The Quest for a Truly Decentralized Stablecoin

Algorithmic stablecoins, which maintain their pegs without collateral, are either a fool's errand or simply a matter of time.

AccessTimeIconJul 6, 2021 at 1:42 p.m. UTC
Updated Dec 10, 2022 at 8:01 p.m. UTC

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. 

"I think stablecoins will replace the eurodollar market completely," said Tushar Jain of Multicoin Capital.

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

Stablecoin history begins with Tether, which runs USDT. Originally known as Realcoin, it began in October 2014.

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.

Second, it remains by far the dominant stablecoin in the market, the third-largest cryptocurrency overall, and has a market cap of $64 billion as of this writing.

Third, sentiment around Tether in crypto has changed. Where once it met widespread skepticism, now it is treated as one of the “too big to fail” pillars of the crypto economy.

"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.

This part of the market is established and it has worked well. Those who want more regulatory confidence than USDT affords tend to turn to the CENTRE Consortium's USD coin (USDC).

There are many others as well, such as Binance USD (BUSD) and TrueUSD (TUSD).

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.

Tokens Liquity's LUSD probably count in here, and perhaps FEI does as well.

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.

As it happens, UST is a purely algorithmic product. It has a small base of users in e-commerce in Southeast Asia plus it has moved strongly into DeFi with savings and synthetic assets products.

"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 the price of a major global fiat currency, scaling massively, becoming intuitive for users and rising to global relevance, but that limitless robot will still forever shadow some state-backed currency. 

Tan disagrees. 

Leaving the dollar standard

One level further, crypto redefines how people think about value.

The consumer price index (CPI) is a way of assessing what the real value of a currency is in an economy based on things people buy. Basically, the U.S. Bureau of Labor Statistics has people who go out and check the prices of lots of real goods and it tallies them up. This is how Washington keeps an eye on inflation.

The Economist magazine does roughly the same thing, tracking the price of just one product around the world (The Big Mac, from McDonald’s), and it works surprisingly well. Which is just a way of showing there's more than one way to sort out what the real value of money is, and investment researcher Lyn Alden has argued the CPI in the U.S. somewhat undercounts inflation. Any way you slice it, no one has ever really come up with a perfect way to track "real prices."

Nevertheless, Tan said the final phase of stablecoins will do better than nation-state tracking systems, and that's where she sees the puck headed.

"Stage four is to redefine what CPI means," Tan said. She believes a good blockchain product will effectively oraclize real product prices in the world, find the right basket that consistently represents real value relative to the most people's lives and that's what the decisive stablecoin will peg its price to – not some fiat currency that could go haywire with one bad administration.

A project that succeeded there would be completely independent of anything centralized.

"Centralization is an attack vector. We want permissionless and decentralized assets in crypto," Jain said.

Unit of account

And here's the thing: At least two products are working on something like a crypto CPI in their own way. And a third is kind of scratching the same itch, but in a different way.

The fist is Frax, which has a plan to roll out its approach to a CPI that will evolve over time. Kazemian explained that the team wants people to know that their wealth one day will be the same tomorrow as today. Your FRAX should always buy as many Big Macs as you expect it to, in other words.The alpha version hasn't rolled out yet but in a tweet thread early this month, Kazemian explained the reasoning behind the plan for the Frax Price Index.

Ampleforth is taking a similar approach, but in a different way. Ampleforth doesn't target the price of the U.S. dollar, full stop. AMPL are pegged to the value of the 2019 U.S. dollar, which means that over time it will diverge more and more from the dollar as it’s known on the street, but to an AMPL holder their wealth should remain basically the same as it was.

Crypto insiders have long complained that everyone holding dollars is invisibly losing money each day, so this is Ampleforth's solution.

"You just want a stable unit of account," Kuo said. "One of the benefits of a purely algorithmic approach is you can do that."

Which really brings up a forth product. This unit-of-account idea is a powerful one. A unit of account is the yardstick for what a thing is worth.

The really precise way to think of the value of things is to think of them in terms of each other. If a candy bar is $1, a large one-bedroom apartment in Brooklyn is $2,000 and a nice used car is $10,000, then really the car is 10,000 candy bars or five months of housing in Kings County.

People don't really think like that, though (at times to their detriment), and currency gives us a way of intuitively assessing value. It would be very hard to get people to think intuitively in two different currencies at once, but if crypto threaded that needle it might be on the way to finally winning hearts and minds.

To that end, there's a third project that isn't really a stablecoin but it aims for lower volatility. Reflexer Labs has made a token called RAI that tracks the price of Ethereum's ETH, but using control theory to take all the big moves out and just follow the broad movements.

If any of these projects were to take off, there would be a crypto-native way for people to think about how much stuff is worth, but it also doesn't need to be any of them. The view of Tan and Leshner and others all came back to this point: it could take a while. Failures now don't really prove that the algorithmic approach can't work, only that the world isn't ready for it.

Not so long ago, the electric car was dead. Then it wasn't

Stablecoins circa 2020 may turn out to be like MC5 putting out its proto-punk track "Kick Out the Jams" in 1969. The band wasn't wrong; the world was. 

"We want to jump all ahead to no reserve-backed. It doesn't work now, but it's okay," Tan said.

Bad seeds

If it feels like most of these projects look much more like experiments than real shots at changing global payments, that's no accident.

Even entrepreneurs taking a very long view don't seriously expect to grab the public's attention yet. It's just too early.

"I think only very, very crypto-native people are likely to use it. This is basically purely for the tech," Kazemian said.

But there is a difference between projects fiddling with the dials to see what works and test incentive structures, and projects set up simply to drive a craze, create a bunch of winners and losers, all while stacking the deck to make sure the creators wind up in the winners' column.

Late in 2020, we saw projects including Basis Cash and Empty Set Dollar come out. Projects in this class have fallen so far off their pegs that their mechanisms couldn't save them. They are in the "dead zone."

Basis Cash, Empty Set Dollar and Dynamic Set Dollar are all trading at under 10 cents, more than 90% off each one's targeted peg. The recent snafu known as Iron Finance is also a relevant case.

So how can crypto denizens tell the difference?

The simplest advice is probably this: Fools rush in.

Some might point to the Iron Finance debacle as evidence that algorithmic stablecoins are fated for chaos, but is it really a relevant case?

If your reason for getting into a stablecoin project is because you're worried about missing out on a lot of fast gains, well, that doesn't sound much like a project driven by stability, does it?

If it doesn't look like a project is working to make itself reliable, it makes sense to look elsewhere.

"The way that we view money is: Money is just a medium of trust that people have. Trust is something that is very hard for us to measure or predict," Hoang said. "If over time more and more people come to trust the system and more and more people come to use it, it could potentially work out."

People trust things that are useful to them. Kwon suggested keeping an eye out for projects that seem to put use cases before buzz and before finding excuses to issue a bunch of tokens to stakers.

"It's not about the most clever design, that actually doesn't matter very much," Kwon said. "It's really about standing up a strong ecosystem."


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