Is this the end of algorithmic stablecoins?
Last week, UST, the digital asset that was supposed to represent the value of $1, exploded in spectacular fashion. The stablecoin, which once had a market cap of $18 billion, now trades for less than 60 cents - a far cry from its peg to the dollar. Terraform Labs, the company that developed the system, reportedly deployed about $3 billion worth of bitcoin, suspended the blockchain, flooded the market with UST's sister token LUNA, and tried to pay off arbitrageurs who took advantage of the volatile situation to bail out the network.
These costly attempts failed, and even Do Kwon, UST's chief architect, said that the network, as it once was, could not be saved. Terra is working on some sort of repayment plan for "small" token holders.
All of this raises two very important questions for the industry: are all "algos," or algorithmic stablecoins, dead from the start? And should there be regulation to prevent a similar disaster?
At least one person believes this is not the end for algos. Jonathan Wu, the head of growth at Aztec Network, a Layer 2 network, told cryptocurrency podcaster Laura Shin just that.
"Algorithmic stablecoin is a holy grail. If you think about what an under-collateralized algorithmic stablecoin is, it prints money out of thin air. In my opinion, there will always be capital chasing that dream," Wu said on an "Unchained" podcast episode last week.
If one person feels that way, others probably do, too. And with somewhat understandable reasons. Wu painted in broad strokes: stablecoins are necessary to offset the volatility of cryptocurrencies, and if there's a cheaper way to do it, people will try it.
There are two main stablecoin models: secured and unsecured. Collateralized stablecoins, such as USDC or Tether, hold financial reserves such as currency or bonds in bank accounts to ensure that holders of these synthetic dollars can eventually exchange them for real money.
Algos forgo this failsafe and seek to maintain their bonds through other financial means. UST used an on-chain redemption tool and an associated token, LUNA, to support UST's value based on supply and demand. LUNA was burned or minted when UST rose or fell against the dollar.
The goal was to create a "crypto-native" dollar-with all the supposed benefits of blockchains, such as censorship resistance-that would be cheaper to use than a fully or partially collateralized option.
Wu calculated that UST users could print a synthetic dollar on Terra for about 20 cents. He compared this to dai, a blockchain-based stablecoin managed by MakerDAO that holds overcollateralized cryptocurrency reserves that cost $2 to use, according to Wu.
"If I'm a venture capitalist or an equity investor now, I look at this and say I can create a monetary system that is ten times more capitalized than the alternative. I am willing to chase this dream over and over again," Wu said.
In addition, Wu said that "as an ecosystem, we have collectively shown that we are willing to chase this dream over and over again and risk systemic toxicity in the DeFi (decentralized financial) markets."
Think of value creation.
But what about the value that has been destroyed?
Widespread risks
Prior to its implosion last week, the UST deviated materially from its peg only twice, including once in December 2020, when it fell to about 85 cents, and another time in May 2021, when it fell to 94 cents. In other words, Terra worked more or less as promised until it didn't.
Meanwhile, figures like Ryan Clements, a professor at the University of Calgary, were ringing alarm bells. In the October issue of the Wake Forest University Law Review, Clements wrote a thoughtful article claiming that all algos are doomed.
These are assets that, like fiat, have value because a dedicated group of people claim they do. The problem is that Terra's user base is necessarily smaller than the U.S. economy, and while it had "crazy" fans, the blockchain lacked an army.
Aside from the demand issue, Clements noted that Terra relied on "self-serving" investors to profit from its algorithm when it began to fail. This problem, as we saw last week, is exacerbated by "herd-like" selling pressure that accelerates a sell-off.
Other algos - such as Magic Internet Money (MIM), Frax (FRAX) and Neutrino USD (USDN) - are far from immune, according to Clements. Because they are underpinned by volatile assets and prone to herd behavior, algos are in a state of "constant vulnerability," he wrote.
Just today, Deus Finance's algo called dei (DEI) fell as low as 54 cents during European trading hours, a decline triggered in part by volatility in stablecoin trading. Kwon's earlier project Basis Cash similarly exploded, as did algorithmic stablecoin IRON - prompting 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 this is headed. If on-chain mechanisms are unable to maintain their own price controls, then some other entity will set the standards.
CoinDesk's Nikhilesh De wrote about the need for proper oversight, and he is far from alone. Treasury Secretary Janet Yellen commented on the UST crisis last week. The question remains, what will the regulations look like?
The writing of the rules
Unfortunately, the crypto industry won't necessarily be able to write its own rules - although it may have a hand in drafting them.
"I expect regulation to look like more and more governance tokens will be considered securities," said noted industry skeptic Bennett Tomlin in a private message to The Node. "[Governance tokens] have claims against assets, claims against cash flows often and are the easiest target for regulators."
Much to the chagrin of regulators, anyone can create a crypto - a process that means the financial police have played whack-a-mole with issuers and likely will continue to do so. Although the U.S. Securities and Exchange Commission has begun cracking down on the industry by issuing broad warnings and doubling the size of its crypto enforcement division, even with clear rules, there will still be some anarchists like Kwon willing to circumvent the system.
Nic Carter, a venture capitalist and CoinDesk columnist, doesn't think official guidelines will be helpful for similar reasons. But the industry, which was already very skeptical of stablecoins, could impose its own rules.
"I don't think you can proactively phase out things like UST any more than you can regulate Plustoken or Paycoin or Onecoin or other similar systems," Carter told me. He added that UST never "lived up to the word stablecoin" because its "real goal was to pump LUNA."
"So the questions of 'how do we regulate USDC' and 'what do we do with UST/Luna' are completely different," he said. "The latter is more about how to prevent large-scale financial fraud."
Rules are being put in place for stablecoins to look and function more like banks. Similar rules could be enforced in the crypto industry itself. Users could even require robust reserves for algos, or something like an "orthodox currency board," Carter said, referring to the monetary authorities that maintain exchange rates for foreign currencies.
Whether such a system is possible, and whether those authorities will use tokens that increasingly look like securities, are open questions. But it seems that one lesson for many investors is to opt for collateralized stablecoins in the future.
How long that preference will last, or how long the memory of the UST implosion may linger in the mind, is another question.
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."