Algostables: An Illusion of Stability - WFM #204
What in the world is an algorithmic stablecoin, and why should I care?
Today marks the end of the first quarter of 2023, which means that we’re about 25% of the way through our journey writing about foundational topics in blockchain. While today gets a little in the weeds, having even a high-level understanding of the various topics in blockchain that we’re covering will prepare you for the coming technological revolution that’s underway. At the least, you may avoid buying a risky token. As always, reply to this email with any questions, suggestions, or comments. We appreciate hearing what you think!
Algostables: Stability, or an Illusion?
By Harrison Smith, Head of Research @ Future Mints
Technical Level: 🛠️ 🛠️
Stablecoins are cryptocurrencies that are intended to maintain a specific price that’s pegged to a government-backed currency (aka fiat) like the US Dollar. The price is not intended to fluctuate, hence why they’re called ‘stable’ coins. This means that owning $1 worth of the cryptocurrency is worth $1, and ideally this price doesn’t change because it’s “pegged” to the dollar.
There are different stablecoins available to buy, each has their own way that they keep their cryptocurrency pegged. The two biggest ones, Tether (USDT) and Circle's USDC, do this the old-fashioned way by having way more money (aka over-collateralized) backing their cryptocurrency than is in circulation. In other words, they have cash or a cash-equivalent asset surplus to cover every dollar put into their cryptocurrency. So each USDT or USDC traded in the crypto market is backed by what’s actually in the possession of the stablecoin issuers.
There have been occasional waves of concern regarding stablecoins. We discussed last week how Circle’s cash holding at SVB was thought to be impacted by the bank’s instability, but in general, stablecoins are stable because they’re backed by real assets that don’t fluctuate with market volatility. After all, a bank run is rare and not so much a market volatility issue as a market meltdown.
Algostables, shorthand for algorithmic stablecoins that use complex algorithms to maintain their stability, often masquerade as stablecoins. However, over the past few years, the majority of high-profile algostables have lost incredible amounts of value for their holders, and we’ve even seen some public figures behind some algostables charged with some sort of financial crime (we’ll talk about Do Kwon further below).
Today we’re going to cover the basic mechanics of algorithmic stablecoins, identify some of the most popular ones, and discuss the problems they’ve had.
The Basics
At their most basic level, algorithmic stablecoins use algorithms to keep a coin stable.
Algorithmic stablecoins are a type of cryptocurrency that are collateralized with another cryptocurrency (one that is not stable) and then use an algorithm to adjust the supply to maintain the peg in a process called ‘rebasing’. The ‘rebasing’ part is critical. While this type of cryptocurrency is pegged to the value of fiat (ie a government-backed currency), they’re backed by a volatile cryptocurrency and not fiat, which is part of their problem.
Rebasing is a way to programmatically increase or reduce the number of tokens (aka supply) of the algostable cryptocurrency depending on the price fluctuations of the main cryptocurrency that is collateralizing the algostable. This is done to peg the cryptocurrency to some government-backed currency, usually the U.S. dollar. In a bear market, it’s easy to see the flaw here, but when the market is booming, many people have difficulty imagining that the market will ever go down.
One other way that algostables try to maintain stability is via staking. Staking is a process where tokens are locked up for some period of time in return for some benefit, often a high interest rate. This increases stability, because you have to take extra steps to un-stake, so if tokens are staked, they aren’t traded at the same frequency as unstaked tokens. Think of it like a CD (certificate deposit, not compact disc). You put money in a CD to yield a higher interest rate, but you can’t pull your money until the predesignated time period is over. Often with algostables, there is no predesignated time period, though.
The algorithms that keep algostables pegged to the given currency are built into a smart contract, which means that the algorithm is public and often cannot be changed without significant effort and authorization.
As you can probably already tell, the main problem here is what happens if the underlying cryptocurrency loses so much value that the supply of the algostable can’t keep up. Many people learned this the hard way.
Early Beginnings: DAI vs. UST
There is nothing inherently wrong with algostables. The problem arises when the backed assets no longer equal or exceed the value of the algostable. To see this evolution, it’s important to start with DAI.
Maker DAO first launched DAI in 2017. Users lend ETH to Maker DAO and receive DAI in return. The ratio for the loan is 1.5 ETH for 1 DAI. If the price of ETH fluctuates so that the ratio is below that threshold, then the loan can be called (meaning there’s a forced redemption). The purpose of this is for a user to be able to get access to dollars without having to sell their Ethereum. In addition, the user who takes this loan must pay an interest rate.
The ride was not always smooth.
DAI’s original collateralization was Ethereum. If you recall, 2017 was a boom period for crypto, but the prices came crashing down in 2018. Which means that DAI also suffered during this time and it survived with the help of external investments (Andreesseen Horowitz).
However, DAI did survive, and because Ethereum has increased substantially in value, the collateralization of DAI has remained healthy.
Three years after DAI first launched, Terraform Labs announced their own algostable, UST. UST was an attempt to emulate DAI using Luna, instead of Ethereum. It was intended to be a direct competitor, and claimed to be the cure to DAI’s scalability issues. UST, similarly, was meant to maintain a $1 price peg.
Notice the word ‘burn’. In the crypto world, when you burn something, it’s destroyed forever. In this case, the LUNA token is removed from circulation when its burned and in return you receive 1 UST (aka TerraUSD).
By late 2020, the Terra ecosystem had exceeded a billion dollar market cap, and on the outside, all looked great.
