“We don’t need a stablecoin booster or stablecoin doomerism, but a return to principled thinking,” Vitalik Buterin emphasized.
Ethereum co-founder Vitalik Buterin shared two thought experiments on how to evaluate the stability of an algorithmic (algorithmic) stablecoin.
Buterin’s comments were prompted by the multi-billion dollar losses caused by the collapse of the Terra ecosystem and its algo stablecoin TerraUSD (UST).
In a blog post on Wednesday, Buterin noted that the increased focus on cryptocurrencies and decentralized finance (DeFi) following the collapse of Terra is “very welcome,” but warned against a complete write-off of all algorithmic stablecoins.
“What we need is not a stablecoin booster or the demise of stablecoins, but a return to principle-based thinking,” he said:
“While there are many automated stablecoin projects that are fundamentally flawed and ultimately doomed to failure, and many others that could theoretically survive but are very risky, there are also many stablecoins that are theoretically very reliable and extreme. Cryptocurrency tests withstood the real market. terms.”
In particular, his blog focused on the RAI Reflexer, a fully ethereum (ETH) stablecoin that is not pegged to the value of fiat currency and relies on algorithms to automatically set an interest rate that proportionally counteracts price movements and encourages users to do so. RAI returns the target price range.
Buterin explained that it is “an example of a pure ‘ideal type’ of a backed automated stablecoin” and its structure also gives users the ability to extract their liquidity in ETH if trust in the stablecoin is significantly undermined.
The Ethereum co-founder proposed two thought experiments to determine whether an algorithmic stablecoin is “really a stablecoin.”
1: Can a stablecoin “settle” to zero users?
If the stablecoin project’s market activity “drops to near zero,” Buterin believes users should be able to extract the fair value of their liquidity from the asset.
Buterin emphasized that UST does not meet this parameter due to its structure, where LUNA, or what he calls a volume coin (Volcoin), needs to maintain its price and user demand in order to maintain its peg to the US dollar. If the opposite happens, then it will become almost impossible to avoid the collapse of both assets:
“Firstly, the price of Volcoin is falling. Then the stablecoin starts to tremble. The system is trying to support demand for stablecoins by issuing more Volcoin. When trust in the system is low, there are few buyers, so the price of Volcoin drops quickly. Eventually, as soon as the price of Volcoin approaches zero, the stablecoin will also collapse.”
Since RAI, in contrast, is backed by ETH, Buterin argued that a drop in confidence in the stablecoin would not cause negative feedback between the two assets, reducing the likelihood of a wider crash. Meanwhile, users can also continue to trade RAI for ETH locked in vaults supporting the stablecoin and its lending mechanism.
2: Negative percentage option required
Buterin also considers it critical that an algorithmic stablecoin be able to implement a negative interest rate if it tracks “an asset basket, consumer price index, or an arbitrarily complex formula” that grows at 20% per year.
“Obviously there is no real investment that can generate about 20% returns per year, and definitely no real investment that can permanently increase returns by 4% per year.” But what happens if you try? he said.
He explained that in this case, there are only two outcomes: either the project “charges holders with a sort of negative interest rate that balances out to essentially cancel out the USD-denominated growth rate that is embedded in the index.”
Related: Ethereum price falls below $1.8K support as bears brace for $1B Friday options expiration
Or: “It turns into a Ponzi, bringing amazing profits to stablecoin holders for a while, until one day it suddenly collapses with a crash.”
Buterin concluded by noting that the fact that an algorithmic stablecoin is able to handle the above scenarios does not make it “safe”:
“He may still be vulnerable for other reasons (e.g. insufficient margin ratios) or