Born to Fail: The Inherent Fragility of Algorithmic Stablecoins

Original title: "Born to Fail: The Inherent Fragility of Algorithmic Stablecoins"

Original author: Dr. Ryan Clements

Original compilation: Block unicorn

Algorithmic Stablecoins are inherently fragile, these unsecured digital assets attempt to peg the price of a reference asset using financial instruments, algorithms and market vulnerable state. Several iterations so far have struggled to maintain a stable peg, and some have even ended in catastrophic failure. The article argues that algorithmic stabilization is fundamentally flawed because they depend on three factors that history has proven impossible to control.

1. First, they require a level of support for the needs of business stability.

2. Second, they rely on independent actors with market incentives for price-stabilizing arbitrage.

3. Finally, they demand reliable pricing information at all times.

None of these factors are definitive, and they have proven historically vulnerable against the backdrop of financial crises or periods of extreme volatility. Regulatory guidelines need to be developed for all stable registration forms, including issuer registration requirements, clear taxonomy description forms, scrutiny, collateral custody and transparency safeguards, and risk disclosure and containment measures. A strong regulatory framework with risk disclosure and containment safeguards is especially necessary for algorithmic stable trading, which currently only serves speculative DeFi trading applications and has little, if any, social or financial inclusion value.

Introduction

Financial product innovation is not always a good thing, some innovative They are inherently unstable by design. In 2008, the entire financial system nearly collapsed as housing loans triggered a complex series of securitization-driven, derivatives-enhanced financial product innovations. Now, a new, increasingly popular, poorly designed and inherently fragile financial product has recently emerged that requires proper regulation — algorithmic stability. Algorithmic Stablecoin is a contradiction in terms. So far, market iterations of algorithmic stabilization have shown a complete lack of stability. It is an unregulated, unsecured digital asset that operates in a perpetually vulnerable state. Algorithmic stability has no real peg, but merely derives value from what the ECB’s crypto-asset working group calls “anticipations of its future market value.” As such, it is an incredibly fragile payment mechanism. Algorithmic stablecoins have been hailed by some as a more "capital efficient" antidote to the wild daily price swings of popular cryptocurrencies like bitcoin and ether, which limits their use as money substitutes for consumer transactions, wages or debt moratoriums function. Others claim that algorithmic stablecoins are “rebuilding traditional banking” as a reserve system for the DeFi segment. Neither of these comparisons hit the point, and the claimed utility of algorithmic stablecoins is grossly exaggerated and misguided because three lessons from history make them inherently vulnerable.

First of all, algorithmic arbitrage stability requires the liquidity of the entire ecosystem to maintain balance. If liquidity falls below a threshold level, the entire system will fail. History has shown that fundamental or minimum levels of support for financial products cannot be guaranteed – especially in a crisis.

Second, algorithmic stability arbitrage relies on independent participants with market incentives to conduct price stability arbitrage in order to maintain the so-called "stable" ecosystem. Once again, history shows that discretionary arbitrage that relies on independent, market-driven actors with no legal obligation to enforce stable prices is also vulnerable. History has proved that in a crisis, information becomes opaque, noise crowds send out signals, prices and counterparties become uncertain, and it is easy to form a herd effect. Information opacity undermines the symbolic “economy” and incentive structure of algorithmic stability.

If the "tokenized" incentive structure in any algorithmically stable ecosystem collapses, the entire ecosystem will fail without a backstop or deposit insurance safety net . Algorithmically stable systems exist in a system that is prone to function, become unstable, and fail when reality deviates from the assumptions embedded in the incentive structure. Multiple iterations of algorithm stabilization have failed catastrophically.

Regulatory safeguards needed for all stabilizer types, including issuer registration requirements, clear classification, clarification of stabilizer forms, review rules, collateral escrow safeguards measures and reporting transparency, risk disclosure and containment measures. Risk transparency, disclosure, and containment measures are particularly relevant to algorithmic stable investing, and algorithmic stablecoins are currently only used to power speculative DeFi trading applications.

