Opinion: Algorithmic stablecoins are inherently fragile and doomed to fail?

Algorithmic stablecoins are inherently fragile . These unsecured Crypto assets attempt to use financial instruments, algorithms, and market incentives to peg the price of a reference asset. They are not stable at all, but are in a state of permanent vulnerability. So far, several iterations have struggled to maintain a stable peg, and some have ended in catastrophic failure. The article argues that algorithmic stabilization is fundamentally flawed because they rely on three factors that have historically proven impossible to control.

  1. First, they require a level of support that demands business stability.
  2. Second, they rely on independent actors with market incentives for price-stabilizing arbitrage.
  3. Finally, they require reliable price information at all times.

 

None of these factors are definitive, and they have proven historically vulnerable in the context of financial crises or periods of extreme volatility. Regulatory guidelines need to be developed for all stable registration forms, including issuer registration requirements, clear categorical description forms, scrutiny, collateral custody and transparency safeguards, and risk disclosure and containment measures. A strong regulatory framework with risk disclosure and containment safeguards is especially necessary for algorithmically stable trading, which currently serves only speculative DeFi trading applications with little, if any, social or financial inclusion value.

 

introduce

 

Innovation in financial products is not always a good thing, and some innovations are designed in ways that make them inherently unstable. In 2008, the entire financial system nearly collapsed as housing loans sparked a series of complex securitization-driven, derivatives-enhanced financial product innovations. Now, a new, increasingly popular, poorly designed and inherently fragile financial product has recently emerged that requires proper regulation – algorithmic stabilization .

Algorithmic stablecoins are a contradiction in terms. So far, the stable market iteration of the algorithm has shown a complete lack of stability. It is an unregulated, unsecured Crypto asset that operates in a perpetually vulnerable state. Algorithmic stability has no real peg, but simply derives its value from what the ECB’s Crypto Assets Working Group calls “expectations of its future market value.” As such, it is an incredibly fragile payment mechanism. Algorithmic stablecoins have been hailed by some as a more “capital-efficient” antidote than the wild daily price swings of popular cryptocurrencies like bitcoin and ether, which limit their use as monetary alternatives for consumer transactions, wages or debt deferrals product function. Others claim that algorithmic stablecoins are “rebuilding traditional banking” as a reserve system for the DeFi part. Neither comparison hits the mark, and the claimed utility of algorithmic stablecoins is grossly exaggerated and misleading because three lessons from history make them inherently fragile.

First of all, algorithmic stable arbitrage requires the liquidity of the entire ecosystem to maintain a balance. If liquidity falls below a threshold level, the entire system will fail. History shows that basic or minimum levels of support for financial products cannot be guaranteed – especially in a crisis.

Second, algorithmic stability arbitrage relies on independent participants with market incentives to conduct price stability arbitrage to maintain the so-called “stable” ecosystem. Once again, history shows that discretionary interest rates that rely on independent, market-driven players with no legal obligations to enforce stable prices are also fragile. History has proven that in a crisis, information becomes opaque, noise crowds signal, prices and counterparties become uncertain, and it is easy to herd. Information opacity undermines the symbolic “economics” and incentive structures of algorithmic stability.

If the “symbolic” incentive structure in any algorithmically stable ecosystem collapses, the entire ecosystem will fail without a backstop or a deposit insurance safety net. Algorithmically stable systems exist in a system that is prone to operating, unstable, and failing when reality deviates from the assumptions of the embedded incentive structure. Many iterations of the algorithm’s stability have failed catastrophically.

Regulatory safeguards need to be provided for all types of stable investments, including issuer registration requirements, clear categorization, clarification of stable investment forms, review rules, collateral custody safeguards, and reporting transparency, risk disclosure and containment measures. Risk transparency, disclosure, and containment measures are particularly relevant to algorithmic stablecoins, which are currently only used to power speculative DeFi trading applications.

 

1. Various stablecoin experiences

 

Stablecoins are cryptoassets that attempt to link their value to another asset (or a basket of assets including reserve currencies or highly liquid government bonds). So far, there has been no uniform definition of stablecoins — which may be one reason the regulatory structure has been so slow to implement. The International Organization of Securities Commissions (IOSCO) recommends that there are many different varieties and forms of stable bonds.

