Algorithmic stablecoins are a good idea on paper, but hard to implement because of competing economic incentives as even seasoned investor Mark Cuban can attest.
“Why is it doing that?” the somewhat perplexed copilot looked over to his Captain.
Not the words he wanted to hear from his deputy commander, as Captain Francois Gerard, an experienced airline pilot with over ten thousand hours under his cap, looked to see what was amiss.
In their brand-spanking new cockpit of the (at the time) state of the art Airbus A330–200, something was indeed amiss, but both Gerard and his young copilot Didier Arnaud couldn’t quite pinpoint what it was.
Referring to various checklists, it appeared that the fuel they had onboard their aircraft was far below what was expected for that stage in the flight.
Suspecting a fuel leak, the duo referred to and carried out the procedure to isolate the source of the leak, a long and complex process, part of which required cross-feeding the tanks.
By the time they realized the source of the leak, they had inadvertently left the crossfeed valves open for so long that the entire aircraft was now at risk of falling out of the sky because it had no fuel.
Before long and given the length and complexity of their checklist, the modern airliner piloted by the duo was reduced to no more than a 150-ton glider.
Fortunately, they managed to glide down to a safe landing, in a remote air force base in the middle of the Pacific Ocean, but things could have ended far worse.
In the aftermath of the incident, Airbus reviewed some of its procedures and realized that the fuel leak procedure was unnecessarily complicated and streamlined many steps.
It’s been said that Airbus cockpits are designed by engineers, while Boeing has the front of the aircraft made by pilots for pilots.
Whether or not the adage rings true, there’s something to be said about keeping things simple.
And unfortunately for billionaire investor Mark Cuban and a clutch of other investors, that saying could not ring more true.
Last week, Cuban conceded that he had lost money (not insubstantial but not life changing either) to a project called TITAN, an algorithmic stablecoin with an inventive but ultimately flawed tokenomics (or token economics if you like).
TITAN, a decentralized finance or DeFi token, was at one stage worth some US$2 billion, before it fell to zero.
And no, investors in TITAN were not the victims of a scam, or a “rug pull” to use the DeFi lexicon, but of engineers who knew how to design the technology, without catering for the economics.
Part of the magic with Bitcoin is that not only had its creator Satoshi Nakamoto solved many of the tough technology issues that a digital currency needed to solve, he, she or they, also managed to solve many of the trickier economic incentive issues as well.
Since then, most iterations of cryptocurrency projects have followed in Nakamato’s precedent one way or another.
Algorithmic stablecoins are just the latest iteration of Nakamato’s seminal work, albeit with mixed results at best.
To the uninitiated, a stablecoin has its value either backed or pegged to another asset, digital or otherwise.
Most cryptocurrency investors will be familiar with dollar-backed stablecoins like Tether (not so backed on closer inspection), while others are backed by other assets, including other currencies and even gold.
But instead of pegging 1-to-1 to their underlying assets, as the vast majority of stablecoins do, algorithmic stablecoins try to achieve price stability by using algorithms (hence the term “algorithmic”) to issue more coins when prices increase, and buying them off the market when prices decrease.
On paper this sounds like a great idea, because traders can reap the many benefits of cryptocurrencies without the risk of price volatility.
Algorithmic stablecoins are programmed with open source code and mechanisms which are transparent and fully auditable, offering the prospect of decentralization, while alleviating the need for them to be backed by tangible assets which need to be audited.
And given the controversies surrounding dollar-based stablecoins like Tether, the value proposition behind algorithmic stablecoins which are “backed” by code and construct instead of actual currency, seems evident.
But the devil, as always, lies in the details, and in the case of TITAN, that detail was execution.
To understand how TITAN collapsed, it’s first necessary to understand how it relates to another token called IRON.
IRON purports to be a stablecoin, receiving its collateral backing from TITAN and users mint new stablecoins through a mechanism on Iron Finance by locking up 25% in TITAN and 75% in USDC, a regulated dollar-backed stablecoin issued by Circle.
So far so good, and nothing out of the ordinary.
IRON is backed by USDC$0.75 and US$0.25 worth of TITAN, however much TITAN that may be.
When new IRON stablecoins are minted, the demand for TITAN increases, driving up its price and conversely when less IRON is in demand, the price of TITAN falls, and TITAN tokens are “burned” or taken out of circulation, to support its price.
But any student of economics will know that a fixed peg is ultimately a tricky thing to maintain.
Take for instance the Bank of England.
On September 16, 1992, the United Kingdom after losing billions of pounds, was forced out of the European Exchange Rate Mechanism or ERM, where the pound sterling was pegged to the deutsche mark.
Because the German central bank had turned hawkish (raising interest rates), the peg would force the Bank of England to import an inappropriately tight monetary policy even as the United Kingdom was in the midst of a recession which would require low interest rates to stimulate growth.
Hedge fund managers like George Soros saw that the Bank of England couldn’t afford to keep pegging the pound to the mark.
And as demand for marks grew, the Bank of England was forced to up interest rates to attract more investors to the pound.
Soros and other traders saw an opportunity, when it became clear that the Bank of England was losing billions of pounds to support its currency, and shorted the pound heavily.
When it became apparent that the Bank of England would blink first, Westminster gave up, withdrawing from the ERM and the pound all but collapsed in the wake of the episode.
The failure of currency pegs is nothing new and has been happening time and time again.
In 1997, the Asian Financial Crisis was a direct result of Asian currencies like the Thai baht and the South Korean won, maintaining artificially supported pegs to the U.S. dollar and were forced to devalue their currencies.
So why would algorithmic stablecoins think they could do what history has demonstrated that even governments can’t?
Because algorithmic stablecoins were designed by engineers, not economists.
