Ethereum founder Vitalik Buterin sees potential for algorithmic stablecoins

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The “vitalik buterin essays” is a blog post by Vitalik Buterin, the founder of Ethereum. In his blog post, he talks about how algorithmic stablecoins could be an effective solution to the volatility problem that cryptocurrency has been facing for a long time.

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Vitalik Buterin, the inventor of Ethereum, has lately been in a reflective mood. Buterin has moved his musings to the realm of “automatic stablecoins” after releasing a series of “open discrepancies” in his “thoughts” and “values.”

Buterin released a blog article this week examining the sustainability of such unbacked tokens in the aftermath of the Terra disaster, dubbed algorithmic stablecoins.

Stablecoins that are automated are evaluated.

Buterin collaborated on the blog article alongside Dan Robinson, the director of research at Paradigm, Hayden Adams, the author of Uniswap, and Ethereum researcher Dankrad Feist.

Buterin opened his statement by mentioning the UST de-peg events and said that he would welcome a “higher degree of monitoring on Defi financial systems, particularly those that strive for “capital efficiency.”

The Ethereum creator went on to urge for a “return to principles-based thinking,” which he offered via two thought experiments:

First thought experiment: can the stablecoin securely “wind down” to zero users, even in theory?

Second thought experiment: what happens if you attempt to link the stablecoin to a 20 percent-per-year-increasing index?

What is an automated stablecoin, and how does it work?

Buterin’s concept of an automated stablecoin is noteworthy: “a stablecoin that aims to target a certain price index… [using] some targeting mechanism,… is entirely decentralized… [and] must not depend on asset custodians.”

He said that the current assumption is that the targeting mechanism must be a smart contract in some form. Buterin said, “By having a pair of two currencies, which we’ll call a stablecoin and a volatile-coin or volcoin (in Terra, UST is the stablecoin and LUNA is the volcoin),” Terra Classic worked.

Terra’s technique of maintaining UST’s peg is seen in the diagram below.

vitalik.eth is the source of this information.

Buterin also mentioned RAI, an Ethereum-based automated stablecoin, in contrast to UST. He stressed that he did not use DAI as a model for RAI:

“Implements the pure “ideal kind” of a collateralized automated stablecoin backed only by ETH. DAI is a hybrid system with both centralized and decentralized collateral backing it up.”

First thought experiment

Buterin contrasted firms in the non-crypto world in his first thought experiment.

Companies do not likely to endure indefinitely, and consumers are seldom harmed financially when they are wound down or closed. Depending on the manner of closure, investors may lose money, however this isn’t always the case since regular insolvency proceedings exist to guarantee creditors are compensated.

Buterin argued that Terra is a perfect example of people being monetarily harmed by the collapse of a crypto “company” in the realm of automated stablecoins. Thousands of investors throughout the globe have lost millions of dollars in the last few weeks, making this statement difficult to refute.

Buterin also said that additional variables may come into play with a Terra-style stablecoin. A dip in “volcoin” activity results in a drop in market cap, which causes the connection with the stablecoin to become exceedingly unstable.

A significant fluctuation in price, like with LUNA, generates hyperinflation inside the volcoin at the time. The stablecoin eventually loses its peg since it can’t tolerate the difference. The seignorage system fails as soon as the peg is lost, resulting in a death spiral for both currencies.

Buterin noted that with Terra, the above became a self-fulfilling prophesy as soon as the market lost trust in the project’s future potential and the market value of LUNA started to decrease. He said that a gradual decline in LUNA’s market value may have halted the death spiral, but the safety procedures in place prevented this from happening.

Buterin went on to say:

“Because RAI’s security is based on an asset that exists outside of the RAI system (ETH), RAI has a much simpler time securely winding down.”

The term “externality” refers to the following:

“There is no fear of a positive-feedback cycle in which a drop in RAI confidence produces a drop in loan demand.”

Second thought experiment

Buterin noted that a stablecoin might be tied to a “basket” of assets such as “a consumer price index, or any arbitrarily complicated formula” in this experiment.

He then proposed an asset class that would grow by 20% yearly in monetary terms. What would happen if a stablecoin was linked to an asset like this? There is no such asset; nonetheless, Buterin argued that there are two methods to get a 20% yield asset, as a thought exercise.

It imposes a negative interest rate on holders that equilibrates to effectively wipe out the index’s USD-denominated growth rate.
It evolves into a Ponzi scheme, providing stablecoin investors incredible gains for a while before collapsing with a bang one day.

Buterin stated that LUNA behaves like point 1 and RAI behaves like point 2. As a result, Buterin’s main argument is as follows:

“In order for a collateralized automated stablecoin to be viable, it must be able to apply a negative interest rate in some way.”

Finally, he proposed that a successful automated stablecoin “must” contain a reaction mechanism for “situations when demand for holding exceeds demand for borrowing, even at a 0% interest rate.”

Buterin sees two options for doing this:

A floating target, RAI-style, that may fall over time if the redemption rate is negative.
Balances do, in fact, deteriorate with time.

Conclusion

Finally, Buterin believes that automated stablecoins have a promising future. It is, however, riddled with technological issues and requires a shift away from typical financial comparisons. Buterin seems to feel that Terra failed to adequately examine the risks during times of high volatility or negative growth.

He concluded his article by stating:

“One of the first things we should look at is steady-state and extreme-case soundness.”

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Ethereum founder Vitalik Buterin sees potential for algorithmic stablecoins. Coinbase, one of the largest cryptocurrency exchanges in the world, has announced that they will be introducing a new type of stablecoin called Tether on their platform. Reference: stablecoins on coinbase.