The rapid proliferation of stablecoins in the past couple of years has made central banks reevaluate the status quo and consider developing their own digital currencies.

The introduction of competition should bring net positive results by forcing rivals to innovate and ultimately provide superior products to consumers. 

However, that’s not the case for the stablecoin niche. One side in this interplay holds monopoly power over the use of force, meaning the competition isn’t really “fair” and won’t necessarily benefit end consumers.

Governments want to push a new form of money through their central banks—central bank digital currencies. Without getting into too much detail, CBDCs are the most Orwellian thing you could imagine, and sooner or later, they’ll become a reality. 

Over 80% of central banks are currently working on developing them. Once they’re ready to deploy, likely due in two to five years, they won’t look favorably towards the idea of fairly competing with private stablecoin alternatives.

I’m reading almost every newsletter and paper on digital currency-related topics issued by the Bank for International Settlements, International Monetary Fund, and World Bank. They don’t like what’s going on with stablecoins. They consider them a “potential risk to financial stability” and have publicly called for stringent regulation on multiple occasions.

Centralized stablecoin issuers like Tether, Circle, and Paxos will be the first on the crosshairs. They’re the biggest and, because they are centralized, easiest to regulate. 

Regulators will likely force them to acquire bank charters (a nearly impossible endeavor in the U.S.), regulate them as money-market funds, classify their products as securities or find some other way to stifle their adoption.

If this happens centralized stablecoins could lose their ground, meaning we have to start thinking about ways we can protect ourselves. One of the most obvious ways is opting out for decentralized stablecoins.

Algorithmic stablecoins are decentralized assets that maintain their pegs by algorithmically adjusting supplies based on market demand. Typically, algo stablecoins are pegged to the U.S. dollar, but that doesn’t necessarily have to be the case. 

I picked algo stablecoins over other types of decentralized stablecoins, like MakerDAO’s DAI, for instance, because they represent a potentially better hedge against adverse regulatory intervention. They’re arguably the most decentralized and can operate almost fully autonomously, meaning they depend on the least amount of external human intervention.

 

DAI, for example, is currently over 52% backed by USDC, which kind of defeats the purpose of decentralization when you think about it. That being said, algo stablecoins do carry some inherent risks, including price oracle and smart contract risks and potentially flawed tokenomics designs.

In this case, I wanted to explore four algo stablecoins that seemed like interesting experiments and potentially viable alternatives to centralized stablecoins if the latter got in hot water because of regulators.

RAI

Built by Reflexer Labs, RAI is a collateralized stable value asset backed by ETH. It’s not “pure” stablecoin but rather a “reflexer index,” meaning it’s not pegged to a fixed exchange rate of $1, but is a stable representation of ETH. 

The protocol relies on an over 100-year old PID controller algorithm to maintain price stability and works with minimal governance or human intervention to maintain its “desired price.”

The desired or target price is known as a redemption price. RAI’s redemption price of $3.14 (Pi) was set on the protocol’s launch, and in the 200+ days (or two centuries in DeFi terms) since then, the protocol has held this price target remarkably well, even in extreme market conditions, including 50% drops in the price of ETH.

Still, this governance-minimized design contains some trade-offs. For one, the Reflexer protocol can’t influence RAI’s supply directly without conducting open market operations. This shifts the burden of maintaining the peg to RAI borrowers. Moreover, being a fully-collateralized stablecoin, it’s significantly less capital efficient than non-collateralized or partly collateralized alternatives.

UST

Terra’s UST stablecoin is the largest and fastest-growing on the market. It currently boasts a market capitalization of over $10.5 billion, surpassing the previous category leader DAI despite being a much younger protocol.

Much of UST’s success can be ascribed to its scalability. Unlike DAI or RAI, UST is not an over-collateralized stablecoin but rather maintains its peg to the U.S. dollar by leveraging basic market forces of supply and demand.