The most popular forms are “off-chain” custodial stablecoins, such as Circle and Coinbase’s widely circulated USDC (USDC), or Facebook’s Diem, both of which use “holdings of fiat currency or high-quality liquid assets as reserves. ” or Tether, purporting to be collateralized by large holdings of commercial paper. Other stablecoins are either fully collateralized or “over-collateralized.” Over-collateralization means that more than 100% of the stablecoin’s value is “held on-chain,” using another cryptoasset to provide the collateral function, such as MakerDAO’s DAI stablecoin. Use over-collateralization of a specified crypto asset (such as WBTC, ETH, and other relatively liquid crypto assets) to generate stablecoin DAI, and the collateral ratio is adjusted for specific locked tokens.

The most volatile and vulnerable stablecoins are “algorithms,” which are not fully collateralized and use market incentives, arbitrage opportunities, automated smart contracts, and reserve token adjustments to try to maintain a stable peg. These types of stablecoins are described as the “central bank/Federal Reserve” of algorithmic stablecoins. The size of the stablecoin market has soared to more than $119 billion in 2021, with algorithmic stablecoins accounting for a large and growing share of this market.

Although Iron Finance failed miserably in June 2021, algorithmic stablecoins claim the benefits of automated operations and the ability to scale without the need for corresponding reserves. Basically, the protocols that back algorithmic stablecoins attempt to operate as a central bank, with “less than one-to-one backing,” by manipulating the number of tokens “in circulation” in response to changes in their value.

There are various models of algorithmic stablecoins, and their exact definitions are debated. They typically seek to combine the money supply with embedded economic incentives to artificially control the price of stablecoins. For example, if the stablecoin is trading for less than $1, an algorithmic stablecoin system may offer some other type of Crypto asset, a Crypto “bond”, “discount” or issued “equity”, for less than $1. The new capital is used to maintain the peg. A common algorithmic stablecoin structure is a “dual-coin” system, where one coin is used to maintain the peg and the other is used to “absorb” market volatility. The latter tokens are often referred to as “stake” or “balancer” tokens, and are often traded on other decentralized exchanges such as Uniswap, the two-token system is often combined with partial staking dynamics, as used in the following section Described by Iron Finance’s Iron Algorithm stablecoin.

 

2. The failure of Iron Finance is a big red flag for the product category

 

Iron Finance describes itself as a “multi-chain, decentralized, non-custodial ecosystem of DeFi products, protocols and use cases”. Their original system was a dual-coin structure that attempted to create an algorithmic stablecoin called “IRON”. IRON is pegged to $1, but not actually backed by $1. The recently announced relaunch of “V2” for “overcollateralized and soft-pegged” stablecoins. Before its nearly $2 billion failure, each IRON stablecoin was secured by locking 75% of its value in collateralized USDC (a fully reserved, fiat-backed stablecoin), and 25% of its value by locking “TITAN” – Iron Finance’s own, unlimited supply internal governance token.

Iron Finance collapsed when the value of its unlimited supply governance token TITAN plummeted in the DeFi secondary market. Iron Finance reports that certain “whale” holders have sold heavily. The market for TITAN was already weak, and this large sale triggered a “negative feedback loop” of cascading sell-offs in TITAN and redemption of IRON. This caused the IRON token to lose its peg, which in turn “triggered” TITAN’s algorithmic minting mechanism and provided arbitrage opportunities in the resulting “death spiral.”

The immediate effect is the large supply of TITAN on the secondary market. At some point, the price of TITAN was essentially zero and Iron Finance stopped redemptions of the IRON stablecoin – they started with only 75% collateralized USDC coverage. The moment the price of TITAN was unstable in the secondary trading market, the entire house of cards as the IRON stablecoin fell, and there was nothing to support this run.

The idea that algorithmic stablecoins are early iterations of DeFi fractional-reserve banking has been advanced. Iron Finance — explaining the failure of its so-called stablecoin IRON — called it “the world’s first large-scale crypto bank run” in a “post-mortem” report. This analogy is clearly flawed, and Iron Finance’s operating structure has been very fragile from the start.

