Algorithmic Stablecoin, the end of stablecoin or Ponzi scheme?
At the end of 2020, US lawmakers drafted a stable currency-related bill (STABLE Act), requiring stable currency issuers to obtain a bank license. Later, the US President’s Financial Markets Working Group issued a new statement on stablecoin supervision. The document stated that stablecoins must meet appropriate anti-money laundering and supervision requirements, and currency holders should accept KYC for user identity verification. Stablecoins, or at least the certain ones that comply with regulation are becoming widely used.
With increasing use cases for stablecoins in the cryptocurrency market, they are becoming indispensable and the recent total market value of stablecoins has exceeded 21 billion U.S. dollars. On the other hand, algorithmic stablecoins, including the launch of ESD and BAC, have naturally attracted a lot of gambling, speculation, arbitrage and other behaviors, which further pushed the currency experiment in the crypto world to a new peak.
The past and present of Stablecoins
Stablecoins are pegged to fiat currency to be used in the blockchain network. It is usually pegged to price of the fiat currency, audited by a third party, and has real dollars as a reserve or complex algorithms to protect its price. According to the different ways of maintaining their peg, we can divide stablecoins into three categories: stablecoins collateralized by US dollars, stablecoins over-collateralized by multi-asset pools, and algorithmic stablecoins .
- Stable currencies collateralized by US dollars:such as USDT and USDC, but also include stable currencies issued by exchanges, such as BUSD, HUSD, etc. They are centrally managed, backed by U.S. dollars, and can be exchanged at a 1:1 exchange rate.The question is, who can guarantee that these stablecoins are actually backed 1–1 by USD. Users will have to trust these centralized institutions. As an example, Tether, the USDT issuer, admitted in 2019 that USDT supply has not received 100% rigid redemption in USD. As this year’s stablecoin transaction volume exceeded 1 trillion US dollars, USDT accounted for about 73% of the share. At the same time, regulation is also the sword of Damocles hanging on the head of centralized institutions. When will it fall has become an increasingly urgent issue.
- Multi-asset pools over-collateralized: Stablecoin such as MakerDAO’s DAI and Synthetix’s sUSD, which are over-collateralized by encrypted assets and rely on price oracles to maintain an anchor with the US dollar. Unlike centralized tokens such as USDT and USDC, they can be minted without permission.The advantage of the over-collateralization model is that there is no need to price assets and provide liquidity quickly. But at the same time, the nature of the over-collateralization mechanism means that there are capital inefficiencies, and the highly volatile nature of crypto assets has made these stablecoins vulnerable to the impact of the unpegging in the past years.
- Algorithmic stable currency: It’s a currency that automatically adjusts the money supply mechanism according to an algorithm program. Increase the market supply when the stablecoin price is higher than the anchor price, and reduce the supply when the stablecoin price is lower than the anchor price, or provide arbitrage space to balance the stablecoin price. The establishment of this model does not anchor real fiat currencies and does not need to collateralize stable currencies. It is controlled by the market and algorithms. These stable coins are also called flexible currency. It does not need to be generated through asset collaterals, but makes full use of people’s profit-seeking characteristics. At the same time, it has the characteristics that the previous stablecoin experiments did not have. It is cryptographically native and has the opportunity to realize a truly decentralized stablecoin vision for the first time. Since the beginning of this year, the skyrocketing prices of ESD and BASIS FRAX led by AMPL has shaken the market, making the industry get interested in algorithmic stablecoins.
Design of several algorithmic stablecoins in the market are borrowed from the operation mode of the traditional fiat currency institutions like the central bank. Their price anchoring power is weak, because their peg depends on the supply of the token rather than arbitrage, and their operation is more like the central bank setting price range targets. Monetary policy is usually slow to run, when the currency is out of anchor, the central bank will try its best to react in real time.
