Stable tokens linked to assets using legacy financial services may seem simple and obvious at first glance, but could also be perceived as somewhat contrary to the spirit of the underlying decentralized technology. This is similar to how Yahoo and many other search engines of the early 1990s attempted to make Internet content available by cataloging websites, much as one would catalog books or magazines in the library. While these search engines were popular and intuitive in the early days of the Internet, they were not at all scalable, nor did they reflect the potential of the underlying technology. Eventually, algorithmic search, as offered by Google and other companies, replaced manual content cataloging. Similarly, asset-backed stable tokens may seem tempting at first, but there are some interesting algorithmic solutions on the rise that may better reflect the nature of smart contracts.
It's a concept for an algorithmic stable token first proposed by Robert Sams in 2014. In his whitepaper, he outlined how smart contracts can be used to fulfill the role of a central bank and formalize monetary policy mechanisms so that the token trades at a stable price. Elastic supply mechanisms can be designed to stimulate either expansion or contraction of token supply, similar to how central banks control the supply of fiat currency. When demand for stable tokens increases or decreases, the algorithm automatically adjusts to maintain a stable price. If the price is too high, the mechanism will increase supply. If the price is too low, the tokens will have to be "frozen" one way or another. The question of how to increase and decrease token supply in a way that is attack-resistant and resilient has not been conclusively resolved. Depending on the project, different algorithmic methods are used for expansion and contraction.
If a Stable token with a 1:1 peg to the EUR is trading above 1 EUR, this would indicate that supply is higher than demand. The token supply needs to be increased to stabilize the price back to 1 EUR. The smart contract is programmed to mint new tokens (seigniorage shares) and sell them on the open market, increasing supply until the price reaches a stable level again. If the value trades below a price of 1 EUR, the token supply must be scaled back. The smart contract cannot simply destroy circulating tokens that belong to someone. However, the smart contract could be designed to buy tokens on the open market to reduce the circulating supply and increase the price. While token supply can be easily expanded by issuing new tokens, reducing token supply requires more sophisticated mechanisms. Why should token holders agree to sell tokens, and how can they be meaningfully incentivized to do so? If the smart contract does not have enough newly minted tokens, it could issue bonds in exchange for a stable token in proportion to the tokens that need to be destroyed. These bonds are sold at a discount and can be paid out at a later date, with the bondholders being the first to be paid out. The discount serves as an incentive for holders to retire their stable tokens.
While the idea of replacing certain functions of a central bank with smart contracts is intriguing, some mechanisms are based on partially unproven economic assumptions and untested monetary policies, particularly with respect to incentivizing contract cycles. In some cases, stabilization is still partially maintained through centralized mechanisms. Moreover, the challenge of decentralized and untrusted price oracles needs to be resolved. As a result, many economists believe that algorithmic stable tokens cannot work because this method assumes unlimited growth of the system. Each contraction cycle initiates the potential for a future increase in the total supply of the stable token, which could lead to a death spiral in the price of the bonds, increasing the time to payout and decreasing the probability that each bond will be paid out. This could lead to a recursive feedback loop that could greatly undermine the goal of reducing supply unless other measures are taken to prevent such a loop. As a solution to this problem, some projects allow token holders to temporarily freeze tokens; other projects issue bonds that expire after a certain time.
An algorithmic stable token is a type of cryptocurrency that is managed by algorithms (i.e., smart contracts) to dynamically minimize the volatility of its price relative to a particular form of asset, e.g., US dollars. As algorithmic stable tokens have grown rapidly in recent years, they are becoming much more volatile than expected. In this paper, we dove deep into the core of algorithmic stable tokens and shared our answers to two fundamental research questions, namely: are algorithmic stable tokens inherently volatile? Are they volatile in practice? In particular, we presented an in-depth study of three popular types of algorithmic stable tokens and developed a modeling framework to formalize their key design protocols. Through formal verification, the framework can identify critical conditions under which stable tokens can become volatile. We also conducted a systematic empirical analysis of real-world transaction activity of Basis Cash stable tokens to relate theoretical possibilities to market observations. Finally, we highlighted important design decisions for the future development of algorithmic stable tokens.
A comprehensive analysis of Algorithmic Stable Tokens can be downloaded here.