However, there were two issues.
The 1:1 ratio meant that there was a smaller margin for error. In DAI, the 1.5:1 ratio meant that there was a buffer for ETH to go down. In UST, there would be no buffer. So if Luna were to fall in price, then the entirety of UST was at risk.
Luna had not reached anywhere close to the scale that Ethereum had, and it was even more volatile.
The Terra/Luna Implosion
The 2022 bear market’s winter storm forced a number of casualties throughout the algostable world. In a bull market, assets being deposited as collateral (such as ETH) are going up, so treasuries end up over-collateralized in USD value. In a bear market, the exact opposite happens, and 2022 proved to be a whopper.
When 1 ETH went from $4,000 to $2,000 (and below)… all of a sudden the treasury is at a deficit. And most cryptocurrencies dropped at similar rates. The stablecoins generally stayed stable (which was a big deal and important), but the algostables were tied to the cryptocurrencies so they faced more pressure.
It’s the same concept as trading traditional stocks on margin. If your collateral is no longer sufficient (meaning the stock you bought on margin has lost value), you need to add more collateral or you’re forced to sell and eat the loss.
And just as a typical bank run would happen on an under-collateralized bank (see SVB’s recent experience), or under-collateralized stablecoin, the same thing is certain to happen to an under-collateralized algorithmic stablecoin.
In March 2022, Do Kwon and the Terra team formed the Luna Foundation Guard (LFG - also a common acronym in the crypto for Let’s F*cking Go. Side note: Maturity is not a hallmark of the crypto space at this time.). The intent was to stop UST from becoming depegged. The LFG raised $1 billion through the sale of LUNA tokens, with Jump Crypto and Three Arrows Capital being the lead investors.
Do Kwon also began making bold statements on Twitter, trying to force UST into a superior position to its self-declared rival, DAI.
The majority of this $1 billion raised by the LFG was spent on Bitcoin, buying the bear market dip and then using it as collateral to defend UST’s $1 peg.
However, the price of Luna was being hit hard, so even the $1B from LFG wasn’t enough to keep the price of UST stable (remember UST was backed by Luna, so if Luna’s price goes down, UST can’t maintain it’s 1:1 peg with the USD).
This created a situation where UST was trading less than $1.
When this happened, short sellers began borrowing UST so that they sell it which drove the price down further. Short sellers make money by buying back UST after the price has cratered. This vicious cycle is common in the stock market, and it’s led many prominent shareholders and CEOs to lament the role of short selling. The reason is because, just like a run on a bank that’s often driven by fear more than rationale though, short sellers can kill companies. Or in this case, cryptocurrencies.
Despite Kwon and LFG’s best efforts, UST was crippled shortly by May 2022, dropping almost 98% in a matter of weeks.
The impacts of the collapse of the Terra/Luna/UST ecosystem were felt throughout the entire crypto world. BILLIONS of dollars worth of crypto were drained from the Terra protocol, simply through the token’s design. BTC and ETH prices would continue to tumble, and investors in Terra/Luna were crippled by the implosion.
This was such an impactful event that it eventually led to the collapse of Three Arrows Capital, the hedge fund that acquired a massive position of LUNA in the LFG sale.
Just this past week, Do Kwon was finally arrested by police in Montenegro, and he is expected to face criminal charges including “conspiracy to defraud, commodities fraud, securities fraud, wire fraud and conspiracy to engage in market manipulation.”
Do Kwon is specifically accused of making untrue/misleading statements of material fact, recruiting a “United States trading and investment firm" to alter the market price of UST, and defrauding purchasers by misrepresenting effectiveness of UST’s algorithmic stability mechanisms.
While there are many factors at play here, including allegedly illegal market manipulation, the structure of UST’s algostable cryptocurrency played a key role in the demise of both UST and Do Kwon.
What’s Next?
To reiterate, there is nothing explicitly wrong with algostables. Using mechanics to ensure proper collateralization is a good idea, in theory.
However, it hasn’t worked out that way due to the high volatility inherent in the crypto space. Almost every algostable gives an illusion of being a stablecoin, without having long-term stability. To call something a “stablecoin,” it needs to be able to solidly withstand bear market pressures - and backing a token algorithmically with an already volatile asset is a recipe for disaster.
Maybe one day this will be solved, but today it is certainly not.
Moreover, how can you expect a first-time crypto user in 2021 to know that USDT (aka Tether) and UST (aka Terra) are significantly different?
You can’t. They have similar tickers and prices, and they’re both described as “stablecoins”.
The idea of algostables is often terribly dangerous to the crypto novice, who buys tokens like UST thinking there is no risk.
This is simply one more reason why thoughtful regulation is desperately needed in the crypto space. To be clear, what the SEC and Federal Reserve have done to date is not thoughtful, and it’s almost certainly going to undermine the crypto space in the US if they don’t change their approach. But that’s a topic for another day.
Sadly, there isn’t enough clear information out there for the average retail consumer, which means it’s your responsibility to understand what you’re buying. Thankfully, you have Future Mints to help explain these nitty gritty details to you.
News of the Week
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Binance and CEO CZ have been issued a suit from the U.S. Commodity Futures Trading Commission (CFTC). The CFTC alleged Binance offered unregistered crypto derivatives products and directed U.S. customers to evade compliance controls through the use of VPNs.
After just a week since its launch, Magic Eden now accounts for more than half of Ordinals inscription trading volume across marketplaces.