UST Won't Be the End of Algorithmic Stablecoins
Is this the end of the algorithmic stablecoin?
Last week, UST, the digital asset that was supposed to represent the value of $1, exploded in a spectacular fashion. The stablecoin, which once had an $18 billion market cap, is now trading for less than 60 cents – well off its peg to the greenback. Terraform Labs, the organization that built the system, supposedly deployed about $3 billion worth of bitcoin, paused the blockchain, flooded the market with UST's sister token LUNA and tried to pay out arbitrageurs taking advantage of the volatile situation in an effort to rescue its network.
Those expensive gambles failed, and even Do Kwon, UST's principal architect, said the network as it once was can't be salvaged. Terra is working on something of a repayment plan for "small" token holders.
All of this raises two very important questions for the industry: Are all "algos," or algorithmic stablecoins, dead on arrival? And should there be regulation in place to prevent a similar disaster?
At least one person thinks this isn't the end for algos. Jonathan Wu, who's the head of growth at the Aztec Network, a layer 2 network, told cryptocurrency podcaster Laura Shin just that.
"The algorithmic stablecoin is a holy grail. If you think about what an undercollateralized, algorithmic stablecoin is, it is printing money out of thin air. There will always be capital chasing that dream in my opinion," Wu said on an "Unchained" podcast episode last week.
If one person thinks that, others likely do, too. And with somewhat understanble reasons. Wu painted with broad strokes: Stablecoins are necessary to smooth out crypto's volatility, and if there's a cheaper way to do that, people will attempt it.
There are essentially two stablecoin models: collateralized and uncollateralized. Collateralized stablecoins like USDC or tether maintain financial reserves like currencies or bonds in things like bank accounts to ensure that holders of these synthetic dollars can redeem them for actual money, at some point.
Algos forgo this failsafe and attempt to maintain their pegs through other financial means. UST used an on-chain redemption tool and a related token, LUNA, that was supposed to prop up UST's value based on changing supply and demand. LUNA was burned or minted as UST rose or fell against the dollar.
The purpose was to create a "crypto-native" dollar – with all of the supposed benefits of blockchains, like censorship resistance – that would be cheaper to use than a fully or partially collateralized option.
Wu's back-of-the-napkin math had it that UST users could print a synthetic dollar on Terra for about 20 cents. He compared that with dai, a blockchain-based stablecoin maintained by MakerDAO that holds overcollateralized crypto reserves, which costs $2 to use, Wu said.
"Now if I'm a venture capitalist or any capital provider, I'm looking at this and I'm saying I can create a monetary system that's 10 times more capital efficient than the alternative. I'm willing to chase that dream over and over and over again," Wu said.
Moreover, Wu said that "collectively, as an ecosystem, we've shown that we're willing to chase that dream over and over again and risk systemic toxicity in DeFi (decentralized finance) markets."
Just think of the value creation.
But what of the value that's been destroyed?
Widespread risks
Before it imploded last week, UST substantially deviated from its peg only twice, including once in December 2020, when it fell to about 85 cents, and again in May 2021, when it dropped to 94 cents. In other words, Terra functioned more or less as promised until it didn't.
Along the way, however, figures like University of Calgary professor Ryan Clements were sounding the alarm bell. In October's Wake Forest University Law Review, Clements wrote a considered piece claiming that all algos are doomed.
These are assets that, like fiat, have value because a committed group of people say they do. The issue is, Terra's user base is necessarily smaller than the U.S. economy, and although it had "lunatic" fans, the blockchain lacked an army.
Apart from the demand issue, Clements noted that Terra relied on "self-interested" investors who could profit from its algorithm as it began to fail. That problem, as we saw last week, is compounded by a "herd-like" sell pressure that accelerates a sell-off.
Other algos – like magic internet money (MIM), frax (FRAX) and neutrino usd (USDN) – are far from immune, Clements argued. Because they are backed by volatile assets and prone to herd behavior, algos "exist in a state of perpetual vulnerability," he wrote.
Just today, Deus Finance's algo called dei (DEI) fell to as low as 54 cents during European trading hours, a drop that was in part precipitated by volatility across stablecoin trading. Kwon's previous project Basis Cash similarly exploded, as did the algorithmic stablecoin IRON – which prompted investor Mark Cuban to call for stablecoin regulation.
"What is an algorithmic stablecoin? Is it stable? Do buyers understand what the risks are? It needs standards," Cuban tweeted in September.
Cuban was mocked at the time for his hypocrisy and aversion to risk, but that – regulation – is certainly where all of this points. If it's not possible for on-chain mechanisms to maintain their own price controls, then some other entity will come in to set standards.
CoinDesk's own Nikhilesh De wrote about the need for proper oversight, and he is far from alone. Treasury Secretary Janet Yellen commented last week on the UST crisis. The question remains, what will regulations look like?
Writing the rules
Unfortunately, for the crypto industry, they won't necessarily get to write their own rules – even if they can participate in the drafting process.
"I expect the regulation will look like more and more governance tokens being considered securities," notable industry skeptic Bennett Tomlin told The Node in a private message. "[Governance tokens] have claims against assets, claims against cash flows often and are the easiest target for regulators."
Unfortunately for regulators, anyone can create a crypto system – a process that means financial cops have been and will likely continue playing whack-a-mole with issuers. Although the U.S. Securities and Exchange Commission has begun to crack down on the industry, issuing broad warnings and doubling the size of its crypto enforcement wing – even with clear rules, there will still be some anarchists like Kwon willing to buck the system.
Nic Carter, a venture capitalist and CoinDesk columnist, doesn't see official guidance as helping either, for similar reasons. But the industry, which was already highly skeptical of stablecoins, could enforce its own rules.
"I don't think you can proactively regulate stuff like UST out of existence, any more than you can regulate plustoken or paycoin or onecoin or other similar schemes," Carter told me. He added that UST was never "befitting of the word stablecoin" because its "true objective was to pump LUNA."
"So the questions of 'how do we regulate USDC' and 'what do we do about UST/Luna' are totally distinct," he said. "The latter is more about how do you stop large-scale financial fraud from happening."
Rules are coming for stablecoins to make them look and function more like banks. Similar rules can be self-enforced in the crypto industry. Users could demand robust reserves even for algos, or something like "an orthodox currency board," Carter said, referring to the monetary authorities that maintain exchange rates for foreign currencies.
Whether a system like that is possible and whether those authorities will use tokens that increasingly look like securities are open questions. But it does seem like one lesson for many investors is to choose collateralized stablecoins in the future.
How long that preference will remain or how long the memory of UST's implosion can stay in mind is another can of worms.
As Wu said, algorithmic stablecoins are the "holy grail." Or, as Tomlin put it, "The main reason I think people will keep trying is the appearance of free money."
– D.K.
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