Is there a future for algorithmic stablecoins beyond UST?

Turkish Crypto Exchange Thodex CEO Faruk Özer Sentenced to 11,196 Years in Prison for Collapse

DeFi and Credit Risk

SEC Finds 'No Grounds' to Deny Conversion of Bitcoin ETF, Grayscale Says

TerraUSD (UST) is a $1-denominated algorithmic stablecoin. However, it was trading for $0.083 on the evening of May 19.

Of course, this isn't meant to happen, but according to NYDIG's May 13 newsletter, UST, along with its linked coin Terra (LUNA), went into a death spiral last week that "wiped approximately $50 billion of investor capital in a few short days."

The crypto market was shaken by the crisis, but it also sparked several questions: Is this a single faulty project or an entire class of cryptocurrencies known as algorithmic stablecoins that rely on an arbitrage mechanism rather than cash reserves to keep their market price stable? Is it true that algo stables are intrinsically unstable?

Also, how have last week's events impacted other traditional stablecoins, such as Tether (USDT), the industry's largest but which also lost its 1:1 peg to the US dollar for a brief period? What about the ramifications for the cryptocurrency and blockchain space in general — has UST's demise tarnished it as well?

Finally, what lessons, if any, can be derived from the stormy events of the week in order to prevent this from happening again?

Will algo stables make it?

As the dust settles, some speculate that the UST/LUNA flatlining signals the end of algorithmic stablecoins as a category. For the record, while some algo stables, such as UST, may be partially collateralized, algo stables rely on market maker "arbitrage" activity to keep their $1.00 market price.

According to Ryan Clements, an assistant lecturer at the University of Calgary Faculty of Law, pure algo stables that put up no collateral are "inherently fragile." "For operational stability, they rely on a number of assumptions that are neither certain nor assured." He continued to explain to Cointelegraph:

"They require consistent demand, willing market participants to arbitrage, and accurate price information." None of them are certain, and they've all proved shaky in times of crisis or increased volatility."

For these reasons, last week's bank run on LUNA and UST, as well as the accompanying "death spiral," may have been predicted, according to Clements, who predicted something similar in a Wake Forest Law Review study published in October 2021.

"Prior to UST's bankruptcy, I claimed that algorithmic stablecoins — those that aren't completely collateralized — are solely predicated on confidence and trust in the stablecoin issuer's underlying ecosystem's economic incentives. As a result, they are everything but stable."

Yves Longchamp, head of research at SEBA Bank, a Swiss licensed digital assets bank, told Cointelegraph, "I don't see how algorithmic stablecoins can exist." The drop in the stablecoin market last week revealed that:

"Quality matters, and not all of them are created equal." USD Coin, a relatively transparent completely collateralized fiat stablecoin, outperforms Tether, a somewhat opaque fully collateralized fiat stablecoin, which outperforms UST, a partially collateralized algorithmic stablecoin."

Is adding more collateral the solution?

Others, like as Ganesh Viswanath-Natraj, an assistant professor of finance at Warwick Business School, concurred that algo stablecoins are "inherently vulnerable," but only to the extent that they are under-collateralized. They can be backed up with "dollar reserves or a stablecoin equivalent on the blockchain." Alternatively, they can use smart contracts to implement an over-collateralization scheme." Decentralized stablecoins like Dai (DAI) and Fei (FEI) operate in this manner.

Multicoin Capital co-founder Kyle Samani mainly agreed. "The absence of collateral was the problem with UST, not the algorithm."

"Creating an algorithmic stablecoin is extremely difficult," said Campbell Harvey, a Duke University finance professor and co-author of DeFi and the Future of Finance. "You incur the risk of a so-called bank run every time you're under-collateralized."

Worse, the UST case involved the use of a related cryptocurrency, LUNA, to keep its price stable. According to Harvey, the fate of LUNA was "very connected" with the fate of UST, and when one began to plummet, the other followed, driving the first token's price farther lower, and so on. He added:

"Does this imply that launching another algorithmic stablecoin will be difficult?" Yes. Does this imply that the concept has vanished? That's something I'm not sure of. "Never say never," I say.

What is more certain, according to Harvey, is that UST was employing a defective model that had not been adequately stress-tested and lacked circuit breaking measures to stop the descent when the death spiral began.

Are algo stables really necessary?

Algorithmic stablecoins are described as a "fascinating" experiment with significant ramifications for the future of global banking. Indeed, Clements told Cointelegraph that a wholly algorithmic stablecoin that maintains operational stability without reserves is sometimes seen as the "holy grail" in DeFi development.

"This is because, if it can be achieved, it can increase capital efficiently while remaining censorship resistant."

"We need a decentralized stablecoin," Ava Labs founder and CEO Emin Gün Sirer said last week. "Stables backed by fiat money are open to lawful confiscation and capture." A decentralized economy requires a decentralized stablecoin with an unfrozen or confiscable backing store."

Is it possible to seize stablecoins? "This is undoubtedly true," Samani said, "but it hasn't been a major issue in the past." In general, I believe most people exaggerate the danger."

