Programmed To Fail
After the Collapse of IRON and UST, Are Algorithmic Stablecoins Dead?
In times of peace and prosperity, we often pause to wonder whether this is the calm before the storm, and cryptocurrencies have certainly experienced some wild weather in recent years. The relative calm of April 2022, a month of strong growth and prosperity for Terra’s LUNA token and the UST stablecoin, belied the weakness inherent in its design. By May, the clouds surrounding it were dark and heavily impregnated with rain that threatened to wipe out the idea of algorithmic stablecoins altogether. Do Kwon, captain of the ill-fated Terra-LUNA ship, made some last-ditch efforts to steady the course, but that wasn’t enough to ensure its survival. Based on the failed architecture of the UST algorithmic stablecoin, should we bury the idea for good? Before attempting to answer this question, let’s look at what algorithmic stablecoins are and how they work.
What Are Algorithmic Stablecoins?
Algorithmic stablecoins make use of a two-token model whereby the value of the pegged stablecoin is backed by a balancer token. An algorithm employs smart contracts to maintain the stablecoin’s consistent 1:1 ratio with the fiat currency it’s pegged to. Traders benefit from arbitrage, which involves either buying or selling their holdings for profit whenever the stablecoin slips from its 1:1 peg. In the case of the Terra blockchain, users were able to exchange (burn) one U.S. dollar’s worth of LUNA for 1 UST and vice versa at any time. Depending on the market price of UST, users could then profit from using it to buy or sell U.S. dollars. In theory, this continuous mint and burn activity in response to supply and demand would push UST’s price back to parity with the dollar.
Despite the advantages of this model, there are systemic issues that have led to the catastrophic failure of top algorithmic stablecoins. Let’s dig into this model to understand the reasons for these failures.
Algorithmic Stablecoins Are Built to Fail
The algorithmic stablecoin model is utopian in outlook and not built for a crisis.
As good as the idea behind algorithmic stablecoins sounds, in theory, with the much-touted burn/mint mechanism to maintain its peg, it is not crafted for real life and has failed over and again to pass a market stress test. Recent examples include Iron Finance, and more recently, Terra. Furthermore, some regulators argue that algorithmic stablecoins have no true peg and derive current value only from expectations of their future market value.
A major problem with algorithmic stablecoins is in their architecture, which assumes that the balancer token will remain stable or even appreciate. This assumption gives no space for the worst-case scenario of the balancer token dropping in value. Arrogantly holding on to this ideal without giving room for the reality of market downturns has prevented stablecoins from having a backstop that could save the ecosystem in case things go downhill. This makes the model a ticking time bomb.
Every major case of failure has arisen from a situation where the balancer token was unable to withstand a market crisis. Once the demand for the balancer token is affected and the price falls, the whole house of cards comes tumbling down. It falls very quickly due to the absence of a backstop to cushion the effect of the failure of the system. That is, it has no additional fiat backing.
A system built for only the good times without insurance for the bad times is built to fail.
The basic diagnosis of algorithmic stablecoins is that the burn-mint mechanism cannot help the stablecoins maintain their peg when the fall in price occurs. Algorithmic stablecoins are a contradiction in terms, since they fail to maintain the required stability regardless of market conditions. They are a speculative, utopian, and glass-eyed system that only functions when things go according to plan and market conditions are favorable.
A Post-Mortem of Iron’s TITAN and Terra’s UST
In a post-mortem document, Iron Finance called the crash of its TITAN token “the world’s first large-scale crypto bank run.” As it happened, this would not be the only large-scale crypto bank run. A year later, something similar happened to another algorithmic stablecoin, UST. Why would this lightning strike twice?
The crack in Iron Finance’s armor first occurred on June 16, 2021, when its balancer token, TITAN, fell from 65 USD to 30 USD in two hours, causing IRON — the ecosystem’s stablecoin — to lose its dollar peg. TITAN recovered to 52 USD an hour later, and IRON regained its dollar peg. This victory was short lived.
What caused this initial shake-up? Iron Finance revealed that “some whales began to remove liquidity from IRON/USDC, then sold TITAN to IRON and then IRON to USDC directly to liquidity pools instead of redeeming IRON, which caused the IRON price off-peg.”
At this point, Iron Finance considered their code battle tested after surviving over a dozen de-pegging scares. However, this latest shake up triggered a death spiral that eventually ate the ecosystem and saw TITAN crash to 0.94 USD.
TITAN is reported to have suffered a price increase from the 60-min delay in TWAP (Time Weighted Average Price) from its price feed oracle, making it unprofitable for arbitrageurs. IRON’s failure exposed the issues with relying on independent arbitrage to maintain the stability of an algorithmic stablecoin and it opened our eyes to a hidden rule in maintaining a crypto project. You can survive the loss of a few whales without being wiped out, but if their activities are not managed or inspire uncertainty in retail users, then the chance of the project surviving is near zero.
We can also add that IRON was 75% collateralized with USDC, while the remaining 25% was with its native token, TITAN. So from the look of things, Iron Finance attempted to create a dollar from 75 cents with the hope that the value of TITAN would remain the same or rise. And they were heavily punished for this overtly utopian outlook that didn’t consider the worst-case scenario.
Barely a year after the failure of Iron Finance’s algorithmic stablecoin, LUNA’s algorithmic stablecoin UST would go down under similar circumstances, with whales manipulating the ecosystem in a Soros-esque fashion, leading to a mass panic among users who were wary of an already shaky crypto market.