Taking BASIS as an example, there are three roles in the system: BAC (Basis Cash), BAB (Basis Bond), and BAS (Basis Share). The simplest analogy is BAC = U.S. dollar, BAB = U.S. dollar treasury bonds, and BAS = Federal Reserve stock shares. The ingenuity of this design is that it has moved the entire issuance power of currency to the algorithm. Among them, Basis Share and Basis Bond are designed to make sure the Basis Cash to always be anchored to the price of $1.
When the transaction price of Basis Cash is less than $1:
Users can enjoy a certain discount to purchase Basis Bond. The purpose of this is to establish the price stability of Basis Cash (increase purchasing power and raise the price of Basis Cash to $1). Users who purchase the discounted Basis Bond can earn a certain profit when they redeem their bonds in the future as the price of Basis Cash moves above 1$.
When the transaction price of Basis Cash is higher than $1:
The contract will allow the Bond redeemer to directly redeem the Basis Bond. If the market price of Basis Cash is higher than $1 after the Basis Bond is redeemed, the demand for Basis Cash will increase at this time, and then new Basis Cash tokens need to be minted (increase the supply so that the price of Basis Cash will fall back to $1), These tokens newly minted tokens will be distributed to Basis Share holders as dividends.
Although algorithmic stablecoins designed to maintain currency stability, their volatility may be a zero-sum game. New credit creation (whether stablecoins or bonds or shares) is not backed by full redemption rights and profits, and is completely dependent on other people’s capital investment. Therefore, most of the current algorithmic stablecoins have fallen into a fateful cycle:
- In the initial stage, first use the concept of liquidity mining and high annual yield (APY) to attract external funds into lock-up positions. At this time, mining with USDT/USDC and other tokens outside can provide high profits to liquidity providers.
- Rising currency prices and high yields attract more capital into the system, and market reflexivity makes them enter the positive feedback loop of rising “stable” currency prices. More funds enter and the market gets into a frenzy.
- No more funds enter to maintain high returns, the death spiral of falling currency prices begins. Stable currency prices are no longer stable (lower than $1 for a long time), speculative funds retreat, and the possibility of project collapse is increased.
The end of stablecoins or Ponzi schemes?
It is foreseeable that algorithmic stablecoins and algorithmic synthetic assets will develop greatly in the future. On the one hand, there are regulatory concerns: the integration and impact of the traditional financial world and the blockchain financial world will inevitably subject centralized stablecoins to more and more supervision, thereby pushing the crypto economy to decentralized Stable currencies. On the other hand, stable currency cross-border payment business will continue to grow. Using stablecoins or any crypto assets for cross-border payments is simpler and cheaper than traditional methods. In this regard, encrypted assets are more effective than traditional legal currency payment methods. This will be the driving factor for the increasing adoption rate of stablecoins in the future.
The decentralization and censorship resistance of algorithmic stablecoins makes it almost certain to enter the mainstream choice in the long run. However, it is currently facing a relatively large problem: it wants to completely offset the price control brought by centralized institutions through algorithms, but it does not have enough market recognition to maintain its price stability through the model of giving arbitrage opportunities. The reflexivity of the market led to the majority of users entering to obtain the excess returns of the early “rich spiral” instead of using algorithmic stablecoins such as AMPL, ESD, and BAC as payment tools or value storage tools. Therefore, some people believe that the algorithmic stable currencies are just Ponzo schemes based on Fomo.
All in all, the destiny of stablecoins must not be speculation. Speculation is only the inevitable path to achieve the stability of algorithmic stablecoins in the early stage, but it is not the goal. In the long run, the rate of return from stablecoins will drop to a reasonable level and it will hopefully maintain equilibrium. Is this a brand new social experiment, or is it a pure Ponzi scheme? After all, algorithmic stable currency is something that has never been tried in human history. According to the Lindy effect (for something that will die on its own, every additional day it exists, the expected value of the remaining time will be reduced; but for something that will not go on its own What is dying out will increase the expected value of the remaining time for every additional day). It is too early to characterize algorithmic stablecoins. Let us wait and see where it will eventually go.
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