4 - 7 minute read
After the collapse of Terraform Labs’ cryptocurrency, Terra (LUNA), and its stablecoin, Terra (UST), the notion of “algorithmic stabilization” has fallen to a low point in popularity, both in the cryptocurrency world and among mainstream observers. This emotional response, however, is strongly at odds with reality. In fact, algorithmic stabilization of digital assets is a highly valuable and important class of mechanism whose appropriate deployment will be critical if the crypto sphere is to meet its long-term goal of improving the mainstream financial system.
Blockchains, and other similar data structures for secure decentralized computing networks, are not only about money. Due to the historical roots of blockchain tech in Bitcoin, however, the theme of blockchain-based digital money is woven deep into the ecosystem. Since its inception, a core aspiration of the blockchain space has been the creation of cryptocurrencies that can serve as media of payment and stores of values, independently of the “fiat currencies” created, defended, and manipulated by national governments.
So far, however, the crypto world has failed rather miserably at fulfilling its original aspiration of producing tokens that are superior to fiat currency for payment or for value storage. In fact, this aspiration is eminently fulfillable – but to achieve it in a tractable way requires creative use of algorithmic stabilization, the same sort of mechanism LUNA and other Ponzi-esque projects have abused and thus given an unjustly bad reputation.
Nearly all crypto tokens out there today disqualify themselves as broadly useful tools for payment or value storage for multiple reasons – they are too slow and costly to transact with, and their exchange values are too volatile. The “slow and costly” problem is gradually being addressed by improvements in underlying technology.
The volatility problem, on the other hand, is not caused directly by technological shortcomings but rather by market dynamics. The crypto markets are not that huge relative to the size of global financial systems, and they are heavily traded by speculators, which causes exchange rates to swing wildly up and down. The best solutions the crypto world has found to this volatility issue so far are “stablecoins,” which are cryptocurrencies with values pinned to fiat currencies like the United States dollar or euro.
But there are fundamentally better solutions to be found that avoid any dependency on fiat and bring other advantages via using algorithmic stabilization in judicious (and non-corrupt) ways. Stablecoins like Tether, BinanceUSD (BUSD), and USD Coin have values tied close to that of the USD, which means they can be used as a store of value almost as reliably as an ordinary bank account. For people already doing business in the crypto world, there is utility in having wealth stored in a stable form within one’s crypto wallet, so one can easily shift it back and forth between the stable form and various other crypto products.
The largest and most popular stablecoins are “fully backed,” meaning, for example, that each dollar-equivalent unit of USDC corresponds to one U.S. dollar stored in the treasury of the organization backing USDC. So if everyone holding a unit of USDC asked to exchange it for a USD at the same time, the organization would be able to rapidly fulfill all the requests. Some stablecoins are fractionally backed, meaning that if, for example, $100 million in stablecoins have been issued, there may be only $70 million in the corresponding treasury backing it up. In this case, if 70% of the stablecoin holders redeemed their tokens, things would be fine. But if 80% redeemed their tokens, it would become a problem.
For FRAX and other similar stablecoins, algorithmic stabilization methods can be used to stabilize the value of the token without relying on the backing of a traditional currency or commodity. The goal of algorithmic stabilization is to create a self-sustaining system where the token value is maintained through a combination of smart contract code and market forces, rather than being pegged to a specific asset.
This approach has several potential advantages over traditional stablecoins. For one, it allows for the creation of stablecoins that are not tied to any specific fiat currency or commodity, which could be useful in cases where the underlying asset is not stable or is not easily accessible. Additionally, algorithmic stabilization can potentially lead to more stable exchange rates in the long run, as it allows for the token value to be maintained through market forces rather than being pegged to a specific asset.
Of course, the use of algorithmic stabilization also brings its own set of challenges and risks. One potential issue is the complexity of the algorithms themselves – if they are not designed and implemented correctly, it could lead to issues with the stability of the token. Additionally, the use of algorithmic stabilization may require the creation of complex financial instruments, which could be difficult for some users to understand and may introduce additional counterparty risk.
Overall, while the failures of projects like Terraform Labs’ Terra (LUNA) and Terra (UST) may be discouraging, it’s important not to let these setbacks discourage the use of algorithmic stabilization in the crypto world. When used appropriately, algorithmic stabilization can be a valuable tool in helping to create more stable and useful cryptocurrencies. While there are certainly risks and challenges to be considered, the potential benefits of algorithmic stabilization – including the ability to create stablecoins that are not tied to any specific fiat currency or commodity and the potential for more stable exchange rates in the long run – make it a promising area of development for the crypto world.
As the crypto sphere continues to evolve and mature, it’s likely that we’ll see a greater focus on the development and deployment of algorithmic stabilization mechanisms. While there will certainly be bumps along the way, the long-term potential for these mechanisms to improve the mainstream financial system and create more stable and useful cryptocurrencies makes them a valuable area of development to watch.