The independent arbitrage model for algorithmic stablecoins is a ticking time bomb.
Evidently, lightning struck twice, this time establishing that the independent arbitrage model for algorithmic stablecoins, which requires whales to redeem the minted balancer tokens in times of market stress, is a ticking time bomb.
Four Reasons Why Algorithmic Stablecoins Are Built To Fail
1. Dependence on high demand for the balancer token without considering market changes.
The ecosystem requires consistent demand of its balancer token for it to optimally operate, but there are no guarantees that this level of support will hold during crises. This refusal to accommodate the worst-case scenario is one reason why the system cannot withstand any shock in the market.
2. Whales and independent arbitrage activity required to maintain the peg always fail when the market experiences a downturn.
For better or worse, large holders play an influential role in crypto ecosystems. The algorithmic stablecoin system requires price-stabilizing arbitrage to maintain a stable ecosystem, and it relies on whales who are independent actors with market incentives to perform this. Whales can choose to pull their liquidity from an ailing ecosystem whose future is uncertain, which is a major problem when their activity is what maintains the stability of that system. The major failures of algorithmic stablecoins show that, time and again, these actors have chosen their personal interests over maintaining the ecosystem. This arrangement is fragile at best, and disastrous at worst.
3. Information opacity common to the ecosystem is bad in a market downturn.
The incentive structures and informational opacity on the tokenomics of algorithmic stablecoins hurt the ecosystem during a crisis. Lack of transparency leads to uncertainty, and in a crisis investors will follow the crowd in making decisions that are harmful to the ecosystem. Market volatility suggests many crypto retail investors do not have a long-term market strategy, so they’re quick to jump ship once there’s any sign of trouble attached to a project. This is one reason why few projects bounce back from such failures.
4. The burn/mint mechanism cannot maintain a peg when demand is low.
When there is a secondary market crisis, such as the current crypto winter where the crypto market remains on a bearish trajectory for months on end, most assets consistently trade at less than 40% of their all-time high. The low demand from this market condition hits the burn/mint mechanism hard, and it hardly survives. When there is low market liquidity, the ecosystem faces its first shock — in this case, the de-pegging of a stablecoin. This has been followed by a liquidity run that, if not checked, will implode the system. And this will occur despite the mint/burn mechanism working properly.
A Community-Led Algorithmic Stablecoin Comeback
After dissecting the algorithmic stablecoin model, and exposing the faults that have made this ecosystem fail time and again, there is a temptation to cast the idea aside as one of those inventions that will never work. Most of all, they need strict self regulation to put the ecosystem in check. Let’s look at how community led regulation could help to stage an algorithmic stablecoin comeback.
Getting Things Right Through Self-Regulation
Innovation is one of the cornerstones of decentralized finance. It is also its major competitive advantage, and strict government regulation would effectively erode this advantage. A basic premise of decentralized finance is to reduce the effect of external influence on the financial system, and its structure gives little or no room for centralized control. A solution? Strong community regulation to get things right and reduce possible government interference. In this case, after observing the failure of the algorithmic stablecoin model, the crypto community can weigh in to enforce certain measures to reduce the risk of failure and insure investors. The crypto community needs to exhibit this level of maturity to push back on increased government regulations. To rebuild the case for algorithmic stablecoins, the following are some focus areas for community regulation:
Enforcing a Backstop
One of the top regulatory moves the crypto community can introduce for algorithmic stablecoins would be a backstop to compensate investors in the event of failure. The backstop could be in the form of any class of asset to insure the balancer token. Regardless of the form the backstop takes, the community should be diligent in ensuring that a backstop exists. The existence of a backstop will help prevent algorithmic stablecoins from deeply losing their peg and falling to zero. Although some have hailed the algorithmic stablecoin model as a re-creation of the traditional fractional reserve system, the model is a far cry from the traditional system without the backstop. The reserves will also build confidence in retail investors. In the case of a market shake up, they can feel rest assured that their investment is insured, thus reducing the possibility of a mass liquidity run.
Transparency and Full Disclosure
Regulations should also place restrictions on stablecoin issuers. Carlo R.W. De Meijer suggests some regulatory approaches to ensuring transparency and full disclosure from stablecoin issuers, such as a defined taxonomy that clarifies the stablecoin forms (in this case the algorithmic stablecoin), prudential rules, collateral custodial safeguards, as well as reporting transparency, risk disclosure, and containment measures. Rather than relying on the government to provide these guidelines, the crypto community can come together to write and enforce these guidelines across multiple protocols. This will give the investor vital information to make decisions and take the right actions in the event of a market crisis.
A Way Forward
Independent market-driven arbitrage by whales was at the heart of the failure of IRON, and again in the failure of Terra’s UST. This means that if algorithmic stablecoins make a comeback, this fault must be resolved. The remedy is strong community regulation that mandates and strictly monitors the activities of the obligated arbitrageurs. In the end, this is a potent way to check their activities and forestall future crypto bank runs and increased governmental regulation.
Author Bio
Psalm_Ogbonna is a content writer, a technical writer and a lover of fiction.
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nonsensetwice is a writer, editor, developer, and fitness professional. A member of, and contributor to, BanklessDAO since its inception, nonsense’s main drive to contribution is the development and growth of contributors in web3, particularly in the realm of governance. When he’s not engaged in DAO work or kicking clients’ asses with yoga, nonsense can be found playing Borderlands, producing work for his L V N A C Y project, or shitposting on social media. Follow the bastard at nonsensetwice and nonsensecodes on Twitter.
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