Can Algorithmic Stabelcoins Solve the Trilemma?


Algorithmic Stablecoins

Algorithmic stablecoins have been promising a solution for the stablecoin trilemma for a long time. Instead of relying on a Fiat-backing or an over-collateralized crypto-backing, algorithmic stablecoins have implemented a complex algorithm balancing the supply and demand of the stablecoin to maintain price stability via smart contracts. Hence, the price stability mechanism does not rely on any off-chain or on-chain direct collateral. The algorithm usually balances a two-token model with a mint and burn mechanism. Thereby, a second price-floating token is issued. The protocol ensures that investors can always swap one stablecoin for $1 of the price-floating token. Thereby, arbitrageurs are incentivized to buy the stablecoin on the market and exchange it for the price-floating if it's trading below the peg and vice versa. If investors want to swap their stablecoins, the protocol mints new price-floating token while the supply of the stablecoin contradicts.

The Case of UST

Algorithmic stablecoins have been the first to create capital-efficient stablecoins. Critics argue that algorithmic stablecoins create value out of thin air and can only survive, as long as the trust in its algorithm is strong enough to manage the demand and supply. Recent events with the crash of UST from the Luna Foundation Guard together with its Luna token have proven the extraordinary risks associated with algorithmic stablecoins. Highly solvent market acteurs have attacked the peg of the UST by heavily dumping UST on the market. If such an attack is only of short duration, the algorithm will balance supply and demand and bring the stablecoin back to its USD peg. But in the case of UST, the well-capitalized attack was coordinated in times of big market uncertainty, and investors more and more lost their trust in UST. This led to a so-called death spiral in which more and more Luna tokens hat to be minted to support the UST price and thus, heavily inflating the Luna price. The lost trust through a further dropping UST price led to more and more people trying to exit the coin. The Luna Foundation guard tried to stabilize the price of UST through the use of its crypto reserve but this was just a drop in the ocean.

The Future of Algorithmic Stablecoins

The crash of UST has shown the high risk associated with algorithmic stablecoins. Not only UST but also other algorithmic stablecoins have lost significant market cap caused by the crash. As an answer, hybrid stablecoins gain some momentum. These stablecoin protocols combine an efficient mint and burn algorithm with on-chain crypto-based collateralization. Thus, the risks of a total crash such as in the case of UST are reduced while the capital-efficiency still remains higher than for solely fiat-& crypto-backed stablecoins.