Ethereum’s Vitalik Buterin proposed two thought experiments on how to determine whether an algorithmic (algo) stablecoin is feasible in the long run. On May 25th, Buterin stated Increasing scrutiny of crypto and DeFi following Terra’s collapse is “really beneficial. However, he advised against completely rejecting any algo-stablecoin.
Buterin’s comments were fueled by the fact that Terra’s UST lost its $1 stable three weeks ago and dropped the LUNA coin from $77 to $0.0014. This put the Terra blockchain at risk and wiped $42 billion from the crypto market.
Two thought experiments by Buterin
He praised Terra’s collapse for bringing “a higher level of scrutiny to DeFi financial mechanisms,” while rejecting the notion that automated stablecoins are flawed by design. said,
“What we need is not stablecoin empowerment or stablecoin doomerism, but rather a return to principles-based thinking. While there are many automated stablecoin designs that are fundamentally flawed and doomed to collapse eventually, and many more that can theoretically survive but are quite risky, there are also many stablecoins that are pretty solid in theory and have survived the extreme tests of the crypto market. Conditions in practice.”
His blog is focused on the fact that Reflexer is fully collateralized with Ether. RAI stable coin especially. The RAI stablecoin is not tied to the value of the fiat and instead uses algorithms to set an interest rate that proportionally opposes market volatility. It also motivates users to return the RAI to the targeted price range.
According to Buterin, it “exemplifies the pure ‘ideal type’ of a collateralized automated stablecoin”. Its structure also allows users to withdraw their liquidity from ETH if their faith in the stablecoin is broken. He mentioned two thought experiments that could help determine the authenticity of automated stablecoins.
Can stablecoin turn into zero users?
According to Buterin, if market activity drops close to zero, users should be able to get the fair value of their liquidity from a stablecoin project.
He also argued that UST did not meet this criterion due to its nature requiring the LUNA, or what it calls a volumetric currency (volcoin) to maintain its price, and failed to meet user demand to maintain the USD stable. Otherwise, it will be almost hard to stop both entities from crashing.
“First, the volcano price is falling. Then, the stablecoin starts to shake. The system seeks to increase the demand for stablecoins by issuing more volcoins. With low trust in the system, there are few buyers, so the price of volcoin is falling fast. Finally, when the volcoin price is close to zero, the stablecoin crashes too.”
The executive also claimed that since RAI is backed by ETH, the waning confidence in the stablecoin will not lead to a negative feedback loop between the two assets. This, in addition, can reduce the risk of a wider collapse.
The second thought experiment would be to see if the stablecoin protocol allows for “negative interest rate enforcement.” In other words, the algorithm must be capable of eliminating the potential growth rate of the index to which the stablecoin is attached.
The manager believes that this is a key feature that distinguishes a reliable protocol from a Ponzi scheme over time.
Are these experiments still not enough?
However, there is a caveat. Buterin continued by emphasizing that an algo-capable stablecoin capable of overcoming the aforementioned conditions does not mean that it is “safe.”
“It may still be fragile for other reasons (for example, insufficient collateral rates) or there may be errors or governance vulnerabilities. But steady-state and extreme-state robustness should always be one of the first things we check.”