“While there are plenty of automated stablecoin designs that are fundamentally flawed and doomed to collapse eventually, and plenty more that can survive theoretically but are highly risky, there are also many stablecoins that are highly robust in theory, and have survived extreme tests of crypto market conditions in practice,” Vitalik Buterin wrote in a May 25 blog post.
The apocalyptic collapse of the Terra (LUNA) ecosystem convinced many that algorithmic stablecoins are an inherently flawed child of the crypto industry. Justin Sun, the founder of TRON protocol, faced harsh criticism for rolling out USDD stablecoin which bears a striking similarity to Terra’s UST. Financial regulators across the world started to take aim at algo stables.
“[Stablecoins] run risks which could threaten financial stability,” said US Treasury Secretary Janet Yellen. “Risks associated with the payment system and its integrity, and risks associated with increased concentration if stablecoins are issued by firms that already have substantial market power.”
Unlike traditional stablecoins, this new breed of crypto assets isn’t backed by fiat reserves and instead relies on complex math. By adjusting the supply and demand of the stablecoin and volatile coin, the algorithm maintains a $1 target price. However, there’s one fundamental flaw in this elegant mechanism: it collapses when confidence in the stablecoin declines rapidly, inflicting a “death spiral.” The price of the volatile coin is derived from the anticipation of future network activity, so once there are signs of a slowdown, the system starts shaking.
“Firstly, the price of Volcoin [volatile coin] is falling. Then the stablecoin starts shaking. The system is trying to support the demand for stablecoins by issuing more volcoins. With low trust in the system, there are few buyers, so the price of Volcoin drops rapidly. Finally, as soon as the Volcoin price approaches zero, the stablecoin also collapses,” Vitalik wrote, adding that “the system's collapse can even become a self-fulfilling prophecy.”
For Buterin, the “ideal type” of an algo stable is Reflexer (RAI) stablecoin which is fully backed by Ethereum (ETH) and relies on an automatic interest rate algorithm incentivizing users to keep RAI at its target price range. Unlike UST, RAI won’t collapse in case of a sudden drop in trust since investors would still be able to withdraw their liquidity by exchanging RAI for ETH locked in safes that support the stablecoin and its lending mechanism. What makes RAI more stable is that it relies on the asset external to its network, so it has better chances of winding down safely.
However, the Terra-style collapse is still possible, Buterin adds. If RAI becomes the primary application on Ethereum, the reduction in expected future demand for RAI will dump the price of ETH leading to the crash of the system.
Another improvement to algo stables proposed by Buterin is to introduce some kind of a negative interest rate when the stablecoin tracks an index that grows 20% a year. According to Vitalik, there are only two possible outcomes: it either charges holders some kind of negative interest rate to “cancel out the USD-denominated growth rate built into the index” or becomes a Ponzi scheme “giving stablecoin holders amazing returns for some time until one day it suddenly collapses with a bang.”
“In general, the crypto space needs to move away from the attitude that it's okay to achieve safety by relying on endless growth, “ Buterin concludes. Instead of the race for growth, we should focus on the safety of the system, taking into account the most pessimistic outcome possible.
“It [system] could still be fragile for other reasons (eg. insufficient collateral ratios), or have bugs or governance vulnerabilities. But steady-state and extreme-case soundness should always be one of the first things that we check for.”