What is DSD?
DSD is an algorithmic stablecoin. The system goes through alternating cycles of expansion and contraction that get progressively smaller until the price stays stable at $1.
During contractions, participants are incentivized to burn their DSD to purchase coupons with a 30-day expiration date and are redeemable only when the price is above $1.
Therefore, during contraction cycles, the total DSD supply decreases.
During expansions, the system prints more DSD to reward participants for bonding their DSD and providing liquidity.
Therefore, during expansion cycles, the total DSD supply increases.
Let’s take a look at the game theory of DSD.
As mentioned above, players (participants) are incentivized to increase the value of DSD when it’s below $1 and decrease it when it’s above $1.
Below $1, players are incentivized in two ways:
- Buy undervalued tokens off the market. If the system works as it should, with cycles of contractions and expansions, they’re buying tokens at a discount as the price will eventually go back to $1. (indirect, out of the system)
- Purchase coupons by burning the DSD for an IOU with a bonus of up to 40%, redeemable when the price is back above $1. (direct, within the system)
From a game theory point of view, during the contraction phase, the best strategy is for everyone to cooperate in the token burn/coupon purchase. If everyone cooperates, the price will for sure go back above $1.
In actuality, just a portion of the players needs to cooperate for the system to work. However, since there’s no communication between them, the players will have to trust each other to do what’s in their best interest: cooperate.
Cooperating comes with a significant risk: if enough people defect, the price won’t go back to $1. And since coupons have a 30-day expiration date, those who cooperated lose all the DSD they burned for coupons, while those who defect still have their tokens that might still be worth something.
Majority cooperates, minority defects
Defecting while the majority cooperates gives the second-best outcome. Defectors don’t get coupon bonuses, but they don’t risk complete loss and might still access the expansion/rewards cycle.
The third worst outcome is everyone defecting. The system fails and dies, but there’s a chance to get something during the bank run.
Majority defects, minority cooperates
The worst outcome is cooperating, while the majority is defecting. Defectors will still have their tokens, and they may be worth something. Cooperators will be left with nothing instead.
So during the contraction cycle, the best strategy for the players and the system is for everyone to cooperate. Once the price is above $1, players can enjoy the rewards.
Above $1, players need to sell their DSD to bring back the price at $1.
However, when the price is above $1, the system offers excellent incentives not to sell. If players stay bonded and LP, they get rewarded.
To unlock their bonded DSD, players have to wait for 36 epochs (3 days), during which they don’t earn rewards. To redeem their LP rewards, players have to wait for 12 epochs (1 day). The time-lock complicates the strategies, all for the good of the system.
Players are faced with a dilemma: lock the tokens to earn more rewards, or ignore the potential rewards and keep the DSD unlocked to sell at a price higher than $1?
During the expansion cycle, the only rational strategy is for some players to defect — keep their DSD unlocked and sell –, and some others to cooperate — lock their DSD for the whole expansion cycle to maximize the rewards.
Let’s see the other options and why they’re not rational choices.
The system would continue to issue rewards, more players would join to get rewards, and nobody sells. The supply and price go up indefinitely, further and further from $1, leading to the system’s failure. No human being would let that happen unless they’re all irrational.
Like the above scenario, not participating in the rewards cycle is against the players’ interest. Nobody would leave the rewards on the table, considering that they’re rewards for the risk they previously took during the contraction cycle. There is no reason for everyone not to participate in bonding / LP to generate rewards.
So the best strategy during expansion cycles is some cooperation and some defection. Both players in this strategy get rewarded. Those who cooperate get more tokens, those who don’t get the possibility of selling at a price higher than $1, freeing up capital to purchase DSD below $1 and get back in the game.
Digging further, an even better strategy would be to maximize the returns, hence cooperate, and then defect — best of both worlds.
But how do you know when to defect? Since it’s impossible to know what other players will do, the best strategy is to be the first to defect, which takes us back to the initial strategy just to cooperate or just defect during expansions.
To sum up, the best rational strategy is to cooperate in all contraction cycles, and sometimes cooperate and sometimes defect in expansion cycles.
Does the system always need new players? Not necessarily, as long as everyone cooperates in contractions and sometimes cooperates and sometimes defects in expansions.
Problems arise when people don’t play correctly during the contraction cycle. The contraction cycle is a belief system. Those who trust the system and other players to do the right thing will purchase the coupons because they will be rewarded with extra tokens and another expansion cycle.
Those who don’t, jeopardize the game for everyone.