Algorithmic Stablecoins: Is it sustainable or a risky gamble?
In a world filled with High’s and Low’s of volatility, Stablecoin was created to be the bedrock of this maturing crypto space. Since its inception, Stablecoin has gathered a lot of scrutiny from regulators calling it “Poker Chips” to the transparency reserve being put in question. Of course out of all this one of them recently grabbed the headlines as not only the longest algorithmic stablecoin to survive but also lost almost 90% of its value in 2 days! So what is an Algorithmic Stablecoin? Is it really that sustainable to be considered a stablecoin?
What is an Algorithmic Stablecoin?
Cryptocurrency as we know was designed to be a much more efficient and decentralized solution to our traditional fiat money but to achieve that this new form of currency should have stability over its value. Fortunately, this is where stablecoin enters the picture as due to its peg to a form of the physical asset, it comes as the closest form to money. These pegs are obviously varied across stablecoin creating a different forms of stablecoin such as fiat money, commodities, or even other cryptocurrencies itself but essentially they were all meant to achieve stability of traditional fiat money combined with the decentralized technology of the blockchain system.
Lately, a new form of stablecoin has come under scrutiny with algorithmic stablecoin, an experiment or idea that has all failed in the past but was resurrected by Terraform Labs. So what is an Algorithmic Stablecoin you may ask? Algorithmic Stablecoin is stablecoin that uses codes to maintain the stability price instead of traditional collateral. It usually involves the creation of two coins in the network with one being the stablecoin itself and the other the native token of the ecosystem which will be used to peg the stablecoin to. Essentially the on-chain algorithm facilitates a change in supply and demand between them (the stablecoin) and another cryptocurrency that props them up.
Why would people want to do that? It’s because the people or arbitragers as we say are literally getting paid just to maintain the stability of the stablecoin at $ 1 and this could add up to a lot for a year. For the mechanism to work smoothly when you exchange a stablecoin for an equivalent of the native token is minted while the amount of stablecoin you exchanged is burned. This continuous process of minting and burning should keep the supply in check and thus maintain its price. Of course the system is much more complex in the real crypto space as a lot of other factors are involved but this represents one of the purest forms of decentralized stablecoin as it’s censorship-resistant and away from the traditional finance space.
The history of Algorithmic Stablecoin was as mentioned before has not been great, with most of them failing and ending up with no value at all. Although the concept and idea seem a genuine winner of having a truly decentralized stablecoin in the market, however the real-life attempts has not proven to be greatly applicable, here are a few of the previous attempt at algorithmic stablecoin:
- Rebase Model: The Rebase system was the first attempt at an algorithmic stablecoins and is used by various stablecoins like Ampleforth (AMPL). It operates on the basis of automatically adjusting the supply of the coin based on the current market price. If the price of AMPL goes higher than $1.05, more tokens are included in the supply, however, when it goes down to $0.95 coins are destroyed from the supply. This automatic supply adjustment is done to every holder proportionally irrespective of where it is stored and should be effective enough in keeping the price stable. Of course as we can see from the graph of AMPL this is not the case as it mimics the chart of the volatile utility coins due to its continuous adjustments instead of a stablecoin.
- Seignorage Supply System: This system is what we mentioned earlier which involves the use of two or more tokens to control the contraction and expansion of the supply. One of the most examples of this is the Basis Cash system which involves two other mechanisms called Shares and Bonds to control the price of Basis Cash. When the price of Basis Cash goes below $1, the system will print more coins, and the sellerwas given a share of these newly minted tokens. When the price goes above $1, the investors are allowed to purchase bonds that will pay them returns first from the newly minted tokens than the shareholders. This is again one of the attempts that stands the benefits everybody when the market goes up but when the market is down the coin literally plunges into a death spiral. Other examples of this system include Empty Set Dollar and Dynamic Set Dollar.
- Fractional Algorithmic Stablecoin: This system comes as a combination of regular stablecoin and algorithmic stablecoin which involves the use of physical collateral and codes to maintain its stability. This system is adopted by Iron Finance and Titan in 2021 with Iron Finance the stablecoin being backed by 75% of fiat collateralized USDC and 25% Titan, the native token within the ecosystem. Unfortunately, this system creates buying pressure for Iron Finance and inflates the supply of Titan which pushes both of these tokens down to a death spiral.
