Learning from FRAX, Perfect Storm Proofing Algorithmic Stablecoins
With the recent UST debacle, there is great fear, uncertainty, and doubt around algorithmic stablecoins. Focus has shifted away from the promise and potential of algorithmic stablecoins toward the risks and capacity of the stablecoins to hold their pegs. Although a great deal of fear, uncertainty, and doubt is valid, it is essential to note that not all algorithmic stable coins are made equal. Protocols like FRAX build resilience and drive innovation, an excellent example for other algorithmic stablecoins.
The Sentiment Driven Perfect Storms
Algorithmic stablecoins are at its core banking algorithms that adjust the balance sheet ratio based on the market’s pricing of the stablecoin. Algorithmic stablecoins usually have arbitrage-driven stabilization mechanisms, where other tokens are traded against the protocol to manage supply and stabilize the price.
One of the principal utilities for stablecoins is lending via DeFi protocols. Understanding that most mainstream DeFi protocols were mainly developed with traders in mind is essential. They allow users to put digital assets like ETH, BTC, and others as collateral and borrow stablecoins. This, in essence, enables users to take long positions on the assets they provide as collateral and free up liquidity to take on new short-term positions. In a perfect world, this allows users to free up liquidity, make profitable short-term trades, and redeem their collateral assets, keeping their long-term position on those assets.
The mainstream, trader-focused DeFi lending ecosystem has a core vulnerability that has caused multiple mass liquidation events; that vulnerability is its high dependence on market sentiments. These are market sentiments within a highly volatile crypto market. The value of the asset, say ETH, put up as collateral for a loan are prone to high volatility driven by market sentiment. The short-term position taken using the liquidity from the loans is prone to high volatility caused by market sentiment. For algorithmic stablecoins, the tokens used in the arbitrage-driven stabilization mechanisms are also prone to high volatility driven by market sentiment.
Putting this together, we can see that a shift in the crypto market sentiment, which can be caused naturally or intentionally provoked, can cause a perfect storm for algorithmic stablecoins. In conventional terms, imagine being a central bank, and overnight a shift in market sentiment liquidates loans and releases an ample supply of your currency onto the market, causing inflation and the value of your currency to drop. On the other hand, the foreign currency reserves you hold, which could be used to reduce the supply of your currency and counteract inflation, have also dropped in value due to the same overnight shift in market sentiment — leaving you with no real way to balance the inflation and stabilize your currency.
For algorithmic stablecoins, on the one hand, the drop in value of collateralized assets enables large-scale liquidation of loan positions, freeing up and increasing the market supply of the borrowed stablecoins. On the other hand, the assets used in the arbitrage-driven stabilization mechanisms lose value, requiring more of it to be minted against burning the stablecoins to manage inflation and price volatility. As we saw with Luna, there is only so much the crypto market, which is experiencing a negative market sentiment, can absorb. Thus rendering the stabilization mechanism ineffective within the given crypto market conditions. An overnight shift in market sentiment can create perfect storms for algorithmic stablecoins. The interconnectedness, high volatility, and core dependence on market sentiment mean that the risk of a perfect storm is always on the horizon.
Storm Proofing Algorithmic Stablecoins
It is essential to realize that not all algorithmic stablecoins are made equal. Their behavior and setup differ from one another. One great example of an algorithmic stablecoin, which is adapting to and building resilience against rapid market sentiment changes within the crypto market, is FRAX. FRAX is an algorithmic stablecoin that is both collateralized by USDC and has mathematical cryptographic algorithms managing the supply of FRAX. It brings both the stability of being asset-backed and the potential for innovation by being programmable money. Being partially collateralized means, that FRAX has a built-in core resilience against rapid market sentiment changes.
FRAX is also actively diversifying and working with more DeFi projects bridging real-world opportunities and DeFi. Diversifying into multiple markets reduces the impact of sentiment change within the crypto market. FRAX’s powerful AMO modules allow it to innovate and partner with a wide variety of DeFi projects, as showcased by its recent partnership with Goldfinch.
FRAX is also a pre-seed investor in MoneySwitch. MoneySwitch aims to transform the cross-border payments industry using decentralized finance, enabling cross-border payment companies to break free from legacy pre-funding models constrained by SWIFT towards a real-time decentralized funding model. The cross-border payment industry is a US $156 Trillion market, which constantly needs liquidity due to the pre-funding requirements within the industry. Working together with FRAX, MoneySwitch is looking to bring “Just in Time Liquidity” solution to the market. These kinds of solutions are possible due to the algorithmic nature of FRAX; it enables financial innovation in a way that fiat currency never will.
Conclusion
More algorithmic stablecoins need to learn from FRAX by building core resilience against rapid market sentiment changes within the crypto market. Further diversification into new market segments away from traditional crypto and DeFi will strengthen the resilience to sentiment changes within any given market.
With all of the fear, uncertainty, and doubt around algorithmic stablecoins, it is essential to understand that not all algorithmic stablecoins are made equal and that there is a great value proposition and innovation space offered by these stablecoins in a way traditional fiat currencies will not be able to offer.
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