Do Algorithmic Stablecoins Provide the Required Stability for DeFi

Do Algorithmic Stablecoins Provide the Required Stability for DeFi

By kev_nag | kev_nag | 29 Mar 2021


INTRODUCTION:

"An algorithmic stablecoin is a token that adjusts its supply deterministically (i.e. using an algorithm) in order to move the price of the token in the direction of a price target.... At the most basic level, an algorithmic stablecoin expands its supply when it is above the price target and contracts when it is below."(https://insights.deribit.com/market-research/stability-elasticity-and-reflexivity-a-deep-dive-into-algorithmic-stablecoins/). To be truly effective in DeFi, an Algorithmic Stablecoin must meet all three of the traditional characteristics of 'money. These characteristics are: 1. as a unit of account (how prices are measured); 2. as a medium of exchange (the asset that is actually used for delivering and representing value); and, 3, as a store of value (an asset that is expected to carry neither losses nor gains over long periods of time). It is, however, necessary to first understand both types of Algorithmic Stablecoins presently existing.

HAYEK MONEY & SEIGNIORAGE SHARES

Hayek Money was envisioned in a 2014 paper by Ferdinando Ametrano. In this paper (Hayek Money: The Cryptocurrency Price Stability Solution), to address Bitcoin's failure as a unit of account, Ametrano proposed a supply elastic strictly ruled cryptocurrency that adapts the token supply through all its token holders pro rata according to demand for the token to maintain a peg. In essence, this is 'rebasing' and Hayek Money finds its present practice in AMPLEFORTH.

Seigniorage Shares finds its inception in another 2014 paper by Robert Sams (A Note on Cryptocurrency Stabilisation: Seigniorage Shares). With a similar justification as Hayek Money, Sams advanced a system of two tokens, the supply elastic token and the investment token, doing away with rebasing. In this system, owners of the Seigniorage Shares (the investment tokens) bear the burden of debt when the supply contracts but receive rewards when supply increases. To clarify, when the token's price is above peg, the system solution is easy - automatically create more tokens until the peg is restored. However, when the token's price falls below peg the solution is somewhat complicated - the supply of the token must be reduced to restore the peg. This is accomplished by enticing token holders to in effect lock up their tokens in exchange for Seigniorage Shares thereby reducing the number of tokens and restoring the price to peg. The enticement is present within the Seigniorage Share as it represents a promise to pay additional stablecoins conditioned on the lock up once the peg has been restored. Seigniorage Shares finds its present application in such Stablecoins as the EMPTY SET DOLLAR  and the DYNAMIC SET DOLLAR.

REBASING STABLECOINS

The rebase system relies on supply elasticity or periodic expansions and contractions of the entire supply to maintain the peg. Resultant therefrom, the token's supply can expand and contract at a feverous pace putting great pressure on the nominal price of the token. A user's portfolio value of the token does not change if the price shift matches exactly the percentage of new tokens minted. In practice the expansion and contraction mechanisms present in rebasing are effective in maintaining peg. But as every wallet in the system is subject to the rebase, nominal price is not the only consideration in terms of volatility. As every wallet in the system is affected by the supply changes these changes must be considered when assessing the 'stability' of a coin. Utilizing AMPLEFORTH as an example when accounting for both supply and price in its total market capitalization, clearly AMPLEFORTH is extremely volatile.

'Stability' is a requirement for an algorithmic stablecoin to achieve long term viability. This requirement is onerous to meet due to the inherent reflexivity of the supply changes. While algorithmic supply changes are intended to be counter-cyclical (inverse change of supply to change in price), in practice these supply changes often reflexively amplify directional movement (direct change of supply to change in price). Thus, the required stability within the system is lost.

In order to achieve long term stability an algorithmic stablecoin must grow to a market capitalization of sufficient size so that buy and sell orders cause no fluctuation in price. The only way an algorithmic stablecoin can achieve a sufficiently large enough size is through reflexivity and speculation, but highly reflexive growth can not be sustained in the long run. So an apparent paradox emerges: the larger the network market capitalization buy/sell orders do not lead to large price fluctuations. However to reach and maintain a network market capitalization of sufficient size in the first place, the stablecoin system must be subjected to extreme expansion/contraction cycles exhibiting high reflexivity. Again, stability is unachievable.

