That’s why the quest for the perfect stablecoin has been ambitiously sought after since the dawn of decentralized finance. In the frenzy of decentralized finance innovation, algorithmic stablecoins, or “algostables”, have emerged and become extremely popular—but almost always seem to fail.

A prime example of an algostable failure is the infamous Terra Luna UST collapse that sent shockwaves throughout the crypto industry, but other examples such as the collapses of Iron Finance and Tomb Finance are equally notable.

To determine what causes these algorithmic stablecoins to fail, the main sources of instability of stablecoin—commonly accepted as the Stablecoin Trilemma—must be initially examined.

Algorithmic Stablecoins in the Stablecoin Trilemma

Peg stability, Capital Efficiency, and Decentralization.

Widely known as the three main trade-offs considered when designing a stablecoin, the Stablecoin Trilemma. According to Kwon et. al., “the trilemma states that no matter how well you design a stablecoin, you cannot attain perfect stability.” Theoretically, these three aspects of stablecoins cannot be perfectly implemented; nevertheless, stablecoins try to specialize and implement at least one of the three dimensions:

• Peg stability: Stablecoins need to manage to stay on the value of the asset it is pegged to, just as its name states. Much of crypto infrastructure relies on stablecoins to be a reliable tokenized representation of the dollar, and losing the peg of a stablecoin would be detrimental to the protocols and products built on top of it.

• Capital Efficiency: The concept of capital efficiency assesses the monetary resources necessary to produce a single unit of a stablecoin. To bootstrap the usage and popularity of the stablecoin, it must have capital efficiency. For example, if a USD-pegged stablecoin requires more than $1 in funds to create a unit, it would be considered capital-inefficient. Conversely, if the cost to issue one unit is less than a dollar, the stablecoin is considered capital-efficient and has the potential for growth and stability. This makes capital efficiency a highly sought-after trait in the world of stablecoins.

• Decentralization: Since stablecoins are built on the blockchain, which in itself emphasizes the narrative of decentralization, it is crucial for stablecoins to employ this ideology as well. Stablecoin issuers aim to efficiently embody the principles of this underlying layer, such as censorship resistance, transparency, and permissionless access, through decentralization. This helps to ensure a more secure and trustworthy stablecoin ecosystem. Governance also mitigates the risk in centralized points of failure.

The most popular stablecoins, namely USD Coin and Tether USD, are issued by centralized companies, Circle and iFinex, respectively. These stablecoins reside between the first and second dimensions. Stablecoins like DAI are overcollateralized by cryptocurrencies, which makes them capital inefficient but manage to tackle the other two dimensions.

Algorithmic stablecoins crudely attempt to address the stablecoin trilemma by emphasizing decentralization and capital efficiency. However, none of the dimensions of the trilemma are effectively implemented in an algostable protocol due to its fragile structure built on extreme monetary incentives and constant inflation.

Backed by a Fragile Incentive Structure

The notion that algorithmic stablecoins are riskier than fully collateralized stablecoins is generally accepted as a fact. Algostables address this problem through extreme incentive modules to bootstrap its usage, which entices potential users to participate.

There have been many unique incentive structures, but one of the most popular algorithmic stablecoin models is the seigniorage model. First envisioned by Robert Sams in his 2014 paper “A Note on Cryptocurrency Stabilization: Seigniorage Shares”, the seigniorage model uses three tokens:

• The Stablecoin is the heart of the algorithm. The stablecoin needs to stay near its peg. It does this through two mechanisms: shares that mint stablecoins when above peg and bonds that burn stablecoins when below peg. The amount of stablecoins to be minted was determined algorithmically proportional to the entire supply—the greater the supply, the greater the amount minted.

• Seigniorage Shares are an inflationary token that is emitted as a reward token for users who provide liquidity for the stablecoin and the shares. These tokens can then be deposited into a module that mints stablecoins as an inflation reward to the depositors, hence the name “shares”—users have a share in the protocol mintage. The minting only happens in 6 hour intervals when the time-weighted average price (TWAP) of the stablecoin is above its peg. This inflationary pressure decreases the price back down to equilibrium.

