A brief look at Vitalik’s “truly stable” algorithmic stablecoin

After the recent LUNA crash that resulted in billions of dollars in losses, Ethereum co-founder Vitalik Buterin has publicly expressed his views, sharing with the crypto community two of his thought experiments on making algorithmic stablecoins “truly stable.”

In a blog post, he explained that greater control over DeFi financial mechanisms — especially those designed to optimize capital efficiency — is most welcome. But more importantly, we should all recognize that good performance today does not guarantee future returns or prevent future crashes.

There are many models of automated stablecoins that are fundamentally flawed and destined to fail at some point, and many more that can survive in theory but are very risky. Many stablecoins are very robust in theory and have withstood the test of extreme conditions in the crypto market. Therefore, what we need is not "stablecoin supporters" or "stablecoin doomsayers", but a return to principle-based thinking.

Could a Stablecoin Drop to Zero Users?

Buterin said that when stablecoin activity in the market drops to close to zero, users should be able to extract fair value liquidity from stablecoin assets.

In the context of Terra, Buterin wrote a “Volcoin” — a volatile counterpart to a stablecoin, in this case LUNA. The price of Volcoin fluctuates with expectations of fees from future activity in the system, and as expected future activity approaches zero, the market cap of Volcoin decreases until it becomes very small compared to the stablecoin.

“First, Volcoin price drops. Then the stablecoin starts to become unstable. The system tries to support the demand for the stablecoin by issuing more Volcoin. Since trust in the system is low and there are few buyers, the price of Volcoin drops very quickly. Eventually, when the price of Volcoin approaches zero, the stablecoin collapses.”

Ethereum uses a different principle. The security of Ethereum's stablecoin RAI relies on Ether, an asset outside the RAI system. Therefore, a decrease in trust in the stablecoin does not lead to a negative feedback loop between the two assets, and users can still exchange RAI for ETH. During this process, Ether is locked in the vault to ensure that the stablecoin is backed.

Another model

Vitalik also explained another working principle of stablecoins. Stablecoins are pegged to an index that grows 20% per year. This can lead to two results: either negative interest rates are imposed on holders, offsetting and balancing the growth rate of the US dollar included in the index. Or it becomes a Ponzi scheme, giving huge returns to stablecoin holders for a period of time, until one day the entire system suddenly collapses.

“This reveals a deeper, more important truth about stablecoins: in order for a collateralized automated stablecoin to be sustainable, it must somehow incorporate the possibility of negative interest rates,” Buterin explained.

“Stablecoins have to be able to somehow cope with a situation where interest rates are zero and demand for holding is higher than demand for borrowing. If that happens, the price will rise above the peg and the stablecoin will be vulnerable to price movements in either direction, which is very unpredictable,” he added.

In conclusion, Buterin pointed out that even if a system passes this test, it does not mean it is safe. Such stablecoins may be vulnerable for other reasons, such as insufficient collateral and governance flaws or loopholes.

“But the steady state and stability in extreme cases should be one of the first things we check,” Buterin said.

It remains to be seen whether Vitalik Buterin’s suggestion will work.