Stablecoins
Stablecoins are the lifeblood of DeFi. They provide investors and protocol users a haven to ride out the waves of volatility that characterize the crypto space. Without them, the growing ecosystem we have all come to know, and love would not exist. Yet despite the core function stablecoins play and the stability they maintain, there are differences between them which are important to be aware of. Some of these differences are structural, some are due to backing and team, and others are due to innovations disrupting an already disruptive technology. This article will be digging into one of those innovations: algorithmic backing.
Maintaining Stability
Stablecoins seek to hold their value at a predefined point, generally 1 USD. The way that stability is achieved varies depending on the coin. Tether and USDC are backed by reserves of US Dollars and other assets. Each USDT or USDC is pegged to the value of a dollar by the equivalent value of assets held in reserve.
Other stablecoins, like DAI, maintain stability through collateralization. Traders and DeFi users can mint DAI stablecoins by depositing Ether into the MakerDAO protocol. This amounts to a loan, as the DAI must be paid back and some interest. Depositors also receive Maker governance tokens, allowing them to participate in the oversight of the DAI protocol.
One of the most significant innovations that blockchain enables is the disintermediation of finance and the removal of centralized counterparties in transactions. There are issues with asset-backed stablecoins, however, especially concerning decentralization. Fully backed stablecoins, owing to the backing held by issuing entities such as Circle or Tether, invariably become somewhat centralized entities in a decentralized world. The same could also be said for MakerDAO to a degree, as holding large deposits of ETH always leads to a degree of centralization. This is seen as antithetical to some in the DeFi and crypto space, so alternative methods of stability maintenance are being researched. One new type of stablecoin that appears to solve this problem is receiving a large amount of attention.
Algorithms and Behavioral Incentives
Full backing by assets held in reserve is not the only way for price stability to be maintained, with newer assets in the stablecoin space achieving this through computer code. This computer code, coupled with some behavioral incentives for traders, maintains price stability by creating or destroying the stablecoin in response to changing market conditions. This is supposed to be the same as the first generation of stablecoins: the stable value of the token at or close to a dollar.
The most famous and widely used of this new generation of algorithmic stablecoins is TerraUSD (UST), the third-largest stablecoin by market capitalization behind USDC and USDT. UST was created by South Korean crypto developer Do Kwon and his company Terraform Labs. UST maintains stability through a mutually dependent pairing with Luna, the token that powers the Terra blockchain. This pairing means that every time a TerraUSD token is minted, the amount equivalent to $1 of Luna is burned, and vice versa. The incentives around burning and minting are where the algorithmic element of the protocol comes in, with adjustment happening on an automatic and dynamic basis depending on UST price action.
When the value of one UST drops below $1, traders are incentivized to burn UST in exchange for a dollar in Luna. This reduces the circulating supply of UST, which increases the price of the token, assuming that demand remains the same. Conversely, if the value of one UST rises above $1, traders are incentivized to burn Luna in exchange for UST, increasing the circulating supply and driving the token price down.
Game Theory
This method of maintaining price stability is enticing, as it allows for a far greater degree of decentralization than USDT or USDC, yet it is not without risk. Game theory, and users acting rationally, are integral concepts to understand when considering algorithmic stablecoins. These types of tokens are only stable if the peg can be maintained, which, in turn, relies upon traders engaging in the right behaviors at the right time as decided by the algorithmic stability mechanism. This generally won’t be an issue with the right economic incentives. Engaging in behaviors that benefit the protocol also helps the user, so doing them is rational. Yet sometimes, market conditions do not encourage rational decision-making.
This happened to the IRON stablecoin when several large investors triggered a selloff. This event caused the stablecoin to lose its peg, eventually dropping the price to zero. Others have raised worries that algorithmic stablecoins could be susceptible to the equivalent of a “bank run” if users lose faith in the protocol supporting the asset. Developers are not unaware of these issues, and several novel solutions have been implemented to manage these risks.
Combining Algorithms With Backing
Many criticisms around algorithmic stablecoins focus on the lack of backing of the assets and the need for users of the protocols to act in a way that reality will most likely deviate from. Due to UST’s rapid growth, much of this criticism has been levied at Do Kwon and Terraform Labs. Kwon is undeterred by the critics and recently began purchasing vast amounts of Bitcoin to hold as reserves to back UST.
These purchases have amounted to more than $1.5B so far, with further acquisitions of similar size planned by the Luna Foundation Guard (LFG), a non-profit organization that supports UST and Luna. On top of this, the Terra Protocol intends to purchase the next $7B in Bitcoin from users willing to exchange their Bitcoin for UST.
Other stablecoins such as FRAX have taken a slightly different approach, combining fractional reserves with algorithmic stability mechanisms. Part of the FRAX supply is backed by collateral, like DAI with ETH, and part of the supply is back algorithmically through the issuance and burning of Frax Shares (FXS), which also doubles as a governance token. The ratio of collateral to algorithmic backing changes depending on whether FRAX is trading above or below $1
Nyan Heroes, a recently released NFT-powered 3rd person, shooting play-to-earn game on Solana, also uses a combination of algorithms and backing to issue their in-game utility token, CATNIP ($CTNP). CTNP powers the in-game economy and has an unlimited supply to cater to player needs. To ensure predictability and deliver value to investors; however, it is backed by $NYN, the governance token of Nyan Heroes, held in the games reserves. In the same way as UST, the creation and destruction of CTNP will be overseen by the algorithms in response to changes in the token price.
The Future
Stablecoins are the lifeblood of the crypto space. The first generation of stablecoins in USDT, USDC and DAI solved the problems of a lack of a risk-off haven for traders or predictable funding for builders. Yet, in doing this, they introduced new issues around centralization in a decentralized world. Algorithmic stablecoins are an innovation that may provide a fix to that problem. UST, Frax, and CTNP are novel protocols that combine some of the best aspects of the first generation of stablecoins with new ideas and ways of doing things. Though it is not without risk, this kind of innovation is the engine that drives the whole blockchain space forward, and it should be encouraged wherever possible.