One, various Stablecoin experience

Stablecoin is trying to compare its value with another A cryptoasset linked to an asset (or a basket of assets including a reserve currency or highly liquid government bonds). So far, there has been no unified definition of a stablecoin — perhaps one of the reasons why regulatory structures have been so slow to implement. The International Organization of Securities Commissions (IOSCO) recommends that stablecoins come in many different varieties and forms.

The most popular form is "off-chain" custody Stablecoin, such as Circle and Coinbase's widely circulated USD Coin (USDC), or Facebook's proposed Diem, two Both use “holdings of fiat currency or high-quality liquid assets as reserves.” Or Tether, which claims to be collateralized by large holdings of commercial paper. Other stablecoins are either fully collateralized or "over-collateralized". Over-collateralization means that more than 100% of the value of a stablecoin is "held on-chain", using another crypto asset to provide the collateral function, such as MakerDAO's DAI Stablecoin. Use a specified encrypted asset over-collateralized (such as WBTC, ETH, and other encrypted assets with better liquidity) to generate Stablecoin DAI, and the collateral ratio is adjusted for a specific locked Token.

The most unstable and vulnerable variety of stablecoins are "algorithms", which are not fully collateralized and use market incentives, arbitrage opportunities, automated smart contracts, and reserve tokens adjustment to try to maintain a stable peg. These types of Stablecoins have been described as the "Central Bank/Federal Reserve" of algorithmic Stablecoins. The size of the Stablecoin variety market has soared to over $119 billion in 2021, with algorithmic Stablecoin varieties accounting for a large and growing share of this market.

Despite the tragic failure of Iron Finance in June 2021, the algorithmic Stablecoin claims the benefits of automating operations and being able to do so without corresponding reserves expand. Basically, the protocol supporting the algorithm Stablecoin attempts to operate as a central bank with "less than one-to-one support" by manipulating the number of tokens in "circulation" in response to changes in their value.

There are various algorithmic Stablecoin models, and there is debate about their exact definitions. They often seek to artificially control the price of a stablecoin by combining the money supply with embedded economic incentives. For example, if a Stablecoin is trading for less than $1, an algorithmic Stablecoin system might offer some other type of digital asset, a digital "bond," a "discount," or an issued "equity" for less than $1, The new capital is used to maintain the peg. A common algorithmic stablecoin structure is a "dual coin" system, where one coin is used to maintain the peg and the other is used to "absorb" market volatility. The latter Token is usually called "equity " or "balancer" Token, and is usually traded on other decentralized exchanges such as Uniswap. The two Token system is usually combined with partial mortgage dynamics. The next part uses Iron Described by Finance's Iron algorithm stablecoin.

Second, the failure of Iron Finance is a big red flag for the product category

Iron Finance Describes itself as a "multi-chain, decentralized, non-custodial ecosystem of DeFi products, protocols, and use cases."  Their initial system was a dual-coin structure trying to create an algorithmic Stablecoin called "IRON". IRON is pegged to $1, but has no actual backing of $1. Recently announced a reboot of “V2” for an “over-collateralized and soft-pegged” Stablecoin. Prior to its nearly $2 billion debacle, each IRON Stablecoin was secured by locking 75% of its value in collateralized USDC, a fully reserved, fiat-backed Stablecoin, and 25% of its value via TITAN" - Iron Finance's own internal governance token with unlimited supply.

Iron Finance collapsed when the value of its infinite supply governance TokenTITAN plummeted in the DeFi secondary market. Iron Finance reports that certain “whale” holders have made significant sell-offs. The market for TITAN was already thin, and this large sale triggered a cascading sell-off of TITAN and redemption of IRON "negative feedback loop". This caused the IRONToken to lose its peg, which in turn "triggered" TITAN's algorithmic minting mechanism and provided an arbitrage opportunity in the resulting "death spiral".

The immediate impact is the large supply of TITAN on the secondary market. At some point, the price of TITAN was essentially zero, and Iron Finance stopped redemptions for the IRON Stablecoin - they only had 75% collateralized USDC coverage to begin with. The moment the price of TITAN was unstable in the secondary trading market, the entire house of cards as an IRON Stablecoin fell, and there was nothing to support this run.

The idea of an algorithmic Stablecoin being an early iteration of a DeFi fractional reserve bank has been advanced. Iron Finance — in explaining the failure of its so-called stablecoin IRON — called it “the world’s first massive crypto bank run” in a “post-mortem” report. This analogy is clearly flawed, and Iron Finance's operating structure was fragile from the start.  

