The initial production version of the Reserve Protocol will contain a substantially centralized fiatcoin, and over time each protocol component will be migrated on-chain and released from control by the founding team, eventually becoming fully decentralized. There are three planned phases of the Reserve network:
In this overview, we will be describing Phase 2, the decentralized phase, where Reserve is backed by a changing basket of assets in a decentralized way, but still stabilized in price with respect to the US dollar. For more info on the other phases, please refer to our whitepaper.
The Reserve Protocol can be implemented on top of any smart contract platform, or on its own chain. Initially we are developing on the Ethereum Network but ultimately we expect two-way bridges to enable complete interoperability of the Reserve token across all major smart contract platforms.
The Reserve token will initially have a target value of $1.00, but is designed to go off of the peg from the US dollar in the long term.
The Reserve Protocol interacts with three kinds of tokens:
If demand goes down for the Reserve token, prices are expected to fall on secondary markets. What happens then?
Suppose the redemption price of Reserve is $1.00. If the price of Reserve on the open market is $0.98, arbitrageurs will be incentivized to buy it up and redeem it with the Reserve smart contract for $1.00 worth of collateral tokens. They'll continue buying on open markets until there is no more money to be made, which is when the market price matches the redemption price of $1.00.
The same mechanism works in reverse when demand goes up. If the price of Reserve on the open market is $1.02, arbitrageurs will be incentivized to purchase newly minted Reserve tokens for $1.00 worth of collateral, and immediately sell them on the open market. They'll continue selling on open markets until there is no more money to be made, which is when the market price matches the purchase price of $1.00.
The Reserve Protocol holds the collateral tokens that back the Reserve token. When new Reserves are sold on the market, the assets used by market participants to purchase the new Reserves are held as collateral. This process keeps the Reserve collateralized at a 1:1 ratio even as supply increases.
At times, the Reserve is collateralized at a ratio greater than 1:1. When this is the case, the Reserve Protocol mints and sells Reserve Share tokens in exchange for the additional collateral tokens needed. Ultimately this excess collateral does not go to waste—when it becomes clear the on-chain ecosystem is mature enough, the excess collateral is simply returned to holders of the Reserve Share token.
Collateral tokens are somewhat volatile. While we may be able to select a portfolio with minimal downside risk, the reality is that drops in the collateral tokens' value will happen. Since remaining undercollateralized exposes the Reserve to risk, if this happens the Reserve smart contract will sell newly minted Reserve Share tokens for additional collateral tokens and add them to its balance.
Why would anyone ever want to buy Reserve Share tokens? As we noted earlier, one of the primary problems with any system that uses a volatile token of its own creation is that it must find a credible way to make that token valuable.
When the tokenized collateral held by the Reserve smart contract appreciates and the value of tokenized collateral exceeds a predetermined collateralization ratio, holders of the Reserve Share token receive the resulting excess collateral in the form of dividends. Recall what collateral tokens are made of: real-world assets such as bonds, property, and commodities. All of these can undergo periods of decreases in value, but in the aggregate their trend tends to be upwards.
In the case of massive network adoption, the vast majority of the capital held by the Reserve smart contract comes from the sale of Reserve tokens. Since holders of Reserve Share tokens didn't have to put up that capital, they receive a magnified upside relative to the capital they contributed to the network. An additional source of revenue may come from a fee on transfers of Reserve (the presence and magnitude of this fee is determined first by the Reserve core team and later by the governance protocol).
Effectively, holders of Reserve Shares take on financial risk in exchange for the opportunity to profit from the appreciation of the collateral tokens, and Reserve token holders forego any opportunity to profit in exchange for greater financial stability.
Learn how the Reserve will achieve stability and how holders of Reserve Shares will be rewarded. Eventually, although not at launch, our protocol will back Reserve with a diversified pool of assets in a decentralized way. This is not light reading – if you are looking for a basic explanation, read our overview of the protocol.