Four Criteria to Restore Confidence in Algorithmic Stablecoins: Huobi Research Institute
London, UK
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June 13, 2022 11:00 AM Eastern Daylight Time
Algorithmic stablecoins became the focal point of the crypto industry in May, following the depegging of UST from the US dollar which triggered the LUNA bloodbath. This had a knock-on effect on other algorithmic stablecoins, resulting in the market cap for the top 5 shrinking from US$23 billion to less than US$4 billion before May 22 – a sharp 82.6% decrease in merely 2 weeks.
Algorithmic stablecoins, which form a critical asset class in the crypto industry, are digital tokens that are backed by a sufficient level of cryptocurrency as collateral. This makes it possible to mint stablecoins efficiently using crypto assets with high price volatility.
In the aftermath of the UST and LUNA collapse, a report from Huobi Research Institute titled “Revival of Algorithmic Stablecoins: 4 Things to be Done” has identified the following criteria for algorithmic stablecoins to succeed:
1. Full-backing assets (backed by exogenous or external assets)
Algorithmic stablecoins backed by endogenous assets could face collapse when the value of both falls concurrently. Conversely, the risks would be limited if backed by exogenous assets, as the price would be more inclined to correct after a depeg. The rationale for burning an algorithmic stablecoin is to mint extra assets for collateral, which will result in a severe depreciation of underlying assets or even a collapse of the whole system. The collateralized ones have a default risk, as some of the users may not retrieve collateralized assets, in part or in full.
2. Robust stabilization scheme
A robust stabilization scheme should function independently regardless of the status of the protocol, serving its purpose when the price falls below 1 USD and hedging the risk of depeg for the system. Trades by users would trigger an adjustment of the system to control the circulation supply, to maintain the price of the stablecoin at 1 USD.
When the price of a stablecoin falls below 1 USD, the above stabilization mechanism could exert considerable selling pressure on the underlying assets, further increasing the possibility of the system entering a death spiral. The degree of openness of redemption venues, however, may determine the extent of the selling pressure on the underlying assets or stablecoin.
3. Flexible asset management strategies
A reserve fund, while being costly, could benefit both the protocol and users in terms of enhancing system stability and drawing more users. Two types of strategies are most commonly seen: an Algorithmic Market Operations (AMO) strategy which absorbs profits from market-making activities in DeFi protocols with the reserve; and an auto treasury management strategy which profits from the market using the “buy low and sell high” approach.
4. Abundant application scenarios.
An increase in application scenarios will naturally drive demand for algorithmic stablecoins. For this to happen, a stablecoin must have high liquidity and numerous agreements with other protocols, so that it is compatible in various scenarios in different environments.
As an example, UST has enjoyed substantial growth owing to the fixed interest rate of 20% on the Anchor platform. USDD from Tron also created various scenarios for potential earnings: an official liquidity pool including SunSwap, Sun.io, Justlend, Poloniex and Ellipsis; and liquidity mining from the collaboration with Tron Reserve. USD of NEAR could receive interest from lending protocols such as Burrow, Bastion and Aurigami.
Commenting on the prerequisites for the revival of algorithmic stablecoins, Huobi Research Institute Researcher Barry Jiang said: “An algorithmic stablecoin can achieve short-term capital efficiency, but its success in the long run depends on the profitability of the stablecoin application. Moreover, a reserve fund is essential for an algorithmic stablecoin, where a high level of liquidity must be maintained by a certain amount of funds from the reserves. While this reduces capital efficiency, the protocol bears the burden instead of users.
“Capital efficiency at issuance – and in the long term – must be examined separately; only one can survive at the expense of the other. For users who are more bullish on an asset's potential for appreciation, using it to overcollateralize can preserve the right to future income. If one is more confident about the near-term development and relatively stable returns of a certain ecosystem, algorithmic stablecoins are a better choice.”
To download the full report, click here.
About Huobi Research Institute
Huobi Blockchain Application Research Institute (referred to as "Huobi Research Institute") was established in April 2016. It is committed to researching and exploring new developments in the global blockchain industry. Its goal is to accelerate the research and development of blockchain technology, promote its applications, and improve the global blockchain industry ecosystem. Huobi Research Institute covers industry trends, emerging technologies, innovative applications, new business models, and more. Huobi Research Institute partners with governments, enterprises, universities and other institutions to build a research platform that covers the entire blockchain industry. Its professionals provide a solid theoretical basis and analyze new trends to promote the development of the industry.
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