Article compilation: Block unicorn
Article compilation: Block unicorn
Algorithmic stablecoins are inherently vulnerable, unsecured digital assets that attempt to peg the price of a reference asset using financial instruments, algorithms, and market incentives, are not stable at all, but are in a permanently 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 the level of support required for business stability.
2. Second, they rely on price-stabilizing arbitrage by independent actors with market incentives.
3. Finally, they demand reliable price information at all times.
introduce
introduce
Financial product innovation is not always a good thing, and some innovations are designed in such a way that they are inherently unstable. 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 stablecoins are an oxymoron. 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 instead only 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 are being 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 usefulness as a money substitute for consumer transactions, wages or debt moratoriums function of the product. Others claim that algorithmic stablecoins are “rebuilding traditional banking” as a reserve system for the DeFi segment. Both comparisons miss 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 stable arbitrage 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 a 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.
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1. Experience with various stablecoins
Stablecoins are crypto assets that attempt to peg their value to another 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 the regulatory structure has been so slow to materialize. The International Organization of Securities Commissions (IOSCO) recommends that stablecoins come in many different varieties and forms.
The most popular forms are off-chain custodial stablecoins, such as Circle and Coinbases widely circulated USD Coin (USDC), or Facebooks proposed Diem, both of which 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. Overcollateralization means that more than 100% of the stablecoins value is held on-chain, using another cryptoasset to provide the collateral function, such as MakerDAOs DAI stablecoin. Use a specified encrypted asset over-collateralized (such as WBTC, ETH, and other encrypted assets with better liquidity) to generate stable currency DAI, and the collateral ratio is adjusted for specific locked tokens.
The most volatile and vulnerable stablecoins are algorithms, which are not fully collateralized and use market incentives, arbitrage opportunities, automated smart contracts, and reserve token adjustments to attempt to maintain a stable peg. These types of stablecoins have been described as the “Central Bank/Federal Reserve” of algorithmic stablecoins. In 2021, the size of the stablecoin market has soared to more than $119 billion, and algorithmic stablecoin varieties account for a large share of this market, and it is still growing.
Despite Iron Finances tragic failure in June 2021, algorithmic stablecoins claim the benefits of automated operations and the ability to scale without requiring corresponding reserves. Basically, protocols supporting algorithmic stablecoins attempt to operate as central banks with “less than one-to-one support” by manipulating the number of tokens in “circulation” in response to changes in their value.
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2. 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 attempting 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 created by locking 75% of its value in collateralized USDC (a fully reserved, fiat-backed stablecoin), and 25% of its value in TITAN - Iron Finances own internal governance token with unlimited supply.
Iron Finance collapsed when the value of its infinite supply governance token TITAN 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 negative feedback loop of cascading TITAN sell-offs and IRON redemptions. This caused the IRON token to lose its peg, which in turn triggered TITANs algorithmic minting mechanism and provided an arbitrage opportunity in the resulting death spiral.
The immediate impact is a large supply of TITAN on the secondary market. At some point, the price of TITAN was essentially zero, and Iron Finance stopped redemptions on the IRON stablecoin - they started with only 75% collateralized USDC coverage. The moment the price of TITAN became 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 algorithmic stablecoins being an early iteration of fractional reserve banking for DeFi 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 Finances operating structure was fragile from the start.
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3. Three lessons from the history of financial markets
Three lessons from financial market history affect the viability of algorithmic stablecoins.
First, any financial product that requires liquidity support or fundamental levels of an entire product class to function as expected (and assumed) will be vulnerable to failure if liquidity dries up. 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 requested (but not received) by major financial institutions is an important factor in the failure of auction-rate securities markets. The reliance on base support levels is probably the biggest problem with the dual-coin structure of unsecured algorithmic stablecoins. Tokens that absorb volatility must maintain a certain level of demand support — and not drop below a price threshold — or the entire ecosystem will fail. Non-collateralized tokens that claim to be “stable” require a consistent (if not growing) level of liquidity, and once that stops, the peg fails.
A second history lesson that makes algorithmic stablecoins inherently fragile and volatile is that they often rely on independent actors with market incentives to perform the arbitrage function of stabilizing prices. 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 exchange-traded funds, market discipline can fail when it is most needed.
During the failure of portfolio insurance in 1987, arbitrageurs stopped buying undervalued assets. More recently, arbitrageurs have moved away from arbitrageurs arbitrage 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 there is widespread information opacity during times of heightened volatility, panic, or crisis. 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. TITAN token price uncertainty caused Iron Finance to fail in June 2021 due to delays in automated oracle feeds.
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4. Stablecoins as dominoes in the emerging algorithmic ecosystem
Perhaps the most popular algorithmic stablecoin platform out there is Terra. Terras creator, Terraform Labs, recently garnered significant venture capital backing and investor interest as a stablecoin for e-commerce creators. Terra mints USD and KRW-pegged algorithmic stablecoins (among others) using a governance balance token (called LUNA) 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 synthetic assets that track the performance of U.S. stocks, futures, and exchange-traded funds; a 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.
The Terra stablecoin is the core that connects the emerging financial infrastructure, which includes the aforementioned e-commerce payments, synthetic stocks, exchange-traded funds, derivatives and other financial assets, savings, lending, and lending applications. 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 the Terra stablecoin goes beyond DeFi speculation. Given their many applications in their Terra economy, these algorithmic stablecoins also directly impact 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 the Terra stablecoin and governance token LUNA. In other words, there must be sufficient arbitrage activity between the two tokens, as well as sufficient 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, along with the ability to “stake” them and earn rewards, creates “network effects” and long-term incentives to hold and maintain the ecosystem.
in conclusion
in conclusion
Despite the search for conceptual models of sustainable price stability, algorithmic stablecoins have so far exhibited a complete lack of stability and are therefore unsuitable as money replacements. Unlike secured stablecoins, algorithmic stable investment varieties appear to be “doomed.” According to financial writer JP Cornyn, they are prone to permanent rupture because they are fragilely dependent on circular relationships 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.
Like other stablecoin varieties, algorithmic forms currently lack 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 has shown that they are likely to be prone to instability and failure,[118] and they should be regulated to provide full transparency and strengthen consumer protection and risk control measures so that they do not interfere with the larger financial system Interrelated.
Current U.S. financial regulation around stablecoins is fragmented, inefficient, and in many cases overlapping. Clarity on the scope of stablecoin “regulatory coverage” 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 Presidents Task Force on Financial Markets. They also act against 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 to regulating stablecoins that transcends institutional divides is needed. Ideally, the regulatory framework for all stablecoins would include issuer registration requirements, prudential measures, collateral custody safeguards and reporting transparency, a clear taxonomy clarifying stablecoin forms (and distinguishing algorithmic varieties from other types), and risk disclosure and containment measures.
Such a framework would likely require what newly-appointed SEC Chairman Gary Gensler described as “carte blanche” for a particular agency in crypto trading, though adapted and applied to 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 a pro-innovation regulatory framework that still creates transparency, risk control and consumer protection guarantees.
