Thread by @QuentinVandewe2

We spent the last year figuring out what algorithmic stablecoins are and came up with a dynamic model that might help us understand what’s going on with #Terra_Luna . Here are our main takeaways. THREAD.

So what’s an algorithmic stablecoin? Fundamentally the idea is simple: you maintain a peg by dynamically adjusting stablecoin supply to match the demand so that the price doesn’t change.

How is that possible? Creating more stablecoins to accommodate a positive demand shock is easy: you launch the printing press. The problem comes from removing stablecoins in buy-back operations because you need to give something in exchange.

Algo platforms solve that problem by buying stablecoins today and selling claims to future stablecoin distribution called a “governance token.” This is Luna for Terra and equity shares in the real world. In other words, to reduce supply, you have to dilute your shareholders.

First insight: pure algorithmic stablecoin will always have a zero-value equilibrium no matter what you do. The price of stablecoins depends on their user value, which itself depends on the price of stablecoins. Hence there always exists a fixed point with no stablecoin value.

Second insight: this zero-value equilibrium is complemented by another one in which the platform maintains the peg and has a positive value (!), provided that the platform keeps growing and is able to commit to dynamic supply adjustments.

So what’s the catch, and what happened to Terra?

First, this second equilibrium only exists when the demand for stablecoins keeps growing. You need to be able to create future coins to justify gov token valuation. That’s the Ponzi element that many are talking about.

Second, although this second stable-peg equilibrium is able to accommodate small demand shocks, it is vulnerable to large ones. This arises when the shock is so large that the system has to remove more reserves than what all governance tokens are worth.

This could, for instance, be generated by a speculative attack on the platform driven by speculators shorting the stablecoin and betting on the platform breaking the buck.

This is likely what happened to Terra between May 9 and 11, as Luna's price fell from $89 per coin to less than a dollar, and today virtually zero. The platform became effectively bankrupt.

What happens then? The platform is unable to make necessary supply reductions as it has nothing to sell to buy back stablecoins. The price of the gov token is zero because buying at a positive value results in the platform expropriating you to reduce stablecoin supply.

Stablecoin price fluctuates between zero and one as investors are betting for demand to resume to a point where buying back stablecoins and restoring the peg becomes profitable. The alternative is that it gets absorbed by the zero-value equilibrium.

The paper has more! Including a discussion on how collateral and decentralization (i.e. DAI) may help with the stabilization problem (work in progress).

Here is the paper: adriendavernas.com/papers/stablec…