The $1 billion Fei Protocol stablecoin project has gotten off to a very rocky start. 

The most important data point is this: Fei was built to maintain a 1:1 peg with the U.S. dollar but it has not quite hit the mark over this first week of its existence.

Backed by major VCs, Fei aimed to create a stablecoin protocol that would outright buy assets with its token, rather than holding them as collateral for loans. It appears the team underestimated the demand it would see to participate in the launch. It also seems clear that many of those who jumped into the project didn't understand Fei’s "direct incentive" method for stabilizing the price.

FEI’s struggles show that the launch of a new decentralized finance (DeFi) protocol is not a sure path to easy money, despite what many individual investors may have come to assume. The episode could be the tipping point where retail investors realize they have to be more judicious about hopping in, perhaps erring on the side of longer-term aims rather than the quick buck. 

For the first few days FEI danced around a nickel to a dime off the target. Since yesterday it has tanked hard, now almost a quarter off its goal of $1, according to CoinGecko.

Right now the outstanding question is whether Fei as we know it will persist. It's a stablecoin that's much too volatile. Stablecoins have proved to be very valuable, in particular to crypto traders. They allow traders to exit quickly from short-term trades and lock in gains with an asset whose price won't move. The most successful stablecoins thus far have relied on the U.S. dollar, and obviously crypto's true believers want to escape fiat. 

Fei's main technique for maintaining its peg to the dollar not only hasn't worked, each time it kicks in it briefly makes matters worse.

The situation underscores just how difficult it is to make a purely algorithmic stablecoin, something of a persistent albatross for cryptocurrency entrepreneurs especially excited about the idea of programmable money.

"It’s hard to make an algorithmic stablecoin stick to the peg, and mechanisms are nascent and experimental,” said Jake Brukhman, founder and CEO of investment firm CoinFund. “I don’t have much skin in the game on $FEI, but I am supportive of figuring it out for the benefit of science and the blockchain space." 

The Fei team did not reply to multiple requests for comment from CoinDesk by press time.

The Fei Protocol innovates on the model of a decentralized stablecoin by creating a system where users directly purchase the stablecoin from a protocol that is capable of owning the assets used to purchase it.

Here's a simplified model of how Fei works to help illustrate. Imagine there's a smart contract that simply says: input $100 worth of ether (ETH, the second-largest cryptocurrency by market capitalization) and the contract will issue 100 FEI to whatever wallet sent in the ETH.

There's no upper bound on the amount of FEI that can be issued other than the fact the smart contract that mints it does so only when it gets purchased. FEI is made on demand, not in anticipation of it, in other words. This is mostly right, but we'll circle back to this.

For now that's the basic idea. The main protocol Fei competes with is MakerDAO. MakerDAO creates DAI as a loan. Users put up collateral and can borrow up to two-thirds of its value in DAI. Eventually they have to pay the loan back with interest to get their collateral back, though, so there is a sense that the assets still belong to the borrowers.

The big innovation is that funds put into Fei belong to Fei. Fei is created not with a debt, but a trade.

Fei has a few ways that it can enforce its peg to the dollar.

First, Fei created a pool on Uniswap, the decentralized trading protocol, that it uses to support the peg. The smart contract that controls FEI is able to create incentives for buying from and selling to that pool.

So far the price has only been below the peg, so we only need to deal with that side of the equation. FEI theoretically incentivizes users to hold by burning some FEI any time they sell to the Uniswap pool and giving them a little any time they buy from it.

In theory, this should increase buy pressure and discourage sell pressure. But it hasn't worked.

Cornell Professor Emin Gün Sirer, also the founder of the Avalanche cryptocurrency project, wrote an extended thread about Fei on Twitter Wednesday. In one tweet, on just this point, he observed, "The penalty mechanism in FEI not only makes the supply disappear, it also makes demand disappear. It punishes both sides, and thereby narrows the feasibility envelope for the coin."

This is also a completely new mechanic and, as we know, few people read documentation carefully (this is true well beyond DeFi). Never before has Uniswap shown a stated price but then delivered less than it stated on a trade. This happens because some FEI gets burned on a sale when FEI is underpriced. Users haven't wrapped their heads around it, but it's causing something of a panic to exit.

That's evident every time Fei exercises its other mechanic, the reweight.

The reweight is a bit complicated, but here's a description that's as simple as possible:

Uniswap is an automated market maker, also known as a decentralized exchange (DEX). It owns no assets itself but it gives people a way to deposit pairs of assets into it and earn a little bit on trades users make with the protocol. So in an ETH/DAI pool, a user could put in 100 DAI and $100 worth of ETH and as people trade ETH for DAI and DAI for ETH the depositor would earn a tiny bit on each trade

The Fei protocol itself is the biggest supplier to the ETH/FEI pool on Uniswap. When FEI is trading below its target of $1, the protocol reweights the whole pool.

