Vitalik recently shared his thoughts on the future of algorithmic stablecoins in the wake of the TeraUSD failure. Although he believes that skepticism and scrutiny of existing protocols is “highly welcome”, he says that recent attempts to permanently dismiss all automated stablecoins are unfair.
A better model for automated stables
TerraUSD (UST) – an algorithmic stablecoin – was effectively backed by the LUNA Governance token. At any time, holders of UST can burn their holdings to obtain the newly minted dollar value of LUNA. Similarly, one dollar value of LUNA was always redeemable for UST.
This was to create a two-way peg arbitrage incentive that kept the market cap of UST at $1.00 at all times. However, when the peg was pressured earlier this month, the system eventually corrected, causing both UST and LUNA to drop in value.
However, in a blog post on Wednesday, Vitalik argued that there are other automated stablecoin models that are far more robust in both theory and practice than TeraUSD.
He cited RAI – an automated stablecoin backed purely by ETH – as an example. The RAI stablecoin is mined by depositing a collateralized amount of ETH in a smart contract. Two-thirds of the value of that ETH is then rewarded to the depositor – or “lender”.
However, if the price of ETH drops so low that the collateral support RAI is no longer high enough, a liquidation event occurs. The deposited ETH is then auctioned off to buy another by depositing more collateral.
Vitalik explains, “The security of the RAI depends on assets outside the RAI system (ETH), so the RAI has a much easier time winding up securely.” By “winding down” he means the RAI undergoes a decline in user demand to properly redeem its coins without jeopardizing the credibility of the opinion holder.
Vitalik believed that TeraUSD lacked the same kind of credibility. The asset “backing” UST – Luna – had a volatile value, which was also based on activity within the Terra ecosystem (Luna holders could earn from the system’s transaction fees).
Therefore, a decrease in UST demand could reduce activity in the system, leading to a decrease in the value and market cap of Luna. This then leads holders to lose faith in the stablecoin and redeem it for LUNA, further devaluing the governance token, creating a negative feedback loop.
In fact, these processes contributed to Terra’s eventual collapse, in which LUNA hyperinflated and lost 99.9% of its value. Terra’s community has now voted to restart the network with a new chain and abandon its stablecoin project altogether.
Requirements for stable coins
Vitalik concludes that stablecoin makers – and the crypto space more broadly – should stop basing their security assumptions on expectations of endless growth. Instead, they should be assessed on the basis of stable and pessimistic conditions, and whether a safe “wind-down” is possible.
“If a system passes this test, it does not mean that it is secure; it may still be fragile for other reasons (such as insufficient collateral ratio), or have bugs or governance vulnerabilities, “He clarified.
There are others besides Vitalik who reflect his critical view of algorithmic stablecoins. Nick Carter – co-founder of crypto intelligence firm Coinmetrics – believes that the industry should stick with standard, centralized stablecoins backed by trusted reserves.
Anyone in their right mind, given the free option, will not be a stablecoin with 100x the default risk of USDC/USDT,” he tweeted A few weeks before the fall of Terra. “If you want a more decentralized stable, use overcollateralized crypto-backed ones.”
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