It’s been said that Cuban’s interest in TITAN, and his tweets about it helped to attract far more attention to the project than perhaps it deserved.
Maybe, but that’s not really relevant.
Because TITAN didn’t have particularly deep markets nor was it particularly liquid, even what would appear to be a relatively benign transaction, like a sale of US$200,000 worth of TITAN, could be blown completely out of proportion in an already thinly traded token.
As investors started to offload their TITAN tokens, they flooded the market with excess tokens, causing a classic run on the crypto(currency).
But as TITAN started to collapse, so did the pegged value of IRON, triggering the stablecoin’s mechanism that mints TITAN in a bid to stabilize IRON at the artificial level of US$1.
This created an arbitrage opportunity between the price of IRON and TITAN, which in turn flooded the market with even more TITAN tokens.
The speed at which TITAN started to fall caused IRON to lose its peg, allowing traders to redeem IRON which was priced at US$0.90 as the peg started to slip, for US$0.75 in stablecoin and US$0.25 in TITAN.
Traders would now take their TITAN and sell it as quickly as possible to realize that US$0.10 gain, while holding on to the US$0.75 in USDC.
A bit of math is in order here.
If IRON’s price drops to US$0.90, a trader still gets back US$0.75 in USDC (another stablecoin) as well as US$0.25 worth of TITAN.
By selling the US$0.25 worth of TITAN into the market, the trader now gets back US$1 for what they only paid US$0.90 for, hence the US$0.10 worth of risk-free profit:
1 IRON = US$1 = US$0.75 USDC + US$0.25 worth of TITAN
And therein lies the issue — because the value of the USDC is stable (it’s a stablecoin), but the value of TITAN is not, an attempt to fix the peg when the price of TITAN is dropping requires minting more TITAN.
As more traders arbitraged and dumped TITAN, panic fed into panic, and dislodged the IRON peg even more.
Because IRON is collateralized by TITAN, IRON losing its peg lead to a self-fulfilling feedback spiral.
And as long as the IRON peg couldn’t be maintained, there was no way to stop the price of TITAN from falling.
Remember, unlike in a traditional currency peg, an algorithmic stablecoin lives and dies by its code — there was no way to stop anything.
As long as TITAN kept dropping, IRON which consists of TITAN, couldn’t maintain its peg.
At its core, TITAN’s problem wasn’t engineering, it was economics.
IRON supports the price of TITAN by creating demand for it as collateral for IRON.
And TITAN is minted to adjust IRON’s collateral value so as to hold the stablecoin peg.
But if IRON loses its peg, there’s actually an incentive for traders to get rid of their IRON in exchange for USDC and TITAN, and while that reduces the supply of IRON which should in theory raise its price, it also increase the supply of TITAN, from which IRON derives its peg!
The circularity of the entire IRON-TITAN algorithmic stablecoin system made it ripe for a collapse.
IRON’s stablization mechanism actually accelerated the collapse of TITAN because engineers (presumably) seemed to have expected that arbitrageurs would hold TITAN in anticipation that the price would rise once IRON regained its peg.
But that’s not how arbitrageurs work.
The goal of an arbitrageur is to make a short-term profit, not hold TITAN expecting that it will increase in price.
In fact, it’s in the arbitrageurs’ interest to accelerate TITAN’s price fall, because once IRON’s price falls below US$0.75, they can make a risk-free profit by redeeming IRON for US$0.75 worth of USDC, and dump the US$0.25 worth of TITAN since that’s going to end up worthless anyway.
Which is precisely what happened, and how TITAN ended up becoming worthless.
The arbitrageurs did their job precisely how they were supposed to, by arbitraging TITAN’s price to zero.
Because the smart contracts which Iron Finance is built upon provide an irrevocable contractual right to a US$1 peg for IRON, this functioned as the equivalent of a hard peg.
And as history has amply demonstrated, hard pegs are, well, hard to maintain.
As TITAN’s price collapsed, more TITAN had to be minted to cater for the avalanche of redemptions of IRON, making matters worse and feeding into the death spiral, what’s known as hyperinflation in currency circles.
Like the Zimbabwean dollar or the Argentine peso, the central bank prints more of the currency as it becomes worthless to maintain the peg, leading to hyperinflation.
So to keep IRON’s peg, more TITAN was minted as its value declined.
But with IRON, there is no central bank, no International Monetary Fund, and no way to stop the vicious cycle into the abyss.
And no, there were no smart contract hacks.
There wasn’t a rug pull either.
No one tried to defraud anyone else, and no one stole any money.
This was a simple example of how decentralized finance is just like traditional finance in so many ways.
DeFi may defy the laws of finance, but not the laws of economics.
Patrick is an innovative entrepreneur and a lawyer passionate about cryptocurrencies and the business world. He is the CEO of Novum Global Technologies, a cryptocurrency quantitative trading firm. He understands the business concerns of founders and business people helping them to utilise the legal framework to structure their companies to take advantage of emerging technologies such as the blockchain in order to reach greater heights. His passion for travel, marketing and brand building has led him across careers and continents. He read law at the National University of Singapore and graduated with Honors in the Upper Division and joined one of Singapore’s top law firms, Allen & Gledhill where he was called to the Singapore Bar as an Advocate & Solicitor in 2005. He created Purer Skin, a skincare and inner beauty company which melds the traditional wisdom of ancient Asian ingredients such as Bird's Nest with modern technology. In 2010, his partner and himself successfully raised $589,000 from the National Research Foundation of Singapore under the Prime Minister’s Office. He has played a key role in the growth of Purer Skin from 11 retail points in Singapore to over 755 retail points in Singapore and 2 overseas in less than a year. He taught himself graphic design, coding, website design and video editing to create the Purer Skin brand and finished his training at a leading Digital Media Company.