The Frankencoin Explained in 5 Minutes
Frankencoin may seem complex to those unfamiliar with cryptocurrencies and smart contracts. This article provides a short explanation – in just 5 minutes, anyone can grasp the basics.
How the Frankencoin is backed
The Frankencoin (ZCHF) represents the Swiss franc (CHF), but for the ZCHF to be worth one CHF, it needs to be secured by something. The value of the CHF is guaranteed by the Swiss government. The ZCHF needs another form of backing, and that backing is provided in the form of other cryptocurrencies.
The idea is simple: If there is one CHF worth of cryptocurrency (the so-called collateral) backing each ZCHF, the value of one ZCHF is equal to one CHF. The real questions are: How can the value of the collateral be guaranteed? And what if the (notoriously volatile) cryptocurrencies used as collateral decrease in value?
The answer lies in the way the Frankencoin is constructed. First, not every cryptocurrency can be used as collateral. The Frankencoin community governs the Frankencoin system – the individuals with the highest incentive to keep the ZCHF stable, ensure that no bad collateral is used A simple veto system ensures that unfit collateral can still be vetoed, even in the highly unlikely event of someone accumulating over half of all voting power. This significantly contributes to the Frankencoin’s stability.
If 100 000 CHF worth of Bitcoin is used as collateral, about 66 666 ZCHF can be minted, with extra reserves to account for price fluctuations. A part of this amount will be used to cover the interest, which is paid upfront, and a part will enter the Frankencoin reserve. The latter fee is refunded to the minter upon repayment of the loan and serves as additional reserve during the loan period.
In this scenario, there would be 1.5 CHF worth of Bitcoin backing each newly minted ZCHF. The collateralization ratio is now at 150%. 1 CHF worth of Bitcoin is backing the minted ZCHF, and the remaining 0.50 CHF worth of Bitcoin are there to absorb a potential drop in Bitcoin’s price. This works if Bitcoin’s value is stable – and as we know, Bitcoin’s value is anything but.
If Bitcoin’s value decreases, the amount backing each ZCHF decreases as well. If the collateral drops to a worth of 80 000 ZCHF, each ZCHF in circulation is now backed by 1.21 CHF worth of Bitcoin. The collateralization ratio is now 121%. This is still not a problem.
Problems only arise if that ratio drops below 100%, as that would mean that each ZCHF is now backed by less than 1 CHF worth of Bitcoin. To avoid that, the collateral is sold off and the loan is repaid on the minter’s behalf. To discourage having one’s own collateral sold off, the minter would now incur a punishment fee, which is taken out of the ecosystem contribution made earlier during the minting process.
Oracle-free principle
The price of Bitcoin is known – at least to us. We can get the price from sources like Coinmarketcap. A smart contract on the other hand needs a so-called price oracle to know the price of an asset. The problem with oracles is that the stablecoin system depends on them. If the oracle malfunctions, it could have catastrophic consequences. For example, if the oracle accidentally delivers a price that’s too low, it could trigger liquidations and fully collateralized positions would be sold off. Oracles are great while they work, but any malfunction can destabilize entire systems.
This is why the Frankencoin doesn’t have a price oracle. Instead, the community surveils the price of a collateral. If the value of the Bitcoin collateral used in the previous example drops towards the liquidation point (or 100% collateralization), members of the community will initiate the liquidation.
The Frankencoin system awards a 2% reward to the challenger (the person who first challenges a dangerous position). This fee serves as a strong incentive for community members and arbitrageurs to keep an eye on the collateral used in the system. In order to pay out the challenger and still guarantee a 100% collateralization ratio, challenges can therefore be initiated slightly before the collateralization ratio hits 100%.
In the odd chance of an under-collateralization, for example during the event of a market collapse, the Frankencoin system will cover the losses.
Governance
The Frankencoin system receives a share of each newly minted ZCHF, as described above. Said contribution is refunded upon repayment. This adds another layer of security to the system. The equity in the system is allocated to the holders of the Frankencoin Pool Share (FPS), the governance token. With that, FPS holders have a direct stake in the Frankencoin system as the tokens function similar to shares in a traditional bank.
Just like a real shareholder, the FPS holder gets paid last. If a bank fails, its debts are paid before the shareholders are paid out. The same principle applies to FPS holders: If the Frankencoin system suffers a loss, the equity is used to re-establish the peg, and that has a direct financial impact on the FPS and its holders.
A question that might arise concerns the collateral itself. Bitcoin is certainly volatile but in the world of cryptocurrencies, it is still among the less volatile currencies. Alternative cryptocurrencies (altcoins) tend to be even more volatile. With tens of thousands of existing cryptocurrencies, not every one of them can be accepted into the Frankencoin system.
To keep bad coins from entering the system, the Frankencoin has a governance mechanism in place. Governance is exercised by the FPS token holders. Anyone holding more than 2% of the FPS supply has the power to veto bad collateral.
The FPS holders have a high incentive to keep the Frankencoin stable as they are the ones suffering a loss in case of a de-peg. Because of that, undesirable collateral (tokens with low liquidity, scam tokens, etc.) have no chance of getting accepted into the Frankencoin system.
With this system in place, all involved parties want to avoid an undercollateralized state:
- The ZCHF minters: If a minter’s position gets liquidated, they lose an additional 2%.
- The challengers: If they spot a position that can be challenged, they will get a reward of 2% by initiating a challenge. With little effort, this could result in a big gain for the challenger.
- The FPS token holders: If the system suffers a loss, the FPS holders do too.
To put it simply: There is no upside in the destabilization of Frankencoin for any of the involved parties.
Thanks to its innovative architecture, the Frankencoin system is uniquely positioned to provide stability and security in the volatile world of cryptocurrencies.