The cryptocurrency industry won’t stop trying to make a purely algorithmic stablecoin work. To understand why, all you have to do is look at the U.S. dollar.
The dollar was once basically a stablecoin tied to gold, and that worked well as the greenback was establishing itself as an asset, said Lisa Jy Tan, founder of Economics Design, a crypto-economics research company. The U.S. left the gold standard ostensibly because there was a war. But in time the American economy got so much bigger that it needed more flexibility than the gold standard afforded.
“It doesn’t work in the long run because the economy is still expanding faster than the amount of materials available,” Tan said.
Similarly, she expects the crypto economy will also outgrow a collateral obligation eventually (hopefully without a war).
An algorithmic stablecoin is one that can keep its peg using only software and rules. If one ever works, it could scale infinitely, to whatever size an economy needs.
“To create USDC you need USD in the bank, and that works well if you’re just starting out,” Tan said. “What comes after, it’s the right kind of monetary policy that allows stability and low volatility to allow people to trade … if we can do that with math and we can do that with monetary policy, that’s more efficient.”
Tan just finished up an extensive study of stablecoins that are either fully algorithmic or could evolve in that direction over time. Her conclusion: None of them are ready yet, but that’s also fine for now.
“The reason algorithmic stablecoins keep getting tried is because it feels like the Holy Grail. It’s like bitcoin and settled on-chain, but actually stable and with purchasing power,” said Sam Kazemian, co-founder of the decentralized encyclopedia, Everipedia, and more recently of a mostly collateralized stablecoin called Frax.
Without stablecoins, there would have been no decentralized finance (DeFi) booms, which means there probably would have also been no non-fungible token (NFT) boom. Stablecoins have been table stakes for what the industry has achieved so far.
And the crypto industry largely agrees that some set of stablecoins will have a very bright future.
A stablecoin that scales infinitely is a very enticing problem to solve, but the last year has been unkind to the approach; several have tried. And yet, entrepreneurs are not giving up.
That said, a lot of the projects we’ve seen have looked and felt more like games than serious attempts at solving crypto’s volatility problem. And even well-intentioned ones seem to operate on the assumption that stable prices are just a matter of the right engineering.
Watching the attempts, Jain has begun to suspect that, as he put it, “Risk cannot be created or destroyed, it can only be transformed.” He sees economic designers looking for the game that erases algorithmic stablecoin risk, but at this point he doubts it’s possible. That said, Jain’s conviction here is not fixed yet.
The rigging might not be the issue anyway. Robert Leshner, Compound Labs founder, which made DeFi money market protocol Compound, said entrepreneurs are looking in the wrong place.
If you imagine a future in which an all-code token is able to hold a stable value, Leshner envisions that it will take “an unbelievable amount of agreement that this asset works.”
To that point, since the Coinage Act of 1792 defined the dollar as 416 grains of standard silver, the U.S. currency unit has had a very long time to establish its underlying economy, hit the world stage and then decouple from its final dance partner: gold. That also took a long time.
Leshner buys the algorithmic stablecoin thesis and has backed many of the projects, but he thinks they are all trying to achieve too much too soon.
For “most actual assets, it’s not a rapid journey to adoption, it’s a slow consensus-building journey to adoption,” Leshner said.
The way of all stable crypto things
Tether’s model was always simple: It promised that for every USDT there would be an actual redeemable dollar in the bank somewhere. The various question marks and traffic bumps that Tether has faced over the years don’t need to be recounted here. There are just really three salient points to make.
First, Tether has shifted its collateral mix but still claims to be fully backed.
“The culture definitely has shifted, mainly due to the continuous existence of Tether and the support of Tether by large institutional traders,” said Kory Hoang, CEO of Stably, an asset tokenization startup (which also once issued its own stablecoin).
DeFi’s best shovel
Since Tether, many stablecoins have followed. Stablecoins have been crucial in DeFi history. If Tether’s USDT and MakerDAO’s DAI had not worked, it is hard to imagine there would be billions of dollars locked up in all these financial smart contracts today.
Hoang and Tan offered a vision for how this future is going to play out (much of which is already here, if not fully realized). Both had views that were largely in sync with a few slight additional wrinkles from one or the other, though without direct contradiction.
The obvious place where it all begins is reserve-backed stablecoins, crypto tokens that are buoyed by assets, usually in the form of fiat currency (almost always dollars) – like Tether’s USDT.
The next phase comes from Hoang: over-collateralized but more decentralized stablecoins, such as MakerDAO’s DAI. DAI began as a stablecoin collateralized only with ETH, the cryptocurrency that runs the smart contract chain Ethereum. This required it to be seriously over-collateralized, at a minimum 150% but in practice usually much higher.
The next phase, Hoang says, is meta-stablecoins. These are stablecoins that exist in smart contracts that are making use of them and give depositors tokens that account for their deposits. These meta-stablecoins have unique properties, either growing in value or growing in quantity based on the success of the deposit.
So DAI deposited in Compound becomes cDAI, which earns the interest on that deposit. Or any of several stablecoins deposited onto the automated market maker Curve, in its yCRV pool. Such deposits become yCRV tokens.
In most cases, they roughly track the fiat currency to which the meta-coin is pegged (see for example Aave’s aUSDC), but they also earn a yield.
Then Tan pointed to partial reserve-backed stablecoins. Her report argues the most successful of these, so far, has been the aforementioned Frax project, which is largely backed by USDC but requires a small portion of each FRAX token to be backed by its governance token, frax shares (FXS). One could argue that DAI has entered this category since USDC has become one of its largest collateralization sources.
They both agree the next level after that will be the purely algorithmic stablecoin, with no collateral.
For what it’s worth, CoinGecko did a report this year that gave Frax a nice endorsement, but it gave similar props to UST as well. UST is the Terraform Labs stablecoin that tracks the U.S. dollar price. Built on a Tendermint-based blockchain, UST has bridged its way to Ethereum and Solana already.
“I think tether and USDC is great, but if you build crypto apps on top of assets that can be regulated, and I think as they get larger they are sure to get regulated, then it holds DeFi hostage,” said Do Kwon, Terraform Labs’ CEO. “The only way you can solve this is if you come up with a truly decentralized and unbiased form of money.”
It’s not the only reserve-less stablecoin either. There’s also Ampleforth (originally known as Fragments), which keeps it simple. It simply expands and contracts the supply of all token holders’ holdings as needed to meet its peg.
It trades price volatility for supply volatility in order for everyone to always know what an AMPL is worth. Ampleforth founder Evan Kuo said that having looked at all the potential features Ampleforth could have added to reinforce stability, he found those extras actually make it worse.
UST and AMPL have not had meltdowns (while others have, more on them later), even though this has been a wild year. Year to date, TerraUSD has traded in a pretty tight band around its target $1 price, though it had one moment at $1.04 and and another at $0.96 in that period. AMPL has had a wilder ride over the same period, going as high as $1.66 and as low as $0.55.
Kuo argued that AMPL has a strong future as a truly decentralized asset to borrow. As that market shapes up, he said, AMPL’s stability should improve and time will prove Ampleforth’s one-token thesis to be right.
Most people think this is where stablecoins stop – if they are even willing to believe that it can get this far.
The final phase, the most optimistic observers say, is that one day someone in the crypto industry will build an algorithmic stablecoin that tracks…