It attempted to create $1 from 75 cents, assuming its secondary trade governance token, TITAN, would not fall below a market-determined price floor. It’s designed with the assumption that TITAN itself will remain stable — or better yet, that its price will rise. Banks also create money through fractional reserves and loans. However, banks are backed by government deposit insurance – they pay huge fees in the form of premiums and are subject to extensive oversight and scrutiny.

 

3. Three lessons from the history of financial markets

 

Three lessons from the history of financial markets influence the viability of algorithmic stablecoins.

First, if liquidity dries up, any financial product that requires a liquidity support or fundamental level of an entire product class to function as intended (and assumed) will be prone to failure. Liquidity is unpredictable and affects the price of all securities. However, a product is inherently fragile if it requires a minimum amount of liquidity to function.

As previous work has identified, requiring (but not receiving) the level of support from major financial institutions is a significant factor in the failure of the auction-rate securities market. The reliance on fundamental support levels is probably the biggest problem with the dual-coin structure of unsecured algorithmic stablecoins. Volatility-absorbing tokens must maintain a certain level of demand support — and not fall below a price threshold — or the entire ecosystem will fail. A non-collateralized token that claims to be “stable” requires a consistent (if not increased funding) level of liquidity, and once it stops, the peg fails.

A second historical lesson that makes algorithmic stablecoins inherently fragile and unstable is that they often rely on independent actors with market incentives to perform price-stabilizing arbitrage functions. Arbitrageurs must step in and take advantage of profit opportunities to maintain price stability through minting or redemption activities. The performance of discretionary price stability arbitrage has historically been fragile in crises, and as previously noted in work on exchange-traded funds, “market discipline can fail when it’s needed most.”

During the failure of portfolio insurance in 1987, arbitrageurs stopped buying undervalued assets. More recently, arbitrageurs stopped arbitraging prices between secondary market prices of fixed-income exchange-traded funds (ETFs) (and their underlying NAVs) when markets quickly turned to pricing in the aftermath of the coronavirus pandemic in March 2020 dislocation.

A third lesson that has historically called into question the long-term viability of algorithmic stablecoins is that in times of heightened volatility, panic, or crisis, there is widespread information opacity. Effectively combining price information is a problem that “has plagued” many algorithmic stablecoins. Price “oracles” (external price feeds) are not always trusted, and there is a “misplaced” incentive problem when token holders vote on which potential price feeds (from their pools) to adopt. Uncertainty over the price of the TITAN token caused Iron Finance to fail in June 2021 due to delays in automated “oracle” feeds.

When information is uncertain, waterfalls and groups of investors form, and assets deemed unsafe are quickly sold off in a sell-off—a phenomenon that was evident in the 2008 global financial crisis, even though for some financial assets, Mutual funds, such as commercial paper and money market, were considered pre-crisis stable. Opaque information can also affect the ability of market participants to conduct price stability arbitrage, as was the case with the failure of portfolio insurance in 1987.

 

4. Stablecoins as Dominos in the Emerging Algorithmic Ecosystem

 

Perhaps the most popular algorithmic stablecoin platform out there is Terra. Terra’s creator, Terraform Labs, recently received significant venture capital backing and investor interest as a “stablecoin for e-commerce creators.” Terra mints USD and KRW-pegged algorithmic stablecoins (among others) using a governance balance token (called LUNA), with built-in money supply and economic incentives, including fees and arbitrage opportunities.

These stablecoins are then used as a payment mechanism in the ever-expanding Terraform Labs financial “ecosystem”, which also includes a protocol (Mirror) for creating synthetic assets that track the performance of U.S. stocks, futures, and exchange-traded funds; a A lending and savings platform (Anchor); and a partner payment platform (Chai). Terra also plans to add DeFi asset management, additional lending protocols, and decentralized leveraged insurance protocols to this budding ecosystem.

