The crash of stablecoin US Terra has not discouraged Vitalik Buterin, the founder of Ethereum: he does not rule out that algorithmic stablecoins can work. According to him, a key feature of such a stablecoin should be that it remains stable even in the face of falling popularity.

Buterin argues that while the euphoria in certain circles about US Terra was unwarranted, the current negative mood around stablecoins in general is an overreaction. In his words, we need to move away from stablecoin boosterism but also from stablecoin doomerism. The latter is Buterin's response to the tendency post-terra to write off the whole idea of algorithmic stablecoins. To be clear, Vitalik Buterin did not and does not have any involvement with UST.

What is a stablecoin in Buterin's definition?

What is usually called an algorithmic stablecoin, Vitalik calls an automated stablecoin. Indeed, that may be a more clear-cut term. These automated stablecoins differ from, say, USDT and USDC in that they are decentralized. That is, there is no 'stash of dollars' parked at a company to back the stablecoin. Instead, there is an automated feedback mechanism that keeps the price as constant as possible against (usually) the dollar. In practice, that mechanism is a smart contract that manages on-chain collateral: other crypto.

Battle tested

Some automated stablecoins have been doing well for years. Ethereum's founder points out that MakerDAO's DAI, for example, has successfully withstood extreme market corrections, for example, the March 2020 covid crash.

Why did things go wrong with UST? The bottom line is that LUNA, the currency that kept UST stable (Vitalik calls LUNA the volatile-coin), does not safely reside outside the LUNA ecosystem - as opposed to the situation with for example DAI, USDC or USDT. UST and LUNA were vulnerable to a death spiral, in which both the stablecoin and the paired volatile-coin crash together. If the mood creeps in that the demand for UST (the stablecoin) is going to fall, LUNA also becomes vulnerable. Because if the price of UST drops below the dollar, UST must be taken out of circulation (burned) to get the price back to $1. That is financed by creating LUNA and that puts pressure on the price of LUNA. The moment confidence in future demand for UST suddenly drops hard, it's the end. That became apparent in early May 2022...

How can automated stablecoins work though?

Buterin suggests two criteria for potentially successful automated stablecoins:

1. Does the stablecoin remain stable even when demand falls hard?
   As long as the collateral can be collected, holders won't care how many other holders there are. Stability then does not depend on rising or stable demand. Collateral can be Ether, for example.
2. Can a negative interest rate be set?
   Suppose the amount of dollars in circulation increases by 20% per year. How can a stablecoin keep up with that growth without becoming a 'ponzi' itself? According to Vitalik, negative interest rates are one solution, such as shrinking the balance sheet.

Certainly that last point is counterintuitive and a tricky one to grasp. Read Vitalik's detailed explanation.

What we are slowly but surely finding out is that an algorithmic stablecoin may not be impossible - but there is no clear path to a future-proof version yet.