Why Algorithmic Stablecoins are never stable.
Updated: Aug 23, 2022
Stablecoin, the concept of traditional money like the liability of the central banks and expressed in a cryptographic money form, enables open protocol on the public internet to allow everyone to store and transmit/transact that value. The world is excited about the idea of taking the money tied up in databases, treasury bills, or cash in a central bank system and unlocking that with the capabilities of cryptocurrency and public internet protocol. Stablecoin is always about how we take the legacy money system and create a public watching base alternative to that.
While some emphasize that stablecoin can fully replace traditional money as a money substitute for salaries, consumer transactions, or deferred debt payments, some believe that algorithmic stablecoins are the way to “recreate” traditional financial systems and work as fractional reserve systems in decentralized finance (“DeFi”). Nonetheless, both statements have overstated the utility of such a product, and we are here to deep down with you guys about the reason why algorithmic stablecoins are inherently fragile.
Stablecoins are crypto-assets that attempt to peg their value to another asset, including reserve currencies or highly-liquid government bonds, and algorithmic stablecoins are typically undercollateralized and use market incentives, automated smart contracts, reserve token adjustments, and arbitrage opportunities to attempt to maintain a stable peg. These coins exist in a system that is prone to destabilization and runs when there is a deviation in reality from the assumptions underlying the embedded incentive structure. This structure requires a support level of demand for operational stability for the entire ecosystem to continue to operate, meaning it is inevitable to encounter a failure if demand falls below a threshold level. As algorithmic stablecoins do not have a fractional reserve or backstop system, the whole ecosystem will break down and fail when the world has doubts or disbelief in its incentive structure. It is common to see algorithmic stablecoins value falling below the peg as excitement is gone and the market is surrounded by anxiety, causing an even more severe of lower demand and higher supply, the price then falls.
The model of Terra (UST) is using the idea of making money, putting it into a BlackBox, and expecting a return. Oftentimes the returns come from VCs and big firms, in this case, Jump Crypto, Binance, Three Arrows Capital, or coming from printing new money. Terra did that with its Anchor protocol, offering an unsustainable 20% yield and encouraging users to lock up and not sell the tokens which the fans had seen as a gift from heaven. Meanwhile, UST’s algorithmic relationship with LUNA means that the latter has to absorb the volatility of the former so UST can maintain its 1:1 parity with the U.S. dollar. The price of UST goes above $1 if the supply is too small and demand for it is too high. Terra protocol lets users trade 1 USD of LUNA for 1 UST at the Terra station portal to bring UST back to its peg. As the supply increases, the price eventually comes down. Since new LUNA can be continuously minted any time UST is below $1, the price of LUNA will free-fall in the face of increasing token supply. Such a model ultimately has a finite amount of runway and relies on traders burning or creating tokens for profit to maintain its peg to the U.S. dollar. We are not here focusing on the consequences of UST / LUNA we already knew how the tragedy happened and UST failed to support the level of demand for operational stability.
UST and all other failed algorithmic stablecoins like TITANS have showcased that such financial products which require a baseline or heavy demand and support so as to work out are only doomed to failure once demand evaporates. Such algorithmic stablecoins ecosystem greatly pins their fates on the arbitrage activity between their tokens as well as sufficient transactional fees in the ecosystem and mining demand in the network. It is relatively unreliable to trust something could become “stable” if it could be heavily impacted, or we can say dominated by its demand. The reliance on continuous demand and baseline support will always be a significant issue for algorithmic stablecoins. Even if they have deviated and survived from depegging in the past, the peg will fail eventually. The fate of the stablecoin should never be a prayer to Jesus (in this case the notorious Terraform Labs founder Do Kown) or the crowd and such a model is inherently fragile. Many investors may blindly FOMO into the tempting “passive income” and lack the awareness that such financial products with no real collateral, lack transparency, supervisory, prudential safeguards, and most importantly guarantee from the authority.
No one is a winner in such an incident and the whole crypto space will suffer from a significant domino effect in the foreseeable future, including the breakdown of other parts of the Terra ecosystem, the strict regulation on stablecoins, and a heavy tax on crypto earning, you name it. While there are still vigorous debates on who should be blamed for this chaos, it is more important for the survivors to pick up the pieces and rebuild the spaces. Speculation on DeFi trading applications is still insufficient, and there’s an urge for a stronger regulatory framework, with risk disclosure and containment safeguards, especially regarding algorithmic stablecoins. Ending the article with a quote from my favorite CT - Sassal ‘Stop “experimenting" with ponzis, algostables, yield farming, and other unsustainable nonsense. Start experimenting with public goods funding, governance/DAOs, decentralized identity/reputation, regenerative finance, and privacy tools.’ To all the builders out there, godspeed!