The Great Algorithmic Stablecoin Experiment

Written by BTSE

May 19, 2022

The Great Algorithmic Stablecoin Experiment

Written by Antonio Liao, Researcher at BTSE

At a Glance: 

  • The popularity of stablecoins has given rise to algo stablecoins, a decentralized variation that operates completely on-chain and maintains its peg through supply- and demand-driven algorithms.
  • Despite being a popular alternative to collateralized stablecoins, the Terra debacle and previous failed projects have brought the risks and vulnerabilities of algo stablecoins to light.
  • The collapse of UST and LUNA has validated concerns over the sustainability and reliability of collateral-free algo stablecoins.
  • However, the future of algo stablecoins is not all grim, as the DeFi community continues to search for decentralized and capital-efficient crypto-native stablecoins.


The Stablecoin Ecosystem 

To understand what algorithmic (algo) stablecoins are, let’s first take a step back and familiarize ourselves with the stablecoin ecosystem. 

Stablecoins, whose values are pegged to the price of an underlying asset such as a fiat currency or tangible commodity, do not fluctuate as significantly as other crypto assets in price. Today, there are four main types of stablecoins — fiat-collateralized, crypto-collateralized, commodity-collateralized, and algorithmic stablecoins — that offer beginner and veteran crypto investors a seamless segue between fiat and crypto assets. 

As crypto adoption grows in popularity, we have seen a proliferation of stablecoin projects in the DeFi space, given the price stability and lower barrier of entry. The top three stablecoins to date by market cap, Tether (USDT), USD Coin (USDC), and Binance USD (BUSD), are all USD-pegged. 

Moreover, the skyrocketing demand for stablecoins by DeFi platforms, centralized exchanges, and crypto investors also contributes to much higher interest rates than those on actual dollars. 

Noteworthily, with more stablecoin projects and holders than ever, the utilities for stablecoin have also expanded into areas of payment, settlement, remittance, and escrow.

While collateralized stablecoins have contributed significantly to the rising popularity of crypto, their intrinsic shortcomings have given rise to a unique breed of stablecoin known as algorithmic stablecoins. 


What Are Algo Stablecoins  

Unlike its off-chain collateralized stablecoin predecessors, an algo stablecoin runs on algorithms to maintain the peg to its reference asset (i.e. 1 UST = 1 USD). That said, an algo stablecoin does not need any collateral and is supposed to be more decentralized and “transparent” than a collateralized stablecoin. 

In a nutshell, the on-chain algorithm that an algo stablecoin runs on ensures its value is pegged to a fiat currency by regulating the supply and demand mechanism in the market. Usually, the supply and demand are regulated through the relationship (most of the time through burning and minting) between the stablecoin (i.e. UST) and its backing token (i.e. LUNA). 

The case in point is Terra’s UST and LUNA, the algo stablecoin that worked until it didn’t. The relationship of the two tokens used a burn and mint mechanism, meaning the minting of a UST required a LUNA to be burnt, and vice versa. The burn constringed the supply of the given token, driving its upward price pressure. Since $1 UST can only be redeemed for $1 of LUNA, should UST dips below $1, the trader could burn 1 UST and be paid to do so with $1 of LUNA. In doing so, the trader could pocket the difference between UST and LUNA on arbitrage. 

One of the biggest appeals for investors to hold UST is to earn an interest rate of as high as 20% by depositing UST in Terra’s lending and borrowing protocol – Anchor Protocol. Two weeks before the collapse, roughly 72% of all UST in circulation was locked up in Anchor. 


How Algo Stablecoins Fit in the Picture

Now, you might wonder if the primary purpose of a USD stablecoin is to peg its value to that of the US dollar, then doesn’t it make more sense to have the actual US dollar as collateral instead of depending on some algorithm? 

To answer the question, we must understand the risks and perhaps controversies associated with collateralized stablecoins. First, the centralized nature of these collateralized stablecoins has made them susceptible to regulatory, censorship, and counterparty risks that can directly affect the value and security of the reserve. 

Second, what makes algo stablecoins even more enticing is some of the collateralized stablecoin issuers have not been particularly forthcoming about their fiat and other financial reserves. Such reservation has been fueling speculation and distrust toward some major collateralized stablecoins.    

Lastly, the lack of capital efficiency often troubles fiat- and crypto-collateralized stablecoins, which means that the more stablecoins issued, the more collateral will be needed to back the peg. 

Even so, regardless of the model of any algo stablecoin, it is essentially an intermediary-free and inflation-proof asset, meaning that algo stablecoins, if successful, offer what the DeFi community has been longing for. 

The lucrative earning opportunity coupled with a bright prospect eventually made UST the third-largest stablecoin by market cap in its heyday. 


But Nothing Is Perfect…

However, as promising as algo stablecoins may seem, the project has seen its fair share of failures and, of course, controversies, too. The UST collapse, once again, brought algo stablecoins under the spotlight, raising questions over the stability of stablecoins alike. 

Looking back on the history of algo stablecoins, there is no shortage of failed projects. From TITAN’s crash to Basis Cash’s explosion, many critics associate algo stablecoins with get-rich-quick Ponzi schemes, claiming that algo stablecoins will never work and are “perpetually vulnerable”

For as long as UST had worked, Terra and UST were used as the prime case to counter the Ponzi scheme allegation since the Terra ecosystem, unlike TITAN, offered investors the purpose to hold UST and use it for DeFi products and services. However, the UST collapse proves again that concerns over algo stablecoins are not unwarranted. 

The UST collapse epitomized that the decentralized nature of algo stablecoins is a double-edged sword. Since algo stablecoins are uncollateralized, they rely on market expectations and the arbitrage mechanism to keep UST and LUNA’s valuations afloat and therefore maintain the stablecoins’ peg to the reference assets. 

As we see from past cases and the UST collapse, the reliance on investor confidence and demand can be dangerous, as it is susceptible to runs and death spirals during a crisis in confidence. 

What we saw in the past week has shown how LUNA’s drop in value caused a general panic over a potential UST depeg, leading to a bank run on UST. Due to UST and LUNA’s burn and mint mechanism, more LUNA were minted, further driving down its value, and the entire cycle replayed itself as the so-called “death spiral.” 

UST was not the only algo stablecoin that is prone to “herd-like” sell pressure, as other stablecoins such as FRAX and USDN operate on similar models and are equally uncollateralized and vulnerable to speculative attacks. 


What’s Next for Algo Stablecoins  

Some have argued that the UST collapse is the final nail in the coffin for algo stablecoins, and the great algo stablecoin experiment has had a good run but to no avail. However, DeFi projects have come and gone, and many have withheld market and psychological stress tests despite early hiccups. As for algo stablecoins, only time will tell if they are a viable long-term solution. 

Meanwhile, the implications of the UST collapse extend well beyond the financial loss, as the ripple effects are going to set the tone for regulatory and institutional discourse for stablecoins. As a matter of fact, the US, Korea, UK, Singapore, and several other countries are now ramping up regulatory efforts targeting stablecoins. 

While Terra and Do Kwon may be out of the picture, it does not necessarily mean algo stablecoins are dead. Given the burgeoning interest in decentralization and intensifying regulatory scrutiny, “crypto-native” algo stablecoins still offer an enticing option for the DeFi community. At the end of the day, algo stablecoins are dubbed the “holy grail” of crypto for a reason.


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Note: BTSE Blog contents are intended solely to provide varying insights and perspectives. Unless otherwise noted, they do not represent the views of BTSE and should in no way be treated as investment advice. Markets are volatile, and trading brings rewards and risks. Trade with caution.

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