You may have heard the phrase “death spiral” with respect to algorithmic stablecoins. Here I will attempt to describe what this means, and how to avoid it.
Defining Death Spiral
The death spiral we are talking about here is specific to a particular type of stablecoin, namely, algorithmic stablecoins based on the “seigniorage shares” model. In this model, there are two coins: a stablecoin and a “shares” coin. Each sharecoin represents a claim on future supply growth of the stablecoin.
The basic idea of any stablecoin is that when demand goes down, you need to reduce supply. In the model we are talking about here, supply is reduced by issuing sharecoins and buying back stablecoins.
The term “death spiral” refers to a situation where declining price of the stablecoin causes a decline in the price for the sharecoin, which causes a further decline in the price of the stablecoin, and so forth. That is, the “death” refers to the declining price of each coin and the “spiral” refers to the fact that a decline in one accelerates the decline of the other.
Explaining Death Spiral
So why does this happen? Well, the problem is that the demand for stablecoins depends on their stability and the stability of the stablecoins depends on the value of the sharecoins, and the value of the sharecoins depends on the demand for the stablecoins.
This isn’t true for every kind of business. For example, if a company makes widgets, the value of the widgets doesn’t necessarily depend on the share price of the company. So, a declining demand for widgets can cause a decline in the share price, but there is no spiral because the falling share price doesn’t cause a further decline in the demand for widgets.
Seigniorage shares aren’t the only type of enterprise that can suffer death spirals. For example, the value of a social networking site can depend on the size of the network. If demand for the product starts to decline, it can reduce the size of the network, which can accelerate the decline in the demand.
However, certain types of algo stablecoins are even more susceptible to death spirals than other business whose product value depends on network size. The reason is that in a traditional stablecoin, the value of the shares depends not on the size of the network, but on the growth of the network. Thus, even if the demand levels out, the share price can decline, which will make the network unable to maintain stability.
Preventing Death Spiral
So given the above explanation, how can an algo stablecoin prevent death spiral? It has to do one of two things: 1) stabilize using something other than sharecoins, or 2) base the value of sharecoins on something other than the future growth of the network.
The first option basically means: use collateral. Most successful stablecoins take this approach. In some cases, like DAI, the whole protocol is based on collateralization. In other cases, like FRAX, the protocol is partially collateralized. In yet others, like Terra Luna, the protocol is fully algorithmic but the team behind the protocol buys collateral anyway to increase confidence.
The second option basically means provide sharecoins a claim on something that doesn’t depend on supply growth. This can be done in a few ways, but the most straightforward is for the system to charge some kind of fees. By charging fees, and providing sharecoins a claim on a future stream of revenue from these fees, the value of the sharecoins can be shifted from depending on the growth of the network back to the size of the network (which is more stable).
One variant of the fee strategy is to introduce a modest (and preferrably constant) level of inflation on the stablecoin. Inflation acts like a tax on holding stablecoins, which can be distributed to the holders of sharecoins. Thus, as long as people are holding any stablecoins, there will be some revenue to give to holders of sharecoins, even if the system isn’t growing.
Black Magic
The above description provides the basic outline for understanding of the “death spiral” and how to avoid it. This next section describes a more arcane method of preventing a death spiral by sucking life the from the future of the protocol. Please stop reading here.
One way a death spiral can play out is that if people suspect the demand for stablecoins is falling, they will anticipate a fall in the price of sharecoins. So, they will start trying to sell sharecoins. At the same time, the protocol is trying to get people to buy sharecoins so it can burn the stablecoins they receive in exchange. So, the protocol is trying to fight the market, and the market will win.
Another way of thinking about this is that people want to short sharecoins. So, instead of fighting the market, a protocol can use this to its advantage by selling put options for sharecoins (or by allowing people to borrow sharecoins, selling anti-sharecoins, etc.). This can help break the death spiral because when the price of sharecoins falls people can use stablecoins to bet against sharecoins. This reduces supply, which helps stabilize the price of the stablecoins.
The obvious problem with this is that if people short sharecoins, eventually they will want to cash in on their bet. If a lot of people do it, the liabilities from the outstanding bets could get large. At some point people could start doubting that the protocol will be able to pay up, which could start a race to exercise the options in addition to a race to sell shares. Then the protocol will be more than mostly dead.
Despite the dangers of a protocol selling bets against their own sharecoins, the technique could potentially be a part of a comprehensive death spiral mitigation plan. Just don’t say you heard it from me.
