Stablecoins are unlikely cryptocurrencies – a bridge between the established world of fiat currencies and its emerging decentralized challengers.
Algorithmic stablecoins take that paradigm a step further by eliminating the fiat component and replacing it with token economics on the blockchain. The challenge of creating a free-standing currency to bridge the fiat and crypto worlds has attracted many developers and the number of algorithmic stablecoin projects has multiplied in the last couple of years.
But things haven’t been gone according to plan lately. Many algorithmic stablecoins have repeatedly lost their price pegs. Hacks, such as the recent one on Beans, have further highlighted their code’s susceptibility. A dip in cryptocurrency markets has exacerbated the situation because it means that algorithmic stablecoins need more reserves to maintain their peg.
These problems could be part of growing pains for stablecoins or they could signal a beginning of the end for such coins.
Maintaining Price Parity
The ambitions of algorithmic stablecoins are grand: to replace the workings of a central bank with an algorithm. The first step to achieving that goal is relatively prosaic: maintaining a price peg of US $1 relative to the coin. Asset-backed stablecoins, like Tether and USD Coin, ensure that peg by backing each digital coin with its equivalent in fiat currency.
The process is more complicated for algorithmic stablecoins.
Some coins peg their prices to other cryptocurrencies. For example, MakerDao’s Dai requires holding of Ethereum ether in smart contracts, like escrow, to before trading or lending the coin. Others manipulate supply by adding or subtracting from the total quantity available to traders.
In the seignorage model, new coins are issued as shareholder tokens or bond tokens. Users buy and resell the coins in open markets to reduce supply when price increases for the former case. Bond token holders decrease supply by purchasing coins at a discount to the stablecoin’s price. Rebasing overall coin numbers through automatic addition and subtraction of tokens held in user wallets is another common tactic.
The secondary token model is designed using another token as a counterweight to the stablecoin. Thus, existing coins are burnt or removed from circulation and new secondary tokens are minted, when a stablecoin’s price increases relative to its peg. New coins are issued and secondary tokens removed from circulation, when its price decreases relative to the peg.
Both models assume that there will be demand for the stablecoin tokens and that individual actors, motivated by profit, will step in to maintain the peg. But there are no clear use cases for algorithmic stablecoins. According to the European Central Bank, an algorithmic stablecoin derives its value from “the expectation of future value.”
Many stablecoin developers are attempting to bring that future value to the present by constructing virtual economies to support demand for their coins.
For example, Terraform Lab’s Terra stablecoin, the crypto market’s fourth biggest stablecoin as of this writing, is used only in a ‘Terra economy’ that includes a lendings and savings platform called Anchor and a partner payments platform called Chai. Terra’s use on these platforms has propelled the stablecoin’s valuation to $17.6 billion, as of this writing. Its secondary token LUNA, which is burned or minted depending on Terra’s price, had a market cap of $33 billion.
The Problems with Algorithmic Stablecoins
Even as they claim to unshackle the financial ecosystem from centralized controls and fiat currency, most algorithmic stablecoins ultimately work to maintain a peg, mostly indirectly, to the US dollar or other fiat currencies. For example, MakerDao’s DAI has significant holdings of USDC – a centralized stablecoin issued by a single firm and backed by a fiat currency. It was forced to initiate this position in its search for liquidity after Ethereum’s ether lost 30% of its value in a price crash on March 12, 2020. That put $1.8 million ETH locked in Dai Collateralized Debt Position (CDP) contracts in danger.
The move was a controversial one for MakerDao because it meant compromising on the blockchain’s decentralized ethos by joining forces with a centralized agency. By the way, this is not the first time that ether’s price has caused havoc with DAI’s price peg.
This case also highlights another fundamental problem with the structure of algorithmic stablecoins: a price crash in one can set up a cascade of price declines in other coins. It is relatively easy to maintain a peg when the stablecoin has a small market capitalization. But it becomes complicated to maintain parity when price increases and the protocol is forced to hunt for other assets to maintain the peg in a thin liquidity ecosystem as happened in the case of MakerDao’s Dai.
Price stability, a key function performed by centralized actors in the mainstream system, is another unanswered question. The founders of algorithmic stablecoins will have you believe that markets are the best determinants of prices. But independent actors and traders, whose actions move stablecoin markets and maintain the price peg, have no legal obligations perform this duty.
Experience has shown that they do not always measure up to the task. A November 2021 paper on algorithmic stablecoins by Dr. Ryan Clements from the University of Calgary points to the reluctance of arbitrageurs to step in during the 1987 Wall Street crash that was exacerbated by algorithmically controlled portfolio insurance products. [The algorithms continued to sell futures contracts that were supposed to hedge portfolios even as prices of the underlying securities dropped].
Iron Finance, a partially collateralized stablecoin, is a similar example in the crypto world. TITAN token, which was used to stabilize price of the IRON stablecoin, jumped 542 percent to a record high of $64.19 in June 2021. Cryptocurrency whales cashed in at that price point, setting off a downward price spiral to nearly $0. Meanwhile, IRON’s peg with the US dollar crashed to $0.7. Individual and institutional crypto traders refused to intervene as the stablecoin lost its peg.
The absence of regulatory oversight also means that algorithmic stablecoins are also susceptible to problems that plague other unregulated asset classes. Investors do not have a legal recourse during stablecoin runs. “If the tokenomic incentive structure in any algorithmic stablecoin ecosystem breaks down, the entire ecosystem fails without a backstop or depositary insurance net,” writes Dr. Clements.
Recent attempts at designing stablecoins without backstops stand on tenuous ground. Terrafirma’s Terra has come under increasing criticism for burning its yield assets (i.e., destroying them) in order to pump up demand for its coin. 74% of Terra’s use cases come from a single lending protocol, Anchor, which offers yields as high as 20%. A March proposal caps further changes to the interest rate at 1.5% in either direction.
What happens if Anchor is hacked or crashes? Investors will lose their shirt and the reputation of algorithmic stablecoins, already tenuous at best, will take another hit.
Terraform is spending heavily to maintain the peg. In the past month, it is reported to have spent as much as $100 million on shoring up the value of Terra relative to the US dollar. As part of this strategy, it has invested in a wide range of assets, including Bitcoin and tokens for the Avalanche blockchain.
Given recent negative press coverage about its hijinks, it is not clear if Terraform will survive or join the graveyard of algorithmic stablecoins. [It has strong backers, including a former hedge fund manager who has tattooed its logo onto his arm]. But it might prove to be an effective testing ground for the economics and viability of algorithmic stablecoins.