It attempts to create a dollar from 75 cents, assuming its secondary transaction governance TokenTITAN will not fall below a market-determined price floor. It was designed on the assumption that TITAN itself would remain stable — or better yet, its price would increase. Banks also create money through fractional reserves and loans. Yet banks are backed by government deposit insurance - which they pay a huge fee in the form of premiums - and are subject to extensive oversight and scrutiny.

Three, three lessons from the history of financial markets

Three lessons from the history of financial markets Affects the viability of the algorithm Stablecoin.

First, if liquidity dries up, any financial product that requires liquidity support or a fundamental level of liquidity across a product class to function as expected (and assumed) will be prone to failure. Liquidity is unpredictable and affects the price of all securities. However, a product is inherently fragile if it requires a minimum amount of liquidity to function.

As previous work has identified, the level of support required (but not received) from major financial institutions is an important factor in the failure of auction-rate securities markets.  Dependence on base support levels is probably the biggest problem with the unsecured algorithmic Stablecoin dual-coin structure. Tokens that absorb volatility must maintain a certain level of demand support—and not fall below a price threshold—or the entire ecosystem will fail. Non-collateralized tokens claiming to be “stable” require a consistent (if not growing) level of liquidity, and once stopped, the peg fails.

A second history lesson that makes algorithmic Stablecoins inherently fragile and unstable is that they often rely on independent actors with market incentives to enforce price stabilization Arbitrage function.  Arbitrageurs must step in and take advantage of profit opportunities to maintain price stability through minting or redemption activity. The performance of discretionary price-stabilization arbitrage has historically been fragile in crises, and as noted in previous work on ETFs, "market discipline can fail when it is most needed." < /p>

During the 1987 portfolio insurance failure, arbitrageurs stopped buying undervalued assets. More recently, arbitrageurs no longer arbitraged prices between secondary market prices of fixed-income exchange-traded funds (ETFs) (and their underlying NAVs) as the market shifted rapidly to pricing in the aftermath of the coronavirus pandemic in March 2020 dislocation.

A third lesson that has historically cast doubt on the long-term viability of algorithmic stablecoins is that in times of heightened volatility, panic, or crisis, there is widespread information opacity. Efficiently combining price information is a problem that "plagus" many algorithmic stablecoins. Price "oracles" (external price feeds) are not always trustworthy, and there is a problem of "misaligned" incentives when token holders vote on which potential price feeds (from their pool) to adopt.  TITANToken price uncertainty caused Iron Finance to fail in June 2021 due to delays in automated "oracle" feeds.

Waterfalls and investor groups form when information is uncertain, and assets deemed unsafe are quickly sold in sell-offs - a phenomenon As was evident in the 2008 global financial crisis, even for certain financial assets, such as commercial paper and money market mutual funds, were considered stable before the crisis. Information opacity can also affect the ability of market participants to engage in price stability arbitrage, as was the case with the failure of portfolio insurance in 1987.

Fourth, Stablecoin as a domino in the emerging algorithm ecosystem

Maybe the most popular at present The algorithm of the Stablecoin platform is Terra. Terra’s creator, Terraform Labs, recently garnered significant venture capital backing and investor interest as a “stablecoin for e-commerce creators.” Terra uses a governance balance token (called LUNA) to mint USD and KRW-pegged algorithmic stablecoins (among others) with built-in money supply and economic incentives, including fees and arbitrage opportunities.

These Stablecoins are then used as a payment mechanism in the ever-expanding Terraform Labs financial "ecosystem", which also includes a protocol (Mirror) for creating A synthetic asset that tracks the performance of U.S. stocks, futures, and exchange-traded funds; a lending and savings platform (Anchor); and a partner payments platform (Chai). Terra also plans to add DeFi asset management, add-on lending protocols, and decentralized leveraged insurance protocols to the budding ecosystem.

