Ethereum co-founder Vitalik Buterin commented on Terra’s UST crash and wrote his manual on how to distinguish a reliable algorithmic stablecoin token.
After the Terra UST token collapse, nobody believes in the power of algorithmic stablecoins anymore.
But one of the greatest minds in the crypto community Vitalik Buterin thinks the problem isn’t in the Terra stablecoin network itself, but rather in the way how the ecosystem is maintained.
Recently he wrote another big blog post about the problem of algorithmic stablecoins. And presented his formula for discovering a reliable token model.
“While there are plenty of automated stablecoin designs that are fundamentally flawed and doomed to collapse eventually, and plenty more that can survive theoretically but are highly risky, there are also many stablecoins that are highly robust in theory and have survived extreme tests of crypto market conditions in practice,” Buterin claimed.
So Vitalik Buterin came up with two thought experiments to determine if an algorithmic stablecoin is ‘truly a stable one’.
First experiment: stablecoin liquidity
According to Vitalik Buterin, even if the market activity for a stablecoin project ‘drops to near zero’, investors should be always able to withdraw the fair value of their liquidity out of the asset.
As we had seen, the UST stablecoin didn’t match this criterion. The LUNA token was needed to maintain the UST dollar peg. In this case, Buterin calls LUNA the volume coin or the volcoin, which backs the UST price.
“First, the volcoin price drops. Then, the stablecoin starts to shake. The system attempts to shore up stablecoin demand by issuing more volcoins. With confidence in the system low, there are few buyers, so the volcoin price rapidly falls. Finally, once the volcoin price is near-zero, the stablecoin to collapses,” he wrote.
In comparison, Vitalik Buterin talks about Ethereum-collateralized RAI stablecoin that isn’t pegged to fiat currency and instead relies on algorithms to automatically set an interest rate.
Buterin calls it the pure ideal type of a collateralized automated stablecoin. Because within this model users should always be able to exchange RAI for the ETH locked in vaults.
Second experiment: negative interest rates
Terra platform proposed its users ‘a basket of assets’, a consumer price index, or some arbitrarily complex formula. It means growing by 20% per year, and Buterin talks about the negative interest rate option.
“There is no genuine investment that can get anywhere close to 20% returns per year, and there is no genuine investment that can keep increasing its return rate by 4% per year forever. But what happens if you try?” he said.
Vitalik Buterin thinks that such stablecoin ecosystems have only two outcomes.
The first scenario is the project ‘would charge some kind of negative interest rate on holders that equilibrates to cancel out the USD-denominated growth rate built into the index’.
The second is about the project going into a Ponzi scheme, ‘giving stablecoin holders amazing returns for some time until one day it suddenly collapses with a bang’.
“It could still be fragile for other reasons (eg. insufficient collateral ratios), or have bugs or governance vulnerabilities. But steady-state and extreme-case soundness should always be one of the first things that we check for,” Buterin concluded.