What is the potential of algorithmic stablecoins, and how to protect them from collapse

Stability algorithms. What awaits decentralized stablecoins

23.08.2022

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5 min

Stablecoins are cryptocurrencies whose price is tied to a stable asset, most commonly the US dollar. Stablecoins have a total market capitalization of more than $153 billion, and they have long been an integral part of the crypto market. However, security problems, operating principles, hacker attacks, or risky investment schemes sometimes cause stablecoins to depeg from the US dollar or cause their value to plummet.

Just recently, the rate of the Huobi cryptocurrency exchange's (HUSD) stablecoin lost its peg to the dollar, and the price of the stablecoin of the DeFi-platform Acala collapsed by 95% as a result of the hack. The May collapse of the Terra ecosystem and the TerraUSD (UST) stablecoin was the trigger for a bearish period in the crypto market.

Depending on the type of stablecoin, the possible problems that could lead to a depeg, explains Letit CEO Rustam Burkeev. If we are talking about a stablecoin backed by fiat currencies (e.g., USDT), information or even just rumors about the lack of necessary reserves in the accounts of the company Tether behind it can lead to its depegging from the dollar. When it comes to algorithmic stablecoins, a depeg usually occurs when the algorithm fails to cope with a sharp imbalance between supply and demand. This can be the result of active use of crypto-lending DeFi-protocols and platforms, the expert explains.

Echoes of Terra

The collapse of UST and similar algorithmic stablecoins is due to the fact that these coins were actively used in lending protocols that offered very high rates of return. “Anchor offered almost 20% per annum. Users would put money on deposit, then take out a loan against that deposit and remortgage it again. This is how the bubble was inflated,” Nikita Vassev, founder of TerraCrypto, explains the chronology of the UST collapse. According to the expert, such schemes are doomed to failure. As soon as investors start fleeing, the protocols face the fact that they are unable to fulfill their obligations.

Critics of cryptocurrencies use the TerraUSD collapse as an argument to attack stablecoins and the crypto industry as a whole, often losing sight of the root cause of the ecosystem's collapse. This is how any decentralized stablecoins come into question, but there is an opinion that they are the ones that have technological advantages over those behind a particular issuing company.

According to Miles Jennings, general counsel at a16z venture capital fund, the problem is not so much with the code as it is with the collateral and the assets that projects use to maintain the value of their stablecoins. In an op-ed column for the FT, Jennings emphasizes that this is something to keep in mind when drafting legislation to prevent future UST-level collapses.

a16z crypto is a division of Andreessen Horowitz for investments in web3 startups. The fund has $7,6 billion in assets. The fund supports developments in the play-to-earn (P2E), DeFi, decentralized social networks, as well as L1 and L2 solutions, bridges, DAO, NFTs and many other areas of the crypto industry.

“If legislators believe algorithms are to blame, they risk enacting counter-productive, innovation-stifling regulations,” Jennings writes. In his opinion, this could disrupt markets and reduce the democratization of the decentralized economy.

Sufficient collateral

Stablecoins differ in the type of collateral, Burkeev explains. Some are backed by reserves in fiat currencies and securities, others in cryptocurrencies or commodities (gold, oil), and there are algorithmic stablecoins that are essentially not backed by anything, but maintain a peg to the dollar through mathematical calculations that balance supply and demand.

There are decentralized, overcollateralized stablecoins that hold a large number of tokens as a reserve for the issuance of a smaller number of stablecoins. This provides a buffer against price fluctuations. This is the principle used by the DAI stablecoin or, for example, the recently announced GHO from the decentralized Aave protocol.

According to Jennings, in a volatile market, the vast majority of decentralized stablecoins backed in BTC or ETH “performed superbly,” coping with “extreme price fluctuations and unprecedented redemptions.” The risks, he believes, come from the assets that serve as collateral for the coin. For example, among the least reliable decentralized stablecoins, he cites those secured by tokens from the DAO management behind the issuance of new coins. When the price of a token falls, the cascading liquidation of the collateral for repayment triggers a "death spiral," as was the case with UST.

While noting that some form of regulation is necessary to prevent large-scale crashes of crypto assets, Jennings believes that overly restrictive regulations could hurt the market. Nevertheless, he believes additional targeted regulation could be helpful. “While it is difficult to pinpoint exactly where regulators should establish collateralization requirements, it is clear that without guardrails, stablecoin issuers may once again take on unreasonable amounts of risk,” writes the a16z representative.

Thoughtful legislation could provide support for the cryptocurrency ecosystem and protect consumers, Jennings believes. A complete ban on algorithms and digital asset collateral would be an “enormous burden” on the DeFi industry, disrupt the digital asset market and hinder innovation in web3, he said.

The collapse of algorithmic stablecoins is not so much due to the lack of collateral, but rather to the “blatantly pyramidal” scheme of most crypto holding platforms, Burkeev said.

According to Vassev, regulation of stablecoins is inevitable. In the US, legislation will likely appear before the spring to regulate stablecoin issuers, the expert said. Whereas companies like Tether or Circle will be subject to fairly obvious requirements for financial disclosure and reserves, possible measures for decentralized stablecoins are still in doubt.

According to Jennings, due to their high liquidity and transparency, decentralized stablecoins could end up being more stable than centralized ones. With more efficient systems, algorithmic stablecoins offer “a unique opportunity to make all sorts of assets productive and drive digital commerce around the globe,” and standards for securing coins could help unlock that potential.

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