• Bonds are illiquid tokens that are used when the TWAP of the stablecoin is below its peg. Stablecoins are destroyed by users to mint bonds. Users are incentivized to purchase bonds because when  the TWAP of the stablecoin is above peg, bonds can be redeemed at a premium for a greater than their initial cost.

In short, the algorithm is based entirely on inflationary monetary incentives, where users benefit from minted rewards when the stablecoin is above peg. On the other hand, when the stablecoin is below peg, the utility of the seigniorage share token is nullified because the protocol cannot mint more stablecoin rewards. The bond token is a weak attempt to address the below-peg scenario; in reality, a rational investor is not likely to bet that the peg of the stablecoin will be restored by burning their stablecoin balance for illiquid bonds.

This fragile structure confines the algostable to its own protocol, preventing its adoption. The inflationary incentive scheme hurts the chance at scalability for the algostable—no project wants to build on top of a risky and fragile financial product.

Additionally, the incentive structure of seigniorage shares makes it a zero-sum game, where an investor’s profits is equivalent to another investor’s loss, so the net change of wealth is zero.

Case Study: Tomb Finance

For instance, one of the biggest projects to utilize the seigniorage share model, Tomb Finance, used its algostable TOMB (pegged to the value of 1 Fantom coin) and TSHARE, its seigniorage share token. TBOND is the illiquid bond token.

The tomb developers initially added just 0.2 Fantom coins (worth ~5 cents at the time) for their seigniorage share token, TSHARE, for its starting liquidity. Yet the project peaked at a whopping $2.5 billion dollars in investments in less than a year. Even with only a couple cents being used as the starting liquidity, participants added their own Fantom coins with TOMB and TSHARE to the liquidity pools (LPs) to accrue the seigniorage share liquidity incentives. Consequently, the TSHARE rewards emitted for the LPs were either staked in the TOMB minting module or sold through its liquidity, provided by users. The minted TOMB could also be sold through the liquidity provided by users. Though compounding the rewards was an option, the entire protocol was an intricate, zero-sum cycle of inflation.

To be more specific, participants of seigniorage protocols were lured by the high interest rates offered on the LPs. In Tomb’s case, the TOMB LP APR was around 130% for the $531m in LP deposits in February 2022. The TSHARE reward rate yearly would be $531m * 1.3 = $690m, or around $1,890,000 TSHARE emitted daily, just for the TOMB pool.

On the same date, a single TSHARE token was $7,300, meaning that $225m TSHAREs in dollar value was staked to mint TOMB earning 227% APR. This equates to $225m * 2.27 = $579m of TOMB minted yearly, or $1,580,000 minted daily.

These statistics are relative to the price of TOMB and TSHARE at the time, but they give a general sense of the unsustainable inflation created by the protocol.

Due to Tomb Finance’s size and popularity, it became a staple asset in the Fantom Defi Ecosystem, with many projects and protocols building on top of Tomb assets.

But as mentioned previously, the amount of TOMB to be minted is determined proportionally with its total supply. A larger supply meant more TOMB would be minted. This increasing inflation rate became unsustainable with millions of dollars in value being minted daily.

Millions of dollars had to be injected periodically to ensure the peg of TOMB was above the threshold for the protocol to mint more.

Towards the end, TOMB’s peg sharply fell almost -80% due to a liquidation crisis with TOMB collateral from another protocol. However, constant inflation resulting in supply expansion, as well as other factors all decreased the integrity of TOMB, contributing to its demise.

A Facade of Stability

Algorithmic stablecoins are financially delicate, and the mechanisms used to maintain stability are unsustainable due to reliance on constant inflation and liquidity injections. Though initially algostable protocols may seem like a safe investment with high returns, these incentives mask the fragility of the algorithm.

The use of algorithmic stablecoins should be approached with extreme caution, and alternative solutions that prioritize peg stability, rather than decentralization and capital efficiency, should be considered when developing algostables. Currently, the potential and realized drawbacks of algorithmic stablecoins make them unsuitable for widespread adoption and use in the current decentralized financial landscape.

Despite the challenges, the allure of a stablecoin that can fulfill all three points of the trilemma looms large. But until then, the graveyard of projects that have attempted to failed to address the trilemma paints a grim picture that uncollateralized stablecoins will not be this magic solution.