Algorithmic stablecoins made a big splash in the first half of 2021. There were many variations of them, but they all attempted to do one thing.
Create a stablecoin that does not rely on redemptions to control the price. In fact, algorithmic stablecoins usually attempt to defend a peg in the same way as a standard central bank, by buying and selling the currency on the open market.
Unfortunately, algorithmic stablecoins have had some very notorious blowups and collapses. It turns out that creating a working algorithmic stablecoin is much more difficult than many of the theories about it would like you to believe.
This article will cover exactly what happened to these algorithmic stablecoins.
What Happened to Empty Set Dollar?
Empty Set Dollar was a stablecoin released in September 2020. It relied on the seigniorage model.
This meant that when the price of Empty Set Dollar rose above $1, then the protocol would mint more stablecoins to increase supply. The protocol would burn coins from wallets when the price fell below $1.
This actually worked pretty well until the end of December 2020. At that point, the value of the stablecoin fell below $0.90 and the peg simply could not be reached again.
A likely explanation is that people do not like to see the amount of coins in their wallet decrease. That caused distrust in the protocol, which resulted in selling pressure that the protocol could not correct by simply shrinking the supply.
To summarize, Empty Set Dollar was a stablecoin that did not use collateral to defend its peg. Instead, it controlled the supply to maintain the peg, which worked until faith in the stablecoin was lost. At that point, the stablecoin became worthless and has not recovered.
What Happened to FEI?
Fei Protocol was certainly not the first algorithmic stablecoin. However, it received a lot of attention because of the investment backing it received. Some investors include Coinbase, Andreessen Horowitz, and Naval Ravikant.
FEI is a little different from the other algorithmic stablecoins on this list because, well, FEI had to become a redeemable stablecoin after some problems after launch.
The protocol was released on April 3, 2021 to a nearly $1 billion Ethereum presale. FEI subsequently lost its peg when the protocol launched the Uniswap pool to go public.
This was because many users only participated in the launch in order to immediately sell governance tokens for the protocol. That created a lot of selling pressure on the protocol and caused the price of the stablecoin to plummet to nearly $0.70 within two weeks of launch.
The stabelcoin protocol had a lot of selling pressure, which meant keeping the peg was nearly possible. The specifics are beyond the scope of the article. The basics are that FEI attempted to defend the peg on the Uniswap pool by buying more FEI when the price dropped and selling it when the price went above $1.00.
Of course, the price never went above $1.00, so that was never a problem.
Also, FEI is not redeemable (like DAI), which means that the peg must be defended on the open market.
Anyway, the problem turned out that the best time to sell FEI was when the peg was low. This caused a downward spiral and the loss of the peg. Fei Protocol was finally able to control the peg by allowing users to redeem FEI for $0.95 worth of Ether.
To summarize, Fei Protocol was an algorithmic stablecoin that failed almost immediately after launch. The failure got worse whenever the protocol attempted to buy more stablecoins because that simply created more selling pressure. The token has recovered only because of a decision to allow redemptions of FEI at $0.95 as a price floor to prevent a death spiral.
The final verdict is that Fei Protocol works as a stablecoin, but Fei is not a true algorithmic stablecoin because it has a redemption price floor.
What Happened To Celo Dollars?
Celo Dollars is another algorithmic stablecoin. It operates with 200% collateralization in reserve to buy coins on decentralized exchanges. This helps it maintain its peg.
If collateralization drops below 200%, then the smart contract will begin collecting transaction fees to replenish reserves.
That said, the only major differences between Celo Dollars and FEI are that Celo has a 200% collateralization rule and Celo can hold other cryptocurrencies as collateral. The trading patterns of Celo are obviously different from FEI, but that’s normal. Every algorithmic stablecoin will have a different algorithm to maintain stability.
To summarize, Celo Dollars is simply a multi-collateral version of FEI with a 200% reserve requirement. The trading algorithm is also different.
Celo Dollars peg is currently stable.
What Happened to Iron Finance’s Stablecoin (IRON)?
Iron Titanium Finance took a stab at the algorithmic stablecoin market when they decided to launch their stablecoin – IRON.
In this case, the stablecoin ended up losing its peg when the entire Iron Finance ecosystem collapsed. Basically, Iron Finance rewarded liquidity providers with TITAN for providing liquidity on the exchange.
Iron Finance then decided to release a stablecoin called IRON. Minting 1 IRON required a deposit with a 25% USDC and 75% TITAN ratio.
What ended up happening is that the price of TITAN soared to nearly $65 before collapsing to essentially $0 ($0.0000035 to be exact) within a day. This crash came on news that Mark Cuban, a public investor of Iron Finance, was providing nearly 100% of the liquidity in the TITAN/DAI swap pool.
As you probably already know, the collapse of the price of TITAN led to IRON losing its peg. Almost $2 billion was lost in the collapse of Iron Finance.
Are Algorithmic Stablecoins Even Possible?
There are more examples of algorithmic stablecoins than just the ones listed. Some have succeeded, but most have failed.
Even amongst the successful algorithmic stablecoins you may have noticed a trend.
These stablecoins rely on a trading algorithm to defend the peg on a Uniswap pool. However, these are not truly algorithmic stablecoins because they all have (or had in the case of IRON) a reserve made up of assets to manipulate the price.
This essentially serves as a convoluted redemption scheme. Holders of the stablecoin can simply sell it on Uniswap to the issuer. The coins sitting in the Uniswap pool technically exist, but they are not really circulating.
A true algorithmic stablecoin, in our opinion, would have little to no reserves. It would defend its peg by controlling the supply.
Unfortunately, this has not really worked out in the cryptoverse. An algorithmic stablecoin needs some type of asset as collateral for it to work.
Do We Need Algorithmic Stablecoins?
Algorithmic stablecoins sound like a good idea on paper, but they really do not work out well in practice. Empty Set Dollar showed that a central bank monetary policy that relies on controlling monetary supply does not work well in decentralized finance.
This is likely because a country does not force users of it to pay taxes in the currency.
A more concerning trend is that centralized finance institutions (or other tech companies) have a great deal of interest in algorithmic stablecoins like BASIS and Libra. These same companies do not appear to have much interest in collateralized stablecoins like DAI.
This is likely because an algorithmic stablecoin closely resembles the mechanics of a central bank using fractional reserve banking. Whereas a collateralized stablecoin relies on a true 1:1 redemption of tokens for assets.
That covers it for what happened to some algorithmic stablecoins. The successful ones that have some form of redemption (and closely resemble fractional reserve banking) on Uniswap are still here.
The true algorithmic stablecoins that attempt to control the price by adjusting the supply simply by minting or deleting coins have disappeared.
It does not really matter in the end because solutions like algorithmic stablecoins that rely on undercollaterization and lack redemption will fail in the long term. The best type of stablecoins are decentralized options like DAI that have redeemability.