Mechanics of Algorithmic Stablecoins

Algorithmic stablecoins depend on market incentives to maintain a peg to the US dollar. This is done by balancing supply and demand. One example of an algorithmic stablecoin is the $UST. $UST was an $18.6 billion stablecoin that recently crashed. 

Conventional stablecoins rely on reserves and collaterals to maintain the 1:1 dollar peg. These reserves and collaterals can either be crypto-backed or fiat-backed. Crypto-backed stablecoins have an inherent risk because it is backed by a volatile asset or a bag of volatile assets. Protocols that use this mechanism will over-collateralize to create a safe buffer. 

This leaves algorithmic stablecoins as the only other option to fit into the narrative of decentralized money in a decentralized ecosystem. An algorithmic stablecoin requires the interaction of two crypto assets. The relationship between the stablecoin and the governance token creates an arbitrage opportunity that keeps the coin ‘stable’. 

If the stablecoin rises above $1, the stablecoin can be swapped for the governance token, returning a profit to the holder. Conversely, if the stablecoin dips below $1, the stablecoin can be purchased using the governance token, reducing the stablecoin’s supply and raising its price. 

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Market Assumptions

The problem with algorithmic stablecoin is the assumption that actors in the ecosystem are driven by incentives. The arbitrage system works on a basic assumption under ‘normal market conditions’ that incentives will drive supply and demand. However, the market does not always react rationally, and this results in the failure of the arbitrage system. 

Irrational market reactions are often temporary, and the market will eventually correct itself. Terraform Labs realized this risk and created a second layer of protection by having a sizeable reserve of Bitcoin ($BTC) to be deployed in ‘extreme’ market conditions. 

Death Spiral

Algorithmic stablecoin can fail, if the assumption is no longer applicable. A death spiral happens when the selling pressure creates a reflexive downward spiral and causes hyperinflation to the governance token. The value of the governance token will take a dip because the market is flooded by newly minted tokens. 

When a death spiral happens, the arbitrate system fails, and the reserves will not be able to maintain the dollar peg once depleted. 

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Decentralized Stablecoin

Stablecoin is the primary source of liquidity in the crypto market. Currently, $USDT and $USDC are the two leading centralized stablecoins in the crypto market. On the other hand, $LUNA and $UST managed to garner market confidence because the ecosystem realized a need for a dependable decentralized stablecoin. 

Algorithmic stablecoin has a systemic risk, and in an imperfect market, it is dangerous to rely on assumptions. $UST’s failure did not eliminate the need for a decentralized stablecoin. It merely ousts algorithmic stablecoin as the form of decentralized money for the ecosystem. 

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