How to make algo stablecoins that don’t collapse or turn into Ponzi schemes

“What we need is a return to principles-based thinking, not stablecoin boosterism or stablecoin doomerism,” Vitalik Buterin said.

Vitalik Buterin, the co-founder of Ethereum, has presented two thought experiments on how to determine whether an algorithmic (algo) stablecoin is long-term viable.

The collapse of the Terra ecosystem and its associated stablecoin TerraUSD resulted in multi-billion dollar losses, prompting Buterin’s remarks (UST).

Buterin wrote in a blog post on Wednesday that while the heightened examination of crypto and decentralized finance (DeFi) following the Terra crisis is “good,” he cautioned against dismissing all algo-stablecoins outright.

His blog focused on Reflexer’s completely Ether (ETH)-collateralized RAI stablecoin, which is not tethered to the value of fiat money and instead uses algorithms to create an interest rate that proportionally opposes market changes and incentivizes users to restore RAI to its desired price range.

It “exemplifies the pure ‘ideal kind’ of a collateralized automated stablecoin,” according to Buterin, and its structure also allows users to withdraw their liquidity in ETH if their trust in the stablecoin erodes sufficiently.

Two thought experiments were proposed by the Ethereum co-founder to establish if an algorithmic stablecoin is “really a stable one.”
Is it possible for the stablecoin to ‘wind down’ to zero users?

Users should be able to take the fair worth of their liquidity from a stablecoin project if market activity “drops to near nil,” according to Buterin.

Buterin explained that UST fails to fulfill this criterion because of its structure, which requires LUNA, or what he refers to as a volume coin (volcoin), to maintain its price and user demand in order to retain its peg to the US dollar. If the contrary occurs, it will be very hard to stop both assets from collapsing.

Buterin stated that because RAI is backed by ETH, a decline in confidence in the stablecoin would not result in a negative feedback loop between the two assets, reducing the risk of a larger collapse. Users would still be able to swap RAI for the ETH held in vaults that support the stablecoin and its loan mechanism in the meanwhile.

Option of negative interest rates is necessary.

When following “a basket of assets, a consumer price index, or any arbitrarily complex formula” that rises by 20% per year, Buterin believes it is equally critical for an algo-stablecoin to be able to execute a negative interest rate.

“Obviously, no legitimate investment can achieve 20 percent annual returns, and no genuine investment can maintain a 4 percent annual return rate indefinitely.” But what if you try?” he wondered.

In this case, he believes there are only two options: either the project “charges some sort of negative interest rate on holders that equilibrates to effectively cancel out the USD-denominated growth rate built into the index,” or the project “charges some kind of negative interest rate on holders that equilibrates to effectively cancel out the USD-denominated growth rate built into the index.”

“It turns into a Ponzi scheme, offering stablecoin holders incredible gains for a while until it suddenly crashes with a bang,” or “It turns into a Ponzi scheme, giving stablecoin investors incredible returns for a while until it suddenly collapses with a bang.”

Buterin finished by emphasizing that an algo-ability stablecoin’s to manage the circumstances outlined above does not imply that it is “safe:”