of a TWAP period.

CASE STUDY: TERRA LUNA (SHARE TOKEN) AND $UST (ALGO-PEGGED STABLECOIN ISSUANCE)

$LUNA is the native token for the Terra Luna ecosystem. Please refer to the fundamental analysis for an in-depth overview of Terra Luna. $LUNA is the primary collateral for the Terra Luna ecosystem. Not only is it utilized in supplying liquidity to optimize yields from financial instruments on the network, but it plays a crucial role in seigniorage. $UST is a decentralized token algo-pegged to the value of the US Dollar, with other decentralized stable coins pegged to the value of several other fiat denominations. There are various mechanics employed to maintain this peg. When below, $LUNA mints to purchase $UST, driving the price back up to peg by removing $UST from circulating supply. When above peg, $UST is sold for $LUNA that gets burned from circulating supply. There is a clear incentive to risk-off into $UST and hold $LUNA during a market downturn. The typical trend is that fearful investors will flee to stable coins. As more people risk-off into $UST, this drives up the price. Once the price deviates from the peg due to investors seeking risk-off assets, this also applies some buy pressure to the $LUNA token.

PROTOCOL MECHANICS

The viability of an algo-pegged token requires a protocol with built-in mechanisms to moderate bond issuance, currency issuance, expansion and contraction epochs, and share issuance.

EXPANSION AND CONTRACTION EPOCHS

Expansion and contraction epochs are contingent upon the supply of algo-pegged tokens. Epochs are a pre-defined time that extracts an average price of the algo-pegged asset.

If the price is below peg, the requirement is for the algo-pegged asset to be removed from the supply. Artificial scarcity has a price-appreciative effect, and this occurs during contraction epochs. The protocol will issue bonds for later redemption at a premium when the peg stabilizes.

If the price is above peg, the share token has value in accessing newly issued algo-peg tokens. An increased supply has a peg-depreciative effect, known as an expansion epoch. As freshly minted tokens enter supply, share stakers are likely, in varying degrees, to sell these tokens. Mainly when there is a clear positive arbitrage to be made between redeeming more of the target asset at a premium in exchange for the algo-pegged tokens.

TAXATION STRUCTURES – DEBT EPOCHS

A protocol will often go into debt epochs to maintain an algo-peg. These typically occur when a transition occurs from a contraction epoch to an expansion epoch. Most of the newly issued algo-pegged currency is stored in the DAO treasury during this time. The function of this is if the peg were to drop below one, the protocol could purchase bonds to drive the peg back above 1.

CURRENCY REGULATION THROUGH BOND AND SHARE ISSUANCE

So far, we have touched on the function of bonds and shares at a high level. The characteristic of bonds is that they are only issued when the peg is below 1, which gives momentum for the protocol to restore the peg. Bonds are not available to be speculated on the open market and are available for purchase in a closed market. Bond issuance does not occur when the algo-peg is equal to or above 1.

Share tokens are constantly emitted on a protocol, regardless of the state of the algo-peg. There are several advantages for investors. Firstly, algo-peg emissions above peg are often compounded into the share token to increase the investors’ share of currency issuance. Secondly, share tokens are often a vote of confidence in the protocol and a means for investors to manage their risk. Should the protocol require liquidity for the algo-peg token, investors may sell a portion of their share token to obtain the algo-peg token that can be changed into bonds for later redemption. En masse, this is not a sustainable mechanic to maintain an algo-peg. Finally, with the added utility of the share token, it is hypothesized that investors will likely retain the share token to reap the benefits from other revenue streams used to push the price. The revenue from such activities gives resilience to the share token in the face of selling pressure in the market.