"I get the argument," Todd Phillips, the Center for American Progress's head of financial regulation and corporate governance and a former Federal Deposit Insurance Corporation lawyer, told Cointelegraph.

What he doesn't understand is how decentralized assets get around this problem: Because decentralized assets are inherently more volatile than traditional assets, pledging that they will hold a stable value — and not backing them with stable assets like the US dollar, but with other decentralized assets like LUNA or an arbitrage mechanism — is essentially asking for a UST-type scenario.

Many people were criticizing Terra and its "flawed" stablecoin approach last week, but the idea of an algorithmic stablecoin isn't so far-fetched, especially if one considers the history of money. Consider how the US dollar and other currencies have changed in terms of their backing or "reserves," according to Alex McDougall, president and COO of Stablecorp, a Canadian fintech startup.

"Fiat currencies began as 'fully-backed,' such as by gold, silver, and other precious metals, and evolved into essentially algorithmic currencies, with central banks serving as the opaque algorithm that underpins and manages their value."

Consequences for cryptocurrency in general

Will the collapse of TerraUSD have a long-term influence on the greater cryptocurrency and blockchain world?

"It will aid in the formulation of explicit principles on stablecoin architecture, as well as the necessity for stable and liquid assets to support the peg at all times," Viswanath-Natraj added. "This is an opportunity for authorities to impose auditing and capital requirements for stablecoin issuers."

The stablecoin ecosystem has already changed, according to Clements. "Demand has shifted to completely or over-collateralized forms in light of Terra's failure and the contagion it triggered across crypto markets."

Stablecoins are mostly a US phenomena, but Oldrich Peslar, legal counsel at Rockaway Blockchain Fund, a Swiss venture funding group, told Cointelegraph that the UST fall could have consequences in Europe as well. For instance:

"In the EU, there is debate over whether all stablecoins should have a legal claim to redemption, whether they should always be backed at least 1:1, if stablecoin issuance can be suspended if they become too large, and even whether the regulation should apply to decentralized stablecoins."

"The UST debacle could serve as a justification for harsher regulation rather than a softer approach," Peslar continued.

Longchamp projected that "algorithmic stablecoins will be under pressure and are unlikely to be part of coming regulation" in Europe, which is bad news for algo stablecoins because acceptability in Europe is synonymous with regulation. "I believe that only audited asset-backed stablecoins will be regulated and encouraged," says the author.

Last week's developments, according to Clements, could "chill" institutional and venture capital formation for stablecoin and DeFi projects in the short term. It will also likely speed the formulation of regulatory policy in the United States and abroad for all stablecoin forms, "defining taxonomic forms, and distinguishing operational models." Because algorithmic stablecoins "are not stable and should be separated from fully collateralized variants," this is required.

Given the implications of Terra's loss on the bigger market, it may even deter retail participation in crypto markets in general, according to Clements.

On the plus side, Bitcoin (BTC), the oldest and largest cryptocurrency by market capitalization, and typically regarded as a harbinger for the entire industry, performed admirably last week. "Even though the market crashed and BTC lost most of its worth, its price has maintained close to $30,000, which is extremely high," Longchamp explained. "The market value of blockchain and cryptocurrency remains strong."

Performances in the stablecoin space were uneven. "How did that affect DAI?" "There was no impact," Harvey added, referring to the most popular decentralized stablecoin. "How did FEI, another decentralized stablecoin, fare?" There was no repercussion. Because such coins are over-collateralized and have several methods to keep the peg as near to one dollar as feasible, there was no impact."

"Where did USDC go?" Nothing," Harvey added, referring to USD Coin (USDC), a controlled stablecoin backed 1:1 by the US dollar. "However, how about Tether?" Tether is a centralized stablecoin backed by money, but the collateral is so opaque that we have no idea." "People said, 'Well, maybe this is just a case similar to UST,'" thus "Tether took a hit." He claimed that its opacity worked against it.

"Tether has never once failed to honor a redemption request from any of its verified clients," Tether asserted in a May 19 statement. Tether also announced that it was lowering its commercial paper investments, which have been criticized, and increasing its holdings of US Treasury Bills.

What lessons have been learned?

Finally, what, if any, lessons can be drawn from the UST debacle? According to Clements, the "search" for a pure algorithmic stablecoin will very certainly continue among DeFi devs. It is critical, however, that it be "done within a regulatory system that provides adequate consumer and investor safeguards and disclosures."

According to Phillips, the last week has pushed us closer to crypto regulation in the United States, "at least I hope so, because we need regulation so investors aren't injured." They should be warned of the dangers at the very least.

Given that the crypto and blockchain industries are still in their infancy – only 13 years old — recurrent disasters like UST/LUNA are likely to occur. "We hope the frequency and magnitudes diminish," Harvey continued.

A certain bit of philosophical calm could also be beneficial. "We have to assume we're 1% into this disruption using decentralized banking and blockchain technology, and it's going to be a bumpy journey," Harvey warned.

"The issues that DeFi addresses are significant. There's a lot of potential here. But it's early, and many revisions will be required before we get it properly."

======