Terra Stablecoin is the "core" that connects emerging financial "infrastructure" including the aforementioned e-commerce payments, synthetic stocks, exchange-traded funds, derivatives and Other financial assets, savings, lending and lending apps. Terra operates as a protocol that incentivizes independent traders to buy its Stablecoin in exchange for LUNA should the Stablecoin drop below its peg. The stability of Terra Stablecoin goes beyond DeFi speculation. Given their many applications in their "Terra economy", these algorithmic stablecoins also directly affect the economic outlook of many businesses and consumers.

For this ecosystem to continue to be viable, there must be a permanent baseline level of demand for Terra Stablecoin and Governance TokenLUNA.  In other words, there must be enough arbitrage activities between the two tokens, as well as enough transaction fees in the Terra ecosystem and mining demand in the network. Terra’s founders assert that mainstream adoption of their Stablecoins as transaction currencies, and the ability to “stake” them and earn rewards, creates “network effects” and long-term incentives to hold and maintain the ecosystem. [

Therefore, Terra is betting that the use of Stablecoin (and LUNA) on their financial application "network" will drive perpetual demand. This assumption is not certain, and Terra Stablecoins have deviated from their pegs in the past. In many ways, a developing DeFi financial ecosystem backed by an algorithmic Stablecoin with no real collateral or government guarantees, but instead relying on the perpetual interest of personally motivated market participants for sustainability, looks like a standing Dominoes - Once the first one falls, all others may be affected.

Conclusion

Despite the search for conceptual models of sustainable price stability, so far To date, algorithmic stablecoins have exhibited a complete lack of stability and are therefore unsuitable as money replacements. Unlike secured stablecoins, algorithmic stable investments appear to be “doomed.” According to financial writer J.P. Cornyn, they are "prone to permanent rupture" because they depend fragilely on a "circular relationship" between different actors -- those who desire "stability" on the one hand, and those who seek "high returns" on the other. opportunity" people. Algorithmic stable investing is unlikely to serve any real long-term investing. Improving consumer welfare, or financial inclusion functions other than short-term debt speculation, would yield few inclusive or system-wide benefits. As others have noted, they are "unstable, threatening their usefulness".

As with other Stablecoin varieties, the algorithmic form currently lacks transparency, review guarantees and oversight. As the paper points out, they are also built on fragile foundations that depend on uncertain historical variables: they require a level of support for baseline demand, they require the participation of willing arbitrageurs, and they require an environment of information efficiency. None of these factors are definitive, and all of them have proven to be highly vulnerable against the backdrop of financial crises or periods of extreme volatility.  History shows that they are likely to be prone to instability and failure,[118] and they should be regulated to provide full transparency and enhanced consumer protection and risk controls so that they do not compete with larger The financial system is interconnected.  

Current US financial regulation around stablecoins is fragmented, inefficient, and in many cases overlapping. Clarity on the scope of the stablecoin's "regulatory scope" has yet to be determined.  They are subject to oversight by the federal Financial Crimes Enforcement Network (FinCEN) and state money transmission and virtual currency licenses. They also create "bank-like risks" -- especially shadow deposits like money market mutual funds, whose monetary policy influence implicates the Fed. Their systemic risk considerations have led the Financial Stability Oversight Advisory, led by the Treasury Department, under the auspices of the President's Task Force on Financial Markets.  They are also responsible for the Consumer Financial Protection Bureau (CFPB), the Office of the Comptroller of the Currency (OCC), the Commodity Futures Trading Commission (CFTC), and the Security and Exchange Commission (SEC).

A comprehensive approach that transcends institutional divides is needed to regulate stablecoins. Ideally, the regulatory framework for all Stablecoins would include issuer registration requirements, prudential measures, collateral safeguards and reporting transparency, a clear taxonomy clarifying Stablecoin forms (and distinguishing algorithmic varieties from other types), and risk disclosure and containment measure.

Such a framework would likely require what newly-appointed SEC Chairman Gary Gensler described as a “carte blanche” for specific agencies with respect to crypto transactions, although adapted and applied Stablecoins. Some fully collateralized stablecoins may have financial inclusion benefits such as faster and cheaper global remittances, real-time payments, application of fiscal stimulus, and the ability to act as transaction brokers for weak credit files and underbanked.  Therefore, there is a need for an innovation-friendly regulatory framework that still creates transparency, risk control and consumer protection safeguards.

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