Step one: It withdraws all the ETH and FEI that it controls on the DEX.

Step two: There will still be some funds placed by others in the ETH/FEI pool, so Fei deposits the right amount, such that the funds that remain in the pool equal 1 FEI for $1 worth of ETH.

Step three: It deposits as much of its remaining ETH and FEI sufficient to maintain that ratio back into the Uniswap pool.

Step four: Some FEI will be left over after the reweight, because the market needs to reduce supply. That's why the price is below the peg. That leftover FEI gets burnt.

Lots of people want to get out of FEI right now, though, so as soon as a reweight happens, users rush to exit because that's the moment that they get the best price for FEI that they are going to get. This rush to trade leads to another plunge in value and once again FEI falls off its peg.

That's why the reweight makes things worse for a bit each time, because a reweight, ironically, creates the best moment to sell.

There's a debate in the Fei community right now about whether FEI will find its footing when more decentralized finance apps create uses for FEI or if none of them will until FEI finds its footing.

Users can hold FEI and its governance token, TRIBE, and stake them in the FEI/TRIBE Uniswap pool to earn more distributions of TRIBE. Right now, that's the only real reason to hold FEI, though, until other DeFi apps open up to it.

One topic that hasn't received a ton of attention is how collateralized FEI is.

In the debate noted above, one Fei supporter on the forum argued that FEI is overcollateralized. But looked at another way, it's undercollateralized.

The ETH that Fei owns now came from a launch event whereby early supporters put in ETH and got FEI at a discount (the formula was complicated). Fei acquired more than $1 billion worth of ETH this way.

So all those wallets got FEI and then the protocol kicked off the Uniswap pool. The pool would launch at 1 FEI equalling $1 of ETH. Theoretically, it should hold that peg. But where did the FEI in the Uniswap pool come from? According to the project’s white paper:

"The FEI for this deposit comes from minting, and therefore this PCV [Protocol Controlled Value] Deposit must be appointed as a Minter by Fei Core. The amount of FEI minted is equivalent to the amount of ETH times the spot price of FEI/ETH in the pool."

In other words, Fei just minted more FEI to match the value of ETH that went into the pool.

So (in simplified terms), a billion FEI were minted to buyers with the $1 billion worth of ETH that got spent in the launch event. Then, another billion FEI were minted to pair with that same ETH to go in the Uniswap pool.

So this is where we're circling back. One could argue that this pile of FEI in Uniswap was made in anticipation of demand and it isn't really circulating. It's more efficient, in terms of on-chain computation (“gas”) fees, for a user to buy it on Uniswap this way than to go straight to Fei. So it could be argued it's fair not to think of the Uniswap FEI as real FEI until someone buys it.

That's why the Fei analytics page shows a protocol controlled value (PCV) of $1.3 billion. This is how much assets Fei's smart contracts own. But the market cap of FEI is $2.2 billion.

Looked at one way: FEI in a Uniswap pool isn't exactly circulating supply. Looked at another way: well, we don't look at any other assets that exist inside Uniswap as not part of circulating supply.

This realization may factor into some of the anxiety around Fei now. With $1 billion worth of ETH at hand, it could have bought some of the newly minted FEI off the market to create the Uniswap pool. It would have been a smaller pool, but this is also a new token.

Nascent Capital's Dan Elitzer, a backer of Fei, does not think this is the true issue, however. He told CoinDesk over Twitter DM, "I find it hard to believe that people are selling because they think it's undercollateralized; they're selling because a lot of them aped into a system they didn't understand, thinking there was a pure arb opportunity. There just isn't enough natural demand for FEI at this point given the massive initial supply, hence the sell pressure."

The Fei team is considering a number of options to hit the peg now. Joey Santoro, the founder, kicked off the discussion, with options such as having reweights occur at regular intervals and reigning in the direct incentives so users are less reluctant to make moves.

Conversation around the options Santoro presented centered on the need for use cases for FEI. Another holder, going by fei.saver, came in to say that the peg is more important than usage, urging modifications that would increase the pace of reweights.

The discussion has been active ever since. Santoro, the founder, for his part, has voiced support in the forums for increasing the cadence of reweights and easing up on the incentives built into the Uniswap pool.

In the FEI Discord forum on Tuesday, he wrote: "@Everyone the PCV is safe and the protocol is still overcollateralized, we will move forward with a solution to help allow FEI to exchange for the fair market price."

As Brukhman put it, "Experimenters will experiment."