Why I believe RAI is inflation resistant
Having received pushback on this topic recently from notable project supporters, I thought it would be helpful to lay out the entire argument for RAI being inflation resistant as a reference for future RAI supporters.
How RAI’s redemption price works
The first thing you need to understand is how the redemption price of RAI works. The redemption price in RAI/USD is used for determining your liquidation price when you borrow RAI against ETH and also for global settlement in case of an emergency shutdown to determine how much ETH each RAI holder should receive. It can be thought of as “the price the system wants RAI to be”, and as also called the target price. As you can read in the following thread, RAI’s redemption price floats to balance supply and demand for RAI.
RAI Supply and Demand
RAI can only be minted with ETH, so the supply of RAI is determined by the demand for ETH leverage via RAI. The more people want to leverage their ETH collateral to mint RAI the higher the RAI supply will be.
RAI demand is determined by the demand for holding RAI, including demand to use RAI as collateral for farming & liquidity mining. The more people want to hold RAI, the greater the demand for RAI.
To balance the RAI supply and demand, RAI’s algorithmic controller sets the redemption rate (the instantaneous rate of change of the redemption price) to proportionally oppose market price movements away from the redemption price.
When the market price of RAI is greater than the redemption price, the controller takes that as a signal that RAI demand is greater than the RAI supply, and sets the redemption rate negative. This disincentivizes holding RAI and incentivizes minting RAI, and continues until the market price deviation is corrected and RAI supply and demand are once again in equilibrium.
Local Dynamics vs Global Dynamics
It would be naive to look at RAI, observe its price movement from inception ($3.14) to present ($3.04) and assume it is not only not inflation resistant, but actually inflating faster than the USD (as a result of RAI’s purchasing power declining faster than USD over the same period).
The reason is that RAI is subject to both local and global supply / demand dynamics. During the first 3 weeks of RAI, our team had created skewed liquidity mining rewards that heavily favored buying RAI over minting RAI. The demand for RAI was so high the redemption rate went to -80% and RAI’s redemption price went down by 5% in just 3 weeks. And when we balanced the lopsided liquidity mining incentives by requiring LPs to also mint the RAI they were LPing, the market price deviation was also corrected and RAI’s redemption price went mostly flat.
In other words, the entire price move from $3.14 → $3.00 in the first 3 weeks of RAI had absolutely nothing to do with the larger context of “USD inflation as evidenced by CPI growth” and everything to do with apes bidding up RAI to LP and earn rewards.
In the 9 months since we balanced the local imbalance, however, RAI has appreciated from $3 → $3.04 (and avg rate of ~1.5%/year). This could be a reflection of RAI being resistant to the ~5-7% inflation in terms of CPI growth.
RAI Equilibrium Bounds
You can somewhat predict RAI’s behavior by understanding the other systems it exists in equilibrium with.
The RAI supply, determined by the demand for ETH leverage via RAI, is in equilibrium with all other sources of ETH leverage. If someone has to pay 5% to borrow DAI on Maker, but observes RAI only has a 2% avg annual redemption rate, then they would save on interest payments by switching their debt over to RAI. Likewise if the redemption rate of RAI is +10%/y, and Maker is only charging 5% to borrow DAI against ETH, then a RAI borrower would save money by switching their debt over to Maker. As such, we would expect the upper bound of the RAI redemption rate to be roughly equal to the ETH borrow rate in Maker and other DeFi products.
The demand for RAI is also similarly in equilibrium with interest rates offered on other stablecoins. If the RAI redemption rate is at a steady -5%, then people can save money by selling their RAI for other stablecoins. Of course, RAI holders farming with their RAI might be willing to stomach a -5% redemption rate if they earn greater than 5% by farming. Indeed this is what took place during the first 3 weeks of RAI, when traders stomached a -80%/y RAI rate because they speculated their LP rewards would be even higher. But all together, simple RAI holders will likely sell RAI if the RAI redemption rate goes negative (because then holding USD stablecoins would be more profitable), and RAI farmers are likely to sell RAI if their net income (redemption rate + farming rewards) is less than the available farming rewards on other stablecoins. As such the lower bound of the RAI redemption rate is determined by the opportunity cost of holding RAI vs other stablecoins.
Why RAI is Inflation Resistant
Ok, now that you have all the relevant background information for the mental model, the main argument is somewhat simple. We’ll argue by contradiction first. Let’s assume the “RAI is pegged to USD” crowd is correct. What happens in a hyperinflation scenario (as defined here as +100%/y CPI growth)?
Well, the first thing that should happen is that traders, expecting the purchasing power of USD to drop significantly, would take out USD denominated loans and dump the USD for anything that seems likely maintain its purchasing power, or possibly appreciate. We would expect the DAI borrow rate against ETH to spike (in an effort by Maker to maintain the 1 DAI = $1 peg), but of course remain well under 100% due to the various risks collateral and liquidity risks involved in locking up ETH and borrowing DAI (which needs to be paid back later). Let’s say the borrow rate for DAI against ETH reaches 30%.
So how might RAI behave if:
- people assume RAI is pegged USD
- USD is inflating with 100%/y CPI growth
- Maker is offering DAI loans against ETH at 30% interest
Assuming RAI starts out at a redemption rate of 0%, we would expect rational traders to mint and sell RAI until the RAI redemption rate is at most 30%, where it would exist in equilibrium with the Maker borrow rate.
There’s a couple things going on here that I’m going to unpack. The first thing is that at t=0, RAI can still be thought as sort of pegged to the USD, since its redemption rate is 0. But the interesting thing is that the more RAI is considered pegged to USD, the more profitable it becomes, in expectation, to mint and sell it in a hyperinflationary environment. If you assume RAI = USD, and the redemption rate on RAI = 0%, then you can save yourself up to 30% borrowing RAI instead of DAI. This works until enough people mint & sell RAI that the redemption rate reaches equilibrium with other ETH leverage markets, and it stops being a profitable interest rate arbitrage opportunity to mint & sell RAI.
So the neat thing that is worth repeating is: RAI can be inflation resistant, even if no one using it thinks it is. In the example above, RAI will still reach equilibrium with other lending markets regardless of the beliefs of RAI market participants, so long as they engage in profitable interest rate arbitrage opportunities. So by virtue of being flexible enough to resist inflation, RAI can do so naturally, and without requiring constant human intervention at the protocol level.
Note - for the purpose of this article I defined “inflation resistant” as RAI appreciating proportional to CPI growth, but not necessarily 1:1. The degree of inflation resistance would be the correlation with CPI, so RAI with 50% inflation resistance would appreciate let’s say 50% of the CPI over the same timeframe. The degree of inflation resistance for RAI is unknown (and likely unknowable) as it depends on the environment that RAI exists in equilibrium with, which is also always changing.