The Terra stablecoin is the “core” that connects emerging financial “infrastructure”, which includes the aforementioned e-commerce payments, synthetic stocks, exchange-traded funds, derivatives and other financial assets, savings, lending and borrowing applications. Terra’s operation, as a protocol, incentivizes independent traders to buy its stablecoin in exchange for LUNA when the stablecoin falls below its peg. The stability of the Terra stablecoin goes beyond DeFi speculation. Given their many applications in their “Terra Economy”, these algorithmic stablecoins also directly impact the economic outlook of many businesses and consumers.

For this ecosystem to remain viable, the Terra stablecoin and governance token LUNA must have a permanent baseline demand level. In other words, there must be sufficient arbitrage activity between the two tokens, as well as sufficient transaction fees in the Terra ecosystem and mining demand in the network. Terra’s founders assert that mainstream adoption of their stablecoins as transaction currencies, and the ability to “stake” them and earn rewards, creates “network effects” and long-term incentives to hold and maintain the ecosystem.

As such, Terra is betting that the use of stablecoins (and LUNA) on their “network” of financial applications will drive perpetual demand. This assumption is uncertain, Terra stablecoins have strayed from their pegs in the past. In many ways, a developing DeFi financial ecosystem backed by algorithmic stablecoins with no real collateral or government guarantees, but relying on the perpetual interests of individually motivated market participants for sustainability, looks like standing The dominoes – once the first one falls, all others may be affected.

 

in conclusion

 

Despite the search for conceptual models of sustainable price stability, algorithmic stablecoins have so far exhibited a complete lack of stability and are therefore unsuitable as a substitute for money. Unlike secured stablecoins, algorithmically stable investments appear to be “doomed to fail.” Financial writer JP Corning argues that they are “prone to perpetual rupture” because they are fragilely dependent on “circular relationships” between different players – those who desire “stability” on the one hand and those seeking “high returns” on the other. opportunity”. Algorithmic stable investing is unlikely to serve any true long-term investing. Raising consumer welfare, or financial inclusion functions other than short-term debt speculation, yields little inclusivity or system-wide benefits. As others have pointed out, they are “unstable, threatening their usefulness”.

Like other stablecoin varieties, the algorithmic form currently lacks transparency, censorship guarantees, and oversight. As this paper points out, they are also built on fragile foundations that rely on uncertain historical variables: they require a level of support from baseline requirements, they require the involvement of willing arbitrageurs, and they require an information-efficient environment. None of these factors are definitive, and in the context of financial crises or periods of extreme volatility, all of them have proven to be very vulnerable. History shows that they are likely to be prone to instability and failure,[118] and they should be regulated to provide full transparency and strengthen consumer protection and risk control measures so that they are not intertwined with the larger financial system. Interrelated.

Current U.S. financial regulation around stablecoins is fragmented, inefficient, and in many cases overlapping. Clarity on the scope of stablecoin “regulatory scope” has yet to be determined. They are overseen by the federal Financial Crimes Enforcement Network (FinCEN) as well as national money transfer and virtual currency licenses. They also create “bank-like risks” — especially shadow deposits like money market mutual funds, whose monetary policy implications implicate the Federal Reserve. Their systemic risk considerations have the Treasury Department-led Financial Stability Oversight Advisor backed by the President’s Working Group on Financial Markets. They also have jurisdiction over the Consumer Financial Protection Bureau (CFPB), the Office of the Comptroller of the Currency (OCC), the Commodity Futures Trading Commission (CFTC), and the Security and Exchange Commission (SEC).

A comprehensive approach to regulating stablecoins that transcends institutional divides is needed. Ideally, the regulatory framework for all stablecoins will include issuer registration requirements, prudential measures, collateral custody safeguards and reporting transparency, a clear taxonomy clarifying stablecoin forms (and distinguishing algorithmic varieties from others), and risk disclosures and containment measures.

Such a framework would likely require what newly appointed SEC Chairman Gary Gensler has described as a “carte blanche” for crypto transactions by a specific agency, although it has been adapted and applied to stablecoins. Some fully collateralized stablecoins may have financial inclusion benefits such as faster and cheaper global remittances, real-time payments, the application of fiscal stimulus, and the ability to act as a broker for weak credit profiles and underbanked transactions. Therefore, there is a need for a regulatory framework that supports innovation that can still create transparency, risk control and consumer protection safeguards.

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