“Instead of being backed by assets like dollars or bonds, algorithmic stablecoins are intended to maintain their dollar peg by what looks to some like financial alchemy. But experts are highly skeptical that these systems’ designers have actually figured out how to turn lead into gold.
Broadly, algorithmic stablecoins rely on a pair of tokens, both created ex nihilo at the token’s launch. One token is the stablecoin itself, and the other is the corresponding “balancer token.” Generally, the balancer token can be “burned,” or destroyed, to create more of the corresponding stablecoin. The defining algorithm in an “algorithmic stablecoin” is a function that changes the amount of the balancer token required to create the stablecoin. This changing burn value is intended to create arbitrage opportunities for traders.
Ryan Clements, an assistant professor of Business Law at the University of Calgary, published a paper about algorithmic stablecoins called “Built to Fail,” arguing that the systems are inherently fragile and can never be truly “stable.” (Note that MakerDAO’s DAI is a bit of an outlier with some unique design features, and these critiques don’t necessarily apply to it.)
An algorithmic stablecoin, he writes, can only function when three conditions are met at all times:
- There is a “support level of demand” for the stablecoin and/or balancer token
- There’s a permanent supply of independent actors to perform price-stabilizing arbitrage
- A market has near-perfect information to trade on
Clements argues these assumptions break down frequently, particularly during times of instability. One clear sign of this is that the teams behind algorithmic stablecoins sometimes have to essentially step in and do the balancing arbitrage themselves. There’s even clearer evidence from algos that have already collapsed, most notably Iron Finance, which unwound in a “death spiral” in June 2021.
‘All the UST in Anchor is just rotator capital, farming for the subsidized yield.’ If Anchor’s yield drops below the competition, there could be a significant rush to the exits. That seems practically inevitable because there isn’t an infinite amount of money to pour into the reserve fund. As soon as that financial nitroglycerin runs out, it could create the conditions for a depegging of terraUSD.
The team behind LUNA/UST seem to agree with the idea that such systems can’t work. They don’t say so out loud, but they’ve made a variety of efforts to add more stability into the system, and those efforts have accelerated alongside UST’s growth.
But it might be even worse than that. What if building a BTC reserve actually increases the likelihood of a bank run? ‘This could create an incentive (effectively an economic moral hazard) to utilize strategies to acquire discounted BTC.’ Such a coordinated, intentional attack could look similar to George Soros’s legendary attack on the British pound. Attacking a pegged asset could be described as an attempt to acquire the backing assets at a discount.
There’s a lot of incentive to attack the peg, especially for people outside the [crypto] space. I think [UST] will collapse on its own, but if someone attacks it, it will collapse even faster.
At $18 billion, terraUSD is far from a systemic risk for mainstream finance, but luna/terraUSD could be a systemic risk to the cryptosphere. Do Kwon has said he would like to grow the system’s BTC holdings to $10 billion. But if that reserve is integrated in the wrong way, it could create the conditions for a future sudden flood of BTC for sale if the peg is attacked or breaks under market strain. It is [also] important to note the terraUSD stablecoin is the central function of the entire Luna layer 1 blockchain.
So while Iron Finance sank alone, terraUSD could drag others down with it.”
“In addition to being high risk, crypto trading can also be a very time-intensive process. It can be an overwhelming task and a barrier to entry for most investors in determining which tokens to invest in. For these investors, index investing could be a profitable alternative for gaining exposure to some of the hottest sectors of the cryptocurrency market.
Index Cooperative (INDEX) is a decentralized autonomous asset manager that allows investors to create a custom index of tokens using smart contracts. Several of the most actively traded indexes originated from Index Coop, including the DeFi Pulse Index (DPI), Metaverse Index (MVI), Data Economy Index (DATA) and Bankless DeFi Innovation Index (GMI).
Since May 29, 2021, the weakness of the decentralized finance (DeFi) sector can be seen in the poor performance of DPI, which is currently down more than 50%. During that same period of time however, the Metaverse index has increased 103% when compared to the price of Ether (ETH), and the gains are even greater when looking at its value in terms of USD. The price of NFTI has increased from $386 on March 5, 2021, to its current price of $1,724, a gain of nearly 350%.
Metaverse and nonfungible token (NFT)-related projects have been a bright spot in an otherwise weak market over the past six months and in this instance, it was beneficial to be invested in a basket of metaverse tokens.
This suggests that indexes offer the opportunity to capture a large percentage of the overall gains in the market while offering a better return. In many instances, this is a better tactic than trying to pick individual tokens that will see the biggest gains.”