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Vitalik: Designing Principles-based Stablecoins that (may not) collapse

Vitalik Buterin | May 25, 2022

Vitalik Buterin thought experiments - Vitalik:  Designing Principles-based Stablecoins that (may not) collapseThe recent LUNA crash, which led to tens of billions of dollars of losses, has led to a storm of criticism of "algorithmic stablecoins" as a category, with many considering them to be a "fundamentally flawed product". The greater level of scrutiny on defi financial mechanisms, especially those that try very hard to optimize for "capital efficiency", is highly welcome. The greater acknowledgement that present performance is no guarantee of future returns (or even future lack-of-total-collapse) is even more welcome. Where the sentiment goes very wrong, however, is in painting all automated pure-crypto stablecoins with the same brush, and dismissing the entire category.

See:  Stablecoins: What’s old is new again – speech by Christina Segal-Knowles

What we need is not stablecoin boosterism or doomerism, but rather a return to principles-based thinking. So what are some good principles for evaluating whether or not a particular automated stablecoin is a truly stable one? For me, the test that I start from is asking how the stablecoin responds to two thought experiments.

1. Can the stablecoin, even in theory, safely "wind down" to zero users?

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 too collapses.

2. What happens if you try to peg the stablecoin to an index that goes up 20% per year?

there is no genuine investment that can get anywhere close to 20% returns per year, and there is definitely no genuine investment that can keep increasing its return rate by 4% per year forever.  There's basically two ways for a stablecoin that tries to track such an index to turn out:

See: 

How Stable is your Stablecoin?

IMF: Capital Flow Management Measures in the Digital Age: Challenges of Crypto Assets

  1. It charges some kind of negative interest rate on holders that equilibrates to basically cancel out the USD-denominated growth rate built in to the index.
  2. It turns into a Ponzi, giving stablecoin holders amazing returns for some time until one day it suddenly collapses with a bang.

But this also shows a deeper and more important fact about stablecoins: for a collateralized automated stablecoin to be sustainable, it has to somehow contain the possibility of implementing a negative interest rate, can be done in two ways:

  1. RAI-style, having a floating target that can drop over time if the redemption rate is negative
  2. Actually having balances decrease over time

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NCFA Jan 2018 resize - Vitalik:  Designing Principles-based Stablecoins that (may not) collapseThe National Crowdfunding & Fintech Association (NCFA Canada) is a financial innovation ecosystem that provides education, market intelligence, industry stewardship, networking and funding opportunities and services to thousands of community members and works closely with industry, government, partners and affiliates to create a vibrant and innovative fintech and funding industry in Canada. Decentralized and distributed, NCFA is engaged with global stakeholders and helps incubate projects and investment in fintech, alternative finance, crowdfunding, peer-to-peer finance, payments, digital assets and tokens, blockchain, cryptocurrency, regtech, and insurtech sectors. Join Canada's Fintech & Funding Community today FREE! Or become a contributing member and get perks. For more information, please visit: www.ncfacanada.org

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