As such, it is apparent that a rebasing stablecoin fails to provide maintainable stability to be useful in DeFi. It is worthy of note that AMPLEFORTH is somewhat useful as a unit of account but fails as a medium of exchange and a store of value due to the volatility surrounding it. Nonetheless, AMPLEFORTH is collaborating with AAVE to integrate the AMPLEFORTH coin into the AAVE lending system resulting in the first such lending application for AMPLEFORTH since launch.

SEIGNIORAGE SHARE STABLECOINS:

The principle challenge in Seigniorage Share Stablecoins is found in the maintenance of market confidence that the underlying algorithm will in fact hold the price of the coin at or near peg. Discussions concerning this type of Stablecoin emphasize the theoretical ability of the Stablecoin to maintain its peg through buyers stepping up in times of price declines being willing to arbitrage the short term price decline on the promise of selling the purchased shares once peg is restored or exceeded for profit. Predicated therein is the belief that the Stablecoin will, in fact return to its peg. It can be argued in a broad sense that this type of Stablecoin may be dependent on the continual expansion of the cryptocurrency market as a whole as the expansion brings with it an increasing crop of buyers for the Stablecoin increasing demand and thereby moving price back up to peg.

Assume, arguendo, a scenario where confidence in restoring peg for a Stablecoin is lost. Absent the confidence in the restoration mechanism buyers for the Seigniorage Share are likewise absent and the attempt to move price to peg by selling shares for coin reducing supply fails in its entirety.

An overall loss of confidence in general cryptocurrency markets as a whole is not necessary to doom a Stablecoin's operations. Any lack of buyer interest (e.g. introduction to the market of a new more appealing Stablecoin; sentiments wherein one type of Stablecoin falls out of favor; any negative general market condition) has the same effect of negating the price stabilization mechanisms. At its worst, this may result in a 'death spiral' for the Stablecoin. As price continues to fall, an increasing amount of Seigniorage Shares must be sold to lower the supply of the Stablecoin in the system and as the unredeemed Seigniorage Shares increases with this dilution and continued inability to restore peg buyers are further discouraged away from the system crashing the Stablecoin to zero.

A question of great importance exists for all Seigniorage Share Stablecoins. A serious risk is present for a Stablecoin in this class as a result for the failure of a peer Stablecoin. A crisis causing one Stablecoin in the sector to fail would disgrace all of the Stablecoins in the sector potentially leading to a series of sector collapses as each individual Stablecoin has its algorithim tested by the market. Worrisome in this regard is that the users of Seigniorage Share Stablecoins are not only betting on the mechanisms of their own Stablecoin but also betting on the mechanisms of the weakest Stablecoin in the group. A failure of the weakest could spell doom for all Stablecoins in the group.

Simply put, there is so much volatility surrounding Seigniorage Share Stablecoins that they fail to meet all three of the characteristics of money and as such fail to meet the needs of the evolving DeFi space. All one needs to do is pull up the price chart for the DYNAMIC SET DOLLAR to demonstrate the reason for Seigniorage Share Algorithmic Stablecoins inability to satisfy the needs of DeFi.

CONCLUSION:

Given the current state of Algorithmic Stablecoins, it is readily apparent they are totally inadequate to meet the needs of the existing DeFi markets. Although the long term success of Algorithmic Stablecoins is far from assured, they provide an interesting monetary experiment in the cryptocurrency space as well as a fascinating topic to research. It is way too early to throw in the towel on Algorithmic Stablecoins as the need to get away from the centralized capital intensive Collateral-Based Stablecoin is present. Clearly, the creation of stability in the absence of collateral is problematic. Perhaps in the long run market dynamics and newer price stabilization mechanisms may yield an Algorithmic Stablecoin which holds its value effectively. But at present, all of the existing Algorithmic Stablecoins have failed to prove they work for the purpose intended.

I am merely an ordinary small investor who likes to share what I've learned and found interesting. Please take a few minutes and check out my other published articles. I am not in any way a financial advisor and as such, do your own research before investing. If you enjoyed this article please like it, comment and/or tip. Feedback is always welcome here.

 

 


kev_nag
kev_nag

Just an ordinary casual crypto investor.


kev_nag
kev_nag

Retired, finally. I enjoy learning about crypto and sharing my discoveries. Also, I follow the News closely and enjoy discussing current events. I have no political agenda, but advance views based in reality with a slant toward real world consequences.

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