When the price of UST is above $1, users can burn $1 worth of Terra’s native governance token Luna in exchange for one UST and then sell it on the open market for profit. By doing this, users are effectively increasing the on-chain supply of UST and lowering its price.

Conversely, when the price of UST drops below the $1 peg, users can burn UST (reduce its supply) to mint Luna and sell it on the open market at a profit. 

For instance, if UST’s price dropped to $0.95, you could swap 10,000 UST worth $9,500 for $10,000 worth of Luna, earning a risk-free profit of $500.

 

UST/USD (Source: CoinGecko)

This mechanism allows UST to scale quickly, but it makes it dependent on the market conditions or market capitalization of Luna tokens. Its peg to the dollar has seen erratic volatility in the past, but due to certain adjustments in the on-chain redemption capacity, the volatility has recently subsided significantly.

Considering the size of Abracadabra’s Degen Box strategy, which leverages UST to farm ridiculous APYs on Anchor, risks of de-pegging due to cascading liquidations still remain.

FEI

FEI is a decentralized algorithmic stablecoin that enters circulation via sale on a bonding curve. The protocol controls its own liquidity, meaning that it keeps the assets it receives via the bonding sale, and uses them to secure sufficient liquidity for its stablecoin.

The only way to mint FEI is to sell ETH to the protocol via the bonding curve. Unlike the case with many other collateralized stablecoin protocols, the ETH isn’t locked as collateral but rather sold to the protocol and isn’t redeemable. 

To sell FEI to ETH then, holders have to go to decentralized exchanges where the protocol itself provides the liquidity using its protocol-controlled treasury assets.

FEI uses a combination of market arbitrage and so-called “direct incentives” to maintain the $1 peg. Namely, it uses dynamic mint rewards and burn penalties on decentralized exchange trades when FEI trades below the peg while relying on arbitrageurs when it trades above it.

The peg stability of FEI isn’t optimal. The protocol lacks liquidity to help stabilize its price. Moreover, audits showed a few signs of inconsistent oracles and bonding curves, only adding additional risk. While the protocol has grown quickly, it remains in its experimental phase.

FRAX

FRAX is a fractional-algorithmic stablecoin, which in simple terms means it is partly backed by collateral and partly managed algorithmically. Because it’s undercollateralized, it is more capital-efficient than the fully-collateralized FEI or RAI.

The ratio of collateralized and algorithmic depends on the market’s pricing of the FRAX stablecoin. If FRAX is trading at above $1, the protocol decreases the collateral ratio. If FRAX is trading at under $1, the protocol increases the collateral ratio. 

A percentage of each FRAX stablecoin is backed by stable assets invested in protocols such as Curve, AAVE, Compound, and Convex, generating additional revenue for the protocol. This percentage is always lower than 100%, leaving the unbacked supply to be managed algorithmically.

The protocol (successfully) maintains FRAX’s $1 peg through a concept called Automated Market Operations. For instance, when FRAX deviates from its peg in the Frax3CRV Curve pool, the protocol will automatically intervene and either directly add newly minted FRAX to the pool or remove FRAX and burn it.

Frax’s Achilles’ heel is that it includes too many components and integrations with other protocols such as Yearn, Curve, and Aragon. This expands the attack surface and exposes the system to increased risk.

Final considerations

Decentralized stablecoins run by DAOs and anonymous founders have a different risk profile to their centralized alternatives. Internal turmoil, protocol design mistakes, and governance issues are just a few of many issues endangering the viability of these assets.

If the internal turmoil at Sushi and today’s public drama with Wonderland has taught us anything, it’s that even the soundest, well-established protocols can fail—either temporarily or permanently—due to unpredictable human errors. 

Hence, when considering stablecoins, diversifying into multiple algorithmic ones might not be a bad idea.

Did you like the content of this Email? Follow us on Twitter.

Our research team at SIMETRI is also constantly sharing alpha. So feel free to follow me: Stefan Stankovic, and my colleagues: Anton Tarasov, Sergey Yakovenko, and Nivesh Rustgi.