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:
- The centralized phase — where Reserve is backed by US dollars, which are held by a trust company.
- 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.
- The independent phase — where Reserve is no longer pegged to the US dollar, with the intent of stabilizing its real purchasing power regardless of fluctuations in the value of the dollar.
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:
- The Reserve token — a stable cryptocurrency that can be held and spent the way we use US dollars and other stable fiat money.
- The Reserve Share token — a normal volatile cryptocurrency that can be purchased to speculate on the growth of the Reserve network.
- Collateral tokens
— other assets that are held by the Reserve smart contract in order to back the value of the Reserve token, similar to when the US government used to back the US dollar with gold. The protocol is designed to hold collateral tokens worth at least 100% of the value of all Reserve tokens. Many of the collateral tokens will be tokenized real-world assets such as tokenized bonds, property, and commodities. The portfolio will start off relatively simple and diversify over time as more asset classes are tokenized.
How the Reserve Token is Stabilized
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.
How the Reserve Protocol is Capitalized
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.
What Happens When the Collateral Tokens Depreciate
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.
How Reserve Share Token Holders Can Make Money
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.