Unfortunately, the stablecoin industry has recently faced huge scrutiny from the SEC in trying to replicate the Fiat money in the crypto space and although algorithmic stablecoin was never pointed out, as of today this category will be heavily targeted by the regulators. All of this brought to the recent incident of the UST and Luna market crash which saw not only the value of these two tokens fall to below zero but also wiped off the $80 Billion Market Cap of the crypto space in less than 48 hours!
Some people might refer to this incident as a black swan or market manipulation from outside sources but there is a reasonable explanation as to why it actually failed. Terra’s UST as we see adopts a similar approach as Basis Cash which in this equation is the stablecoin and Luna the native token to which the coin is pegged. Through the TerraSwap ecosystem, the investors are allowed to swap UST for an equivalent amount of Luna and make a profit on the difference in price. Of course instead of the use of Bonds and Share, Terra Ecosystem uses the Anchor Protocol to play a key role in absorbing the supply of UST from the market and therefore maintaining its peg.
It’s all going well as both of the tokens are in the top 20 ranks of Coin Market Cap plus the Terra Ecosystem and its liquidity are growing at a massive pace. The question is what will happen when market sentiment is negative? 2022 has started that way as even though the market has recovered but the presence of war and skyrocketing inflation brought the Luna value down. As the Luna Value goes down, people will tend to seek for safe haven and where else is a better place than the Anchor protocol which offers a ridiculous amount of 20% APR. This then reduces the amount of Luna and create a massive supply of UST which is locked in the Anchor Protocol.
This sentiment was made worse when Ancor Protocol announced a decrease in interest rate level and then inflate the supply of the two tokens. With a massive supply, the price goes tumbling down and in a span of a week from when it was first de-pegged, UST’s price sits at 20 cents a coin while Luna went from $66 to a mere non existent value.
Unfortunately, a promise of a truly working decentralized stablecoin was squashed along with huge losses for all of its investors. So can this idea be worth experimenting if all of them fail? Is it sustainable to have this type of stablecoin in the long run?
Is it Sustainable?
There is some merit in the idea of creating decentralized stablecoins as it is quite possibly beneficial of having a stablecoin that can be a safe haven but is not quite affected by the off-chain factors such as inflation or economic crisis. The promise that it will enable crypto space to build a truly decentralized world is why there is so many attempts made on this idea. But the question to be asked is can we really prevent those outside factors from the crypto space?
Obviously not as we can see with the case of Terra’s UST that the fears and negative sentiment of the investors will always play a huge role in ensuring the working mechanism of these algorithms. Everything will seem fine when the crypto space is at its all-time highs and the economy is booming but what will happen if it doesn’t? Valuations will start to tumble and the mechanism that was designed to protect its stability ends up working against it.
To be fair the concept is smart and algorithms are always going to work as they are designed to be but perhaps in all these equations we forget the lessons learned from Fiat Money. When we keep on inflating a supply without any limit whatsoever and hope that market action will balance it out, that system will always be open to being manipulated. This is where collateral plays a role because it exactly limits the money from ever-expanding beyond its peg, of course unless the peg is not readjusted.
Unfortunately, algorithmic or non-algorithmic the essential idea behind a stablecoin is it should be able to maintain its value throughout the rise and fall in market conditions and you can only achieve that when the supply of a currency/coin is held accountable by its collateral.
We from Nagaya Technologies Pte. Ltd are really shocked by what happened to the crypto space and hopes there is a lesson that could be learned by all of us from this incident. We understand in the development of Nagaya the importance of collateral which is why we decided to back up each coin with gold to maintain the stability of its value while still allowing it to grow over the long run. This hybrid concept of cryptocurrency proves to be the first of its kind in the space and hope that it could deliver massive value to all of you. For more information regarding the latest updates on Nagaya and our whitepaper, you can visit us at nagaya.io
Or you can talk to us at t.me/nagayaofficial
