Stable Patterns: Understanding Algo-Stablecoins

By the AlphaGrowth Research Team

The Big Picture

Algorithmic stablecoins are gaining more and more attention in DeFi. Though examples like DAI (launched in 2017 by MakerDAO) have been around for years, the rise of FRAX, UST, and TOMB have raised the noise level around the category in recent months. No surprise that we’ve been following along closely to watch and evaluate the levers that control their stability (or inherent vulnerability, as some researchers describe it).

In general, we’re a team that gets excited about DeFi and projects that succeed. For now, Terra and TOMB are seeing success. But we have also seen a graveyard of unsuccessful attempts (Basis Cash is a good example). There are for certain many more experiments and failures to come.

So what can we learn from Terra (UST / Luna) and TOMB about the controls behind algo-stable success?

Really, it all comes down to two things:

• Reserves
• Optionality

We’ll go deeper into this below after a brief look at the basics at play.

The Backstory

Most stablecoins (e.g. USD, USDT) are collateralized with assets such as fiat currency, cryptocurrency, commodities or a combination. These assets ensure the stablecoin’s peg, typically to the U.S. dollar, though the peg can be to an alternative currency such as Fantom Opera’s FTM, as in the case of TOMB.

In contrast, algorithmic stablecoins rely on algorithm-based rules programmed into their smart contracts that, in theory, automatically maintain their peg to another currency (usually USD).

There are different models for algorithmic stablecoins. The most common are:

• Rebase
• Seigniorage

When rebasing is used to keep the peg, the algorithm adjusts the number of tokens people hold, not the value of the tokens, in order to keep balance. Seigniorage involves a system with either two or three tokens that interact with each other to keep the peg. Terra’s UST coin stays pegged to the US Dollar thanks to LUNA, which operates as an incentive to encourage people to buy and sell UST as needed to keep the peg. There are other models of Seignorage that involve three tokens, but they are notorious for losing peg. If you’d like to research that, again, an example is Basis Cash.

While Terra has maintained its peg so far, the recent $1B Luna sale to raise funds for the Luna Foundation Guard (led by Jump Crypto and Three Arrows Capital alongside other investors) is as solid evidence as you can get that even they were worried about unforeseen forces creating enough volatility to lose the peg. Then this week, their team announced an additional $500M raise. Terra’s UST might have made it until now operating as an uncollateralized algo-stable, but going forward it has a $1.5B backing it in case of a “Black Swan” crisis level event that threatens markets.

The worry is for good reason: as soon as an algo-stable starts to lose its peg beyond a short range (say the few cents on either side that is typical for UST — see the 90-day price chart on CoinGecko here), people start to get nervous about overall stability.

Volatility over peg is correctable. It’s when price drops well below peg that the real problems start, people start dumping and you rarely see a true return to it. Just look at Basis Cash, which admittedly ran into hacking and other problems on top of losing its peg, but shows very little chance of ever returning to the $1 value it was supposed to maintain through its Seigniorage model.

Peg Problems

So why do Seigniorage tokens lose peg? The simple answer is: when people stop playing the game. Why do people stop playing the game? People, especially in crypto, have short attention spans.

If they’re not getting those dopamine hits (rewards, incentives, utility) or there’s simply a more exciting project out there, they’ll move.

This is exactly what causes mercenary capital, which is felt on every protocol, but is heightened with Seigniorage algo-stables.

Why is that the case? Well think about your perspective if you’re a liquidity provider on a DEX vs. a Seigniorage protocol. On a DEX, there’s so much activity and volume, that you don’t necessarily notice the effects of several people un-bonding and leaving.

If you’re an LP for a Seigniorage coin, the first thing you are going to pay attention to is the variance from the peg. Any significant movement, and you will notice the effects — potentially even with a small number of people withdrawing.

In fact, it’s actually the high level of attention and emphasis Seigniorage protocols put on variation to peg that is ultimately the catalyst to a downward spiral. It’s crypto — people will always be selling. But in this particular scenario, even normal activity can spark a reaction that weakens peg and gets people questioning overall stability. When a lot of people start selling, the challenge to maintaining peg can be insurmountable. The only thing that will stop the spiral: buy pressure and lots of it.

So what can chains do to counteract the natural vulnerability algo-stables are facing and create buy pressure when it’s needed?

The Controls

So far, we’ve only seen two controls successfully create the buy pressure that’s needed to maintain peg.

The Reserves Control

The simplest solution as your algo-stable protocol starts to lose peg, is to buy it back up via capital controls. This obviously requires access to huge amounts of readily available reserve capital. That makes this control the hardest to architect for non-billionaire builders and those who aren’t backed by investment funds.

Also problematic: this solution can’t work forever or in a vacuum, but as an immediate fix, it work.

Why it works: if you know you need buy pressure to keep your base token at peg, and you can see that outside demand is falling, you bring the heat from the inside with your capital reserves.

This synthetic buy pressure will bring the token back up to peg and stop the sell-off cascade long enough to attract more attention, reactivate the money printer and hopefully encourage more buy outside pressure.

Where we’ve seen this in action: TOMB is owned by investor (and reported billionaire) Harry Yeh. Terra’s Anchor protocol, which operates as a savings reserve entity for the ecosystem, recently received a $450M USD infusion to aid stability. And then you have the classic example: the seemingly endless money printers propping up the value of the US Dollar itself.

Optionality Control

If you’re not one of the world’s 2,700 billionaires or backed by one, there is another control to look at: optionality, a.k.a. the presence of your base token on other protocols.

It’s a slower strategy, but it has the potential to create much greater stability over time. In other words, kick that can down the road baby.

Why it works: what’s the number one threat to any DeFi protocol today? Mercenary capital.

People who come to play, but have no intention of sticking around for the long-term. As soon as users get bored of whatever hopium a protocol offers or find new and enticing hopium elsewhere, they’ll un-bond or withdraw and move on to the next. For protocols, it would be a nicer world if that weren’t the culture. And maybe it will be different in the future. But for now, that’s what we see at play.

We hear a lot of talk about stopping the shiny object syndrome most degens have developed in the last year, but that’s the wrong problem to try to solve.

If you’re a protocol or chain with an algo-stable, hear us out: instead of trying to change degens’ natural tendencies and exerting a ton of effort to get them to stay via incentives and algorithm mechanisms, there’s another approach: get your protocol every place your ideal user is likely to want to be.

When users (and it is a when, not an if) lose interest in your money printer and move on to the new hot ink jet in town, they need to have a reason to still hold & use your coin.

Make this a proactive part of your strategy for stability and growth, and you mitigate a) having to worry about convincing mercenaries to stick around and b) sell pressure thanks to your presence in numerous places where people can use your token. After all, mercenaries move, but they don’t dump if someone will accept your token elsewhere.

The Bottom Line

From what we see, winning at the algo-stable game requires a deep reserves and/or serious optionality across protocols. And optionality itself requires capital. Looking ahead, it’s likely the winners over the long-term will have both at play. We are experiencing innovation and experimentation at unprecedented levels in DeFi right now, but don’t be fooled: money is still king, and any successful protocol needs it — and lots of it.

If you’re interested in learning about more growth strategies for your project, we encourage you to connect on Twitter @bryancolligan. Join our Telegram for a members-only DYOR resources on algo-stablecoins and their potential for creating growth, credibility and engagement for your project.