Algorithmic Stablecoins: What is it?

Have you ever wondered why the PayPal balance is always equivalent to a dollar? PayPal uses a time-tested recipe to create a stable representative of the dollar: it ensures that every PayPal dollar is backed by sufficient assets.

New solution or absurd?

A new generation of financial engineers, the so-called developers of algorithmic stable coins, want to do something that has never been done before. They want to create a stable representative of the dollar, but without any means to support it. That is, they want to create stability… out of nothing.

Is that even possible? Or are these experiments doomed to failure?

The PayPal dollar is stable because for every dollar issued, PayPal keeps another one in a bank account, or invests in a reliable government debt. As long as PayPal assets retain their value and customers are free to convert between PayPal and bank assets, the value of PayPal dollars will never deviate from $1.

This is an old formula. The issuer of ten-shilling notes in the nineteenth century kept in its vaults interest-bearing loans and stocks of coins worth at least ten shillings. This, combined with the promise to redeem the notes on demand, ensured that his ten-shilling notes were always worth ten shillings.

Advanced financial technologists continue to rely on this old-fashioned recipe. MakerDAO, the blockchain-based protocol that manages the Dai stablecoin, supports about $ 1.5 billion worth of Dai stablecoins in circulation, holding in reserve Ethereum, Bitcoin and other crypto assets worth about $ 4.5 billion.

But is this stock of collateral and reserves even necessary? The algorithmic stablecoin development team thinks not. They want to issue stablecoins denominated in dollars, pegged to $ 1, but they also want to make them “capital efficient”. That is, they want to be released from the obligation to hold huge amounts of collateral to stabilize their bindings.

How Algorithmic Stablecoins Work

The algorithmic stablecoin system begins life by creating a series of digital tokens, or stablecoins, out of thin air. If a stablecoin trades above $ 1, the system automatically creates new stablecoins until the price drops to $1. This is the easy part.

If the stablecoin falls below $ 1, things will be a little more complicated. To restore the binding, the algorithmic stablecoin system must reduce the supply of stablecoins. The Empty Dollar Set (ESD), the largest of the algorithmic stablecoin systems, does this by encouraging users to exchange their ESD stablecoins for coupons. These coupons block ESD stablecoins for a certain period of time. Theoretically, as more and more funds are transferred to coupons, enough ESD stablecoins will be withdrawn from circulation, so that their price will rise again to $ 1.

To encourage users to buy coupons, the Empty Set Dollar system sets an enticing exchange rate between ESD stablecoins and coupons, say, 1 ESD stablecoin for 1.1 coupons. Thus, if you have 10 ESD stablecoins and their price falls below the $ 1 peg, the system will allow you to convert your 10 ESD stablecoins into 11 coupons. When (or if) the price of ESD stablecoins rises above $ 1 again, you will be able to convert your coupons into 11 ESD stablecoins. Voila, your 10 ESD stablecoins have turned into 11 with a 10% profit.

In short, the coupon can be seen as a promise to pay even more ESD stablecoins, in the future, provided that the ESD stablecoins are blocked now, but only if and when the peg to the dollar is restored.

The further the price of ESD stablecoins falls below $ 1, the more attractive the coupon conversion rate set by the system becomes. In other words, the more it fails, the more the stablecoin’s algorithmic system tries to use forces to self-repair.

All of this sounds good in theory, but what about practice? Fortunately for us, algorithmic stablecoins are not just ideas written on paper. ESD debuted last September and provides real data on how these things work. It was joined by a second algorithmic stablecoin. Dynamic Set Dollar (DSD), an ESD clone, was launched in late November.

Both algorithmic stablecoins proved popular. At its peak, at the end of December 2020, ESD and DSD issued $ 550 million and $ 300 million worth of stablecoins. accordingly.

How close are their prices to $1?

For the first few months, the binding mechanisms seemed to be working. When the ESD or DSD rose above $ 1, new coins were created, which led to a decrease in their price. And price periods below $ 1 have also been successfully fixed with the aforementioned coupon freeze mechanism returning them back to $ 1.

Однако с конца декабря цена ESD постепенно упала до 23 центов. DSD stablecoins fell to 24 cents. There is no indication that they will ever return to $ 1. The ESD value is shown in Figure 1. The size and volume of the DSD are shown in Figure 2.

It turns out that the dollar with an empty set and the dollar with a dynamic set do not work on a permanent basis? It’s probably too early to tell. But it is worth assuming that algorithmic stablecoins are subject to irreversible failure.

To understand why, let me suggest a simple way to think about these systems. The success of an algorithmic stablecoin depends on a careful dance with tambourines around two types of participants. For example, Vasya likes stability, so he prefers stablecoins, and Lyusya likes to speculate and prefers high-yield opportunities, such as coupons.

The relationship between them is circular. Vasya’s decision to keep the ESD stablecoins depends on whether he believes that Lusya will buy the coupons when the binding starts to fail. But Lucy’s decision to buy coupons depends on whether she trusts Vasya to use the ESD stablecoin system.

As long as the two participants remain positive, their mutual expectations can keep the system at $ 1. But if, for any reason, Vasya and Lucy’s self-referential beliefs in each other begin to deteriorate, the price of stablecoin will irrevocably collapse. Vasily will not use stablecoins, because he does not think that Lyusya will support the system by buying coupons. Lyusya will not support the system, because she does not think that Vasek will use the system’s stablecoins.

Conclusion

It is possible that the self-rated beliefs of users of algorithmic stablecoins in each other will hold the $ 1 peg for a certain period of time. But this balance is fragile. At any given time period, there is some probability that the system will fail. Hence, the probability that the system will fail after some time interval between now and X approaches 1 when X approaches infinity. In other words, it is very likely that at some point the system will fail, even if it works exceptionally well today.

The stability of traditional dollar representatives, such as PayPal balances or MakerDAO’s Dai stablecoins, depends on a less fragile stabilization mechanism than users ‘ self-preferential expectations. Stocks of assets or collateral of PayPal and Dai-that’s what protects them. If PayPal or MakerDAO users suddenly lose confidence, having an independent anchor of solid reserves should help overcome, or at least loosen, the negative feedback loops.

Efforts to create stability without collateral are ambitious. The evidence that the empty-set dollar and dynamic-set dollar have provided over the past few months suggests that they are too ambitious.

An algorithmic stablecoin works only as long as the self-referential beliefs of its users are preserved.