After finishing the article about Ethena yesterday, I recalled some of my thoughts on stablecoins in 2021. Looking back at my past thoughts now, I believe they are still valid.

In the crypto ecosystem, the so-called stablecoins we often discuss are actually similar to US dollar certificates like the Hong Kong dollar. These certificates need to ensure that users can exchange them for US dollars at an equivalent value.

So the key to these stablecoins lies in whether the collateral assets provided by the project when users redeem the certificates (stablecoins) for US dollars are recognized by the users.

What kind of collateral assets are likely to be recognized by users?

They must be recognized as valuable assets by users.

In the crypto world, the most mainstream valuable assets are basically two types:

One is the simplest, namely, US dollars deposited in a bank. The most typical stablecoin built on this idea is USDC.

The other type is valuable assets held in secure institutions, specifically in the crypto ecosystem, assets held in smart contracts (such as ETH). The most typical stablecoin built on this idea is DAI.

For stablecoins like USDC, because its value is directly supported by the US dollar, as long as the collateral assets are sufficient, it can naturally maintain a 1:1 peg to the US dollar. This eliminates the trouble and challenge of maintaining the exchange rate, but inevitably introduces centralized interference.

For stablecoins like DAI, because its value is not supported by the US dollar, but by crypto assets with relatively large volatility compared to the US dollar. So its biggest challenge lies in how to maintain the exchange rate stability against the US dollar.

There are two ways to maintain exchange rate stability against the US dollar:

One is a nearly risk-free approach, which ensures that the value of the assets always exceeds the value of the certificates (stablecoins). Although this approach completely avoids risk, it comes at the cost of sacrificing capital efficiency. This is why DAI uses over-collateralized assets to maintain the stability of the exchange rate, but it also immobilizes a large amount of capital, severely restricting liquidity.

Because of this flaw, people have always been trying to find their "ideal country" - to break free from the constraints of liquidity, not be bound by the value of the collateral assets themselves, that is, the value of the collateral assets does not need to exceed the value of the US dollars lent out.

If the value of the collateral assets is less than or equal to the value of the lent US dollars, then the difference in value between them is the risk that this type of stablecoin needs to address.

When the value of the collateral assets is extremely low, it is 0. In this case, the stablecoin becomes a purely algorithmic stablecoin. When the collateral assets have some value, but not higher than the value of the US dollar, this type of stablecoin is a semi-algorithmic stablecoin.

Purely algorithmic stablecoins have been attempted by several projects in the previous bull market, with classic examples being AMPL and BAC. They have all been proven to have difficulty maintaining a stable exchange rate.

Semi-algorithmic stablecoins have also been attempted by several projects in the previous bull market, with classic examples being LUNA, ESD, and others. They have also been proven to have difficulty maintaining a stable exchange rate, although they may have maintained it slightly longer than purely algorithmic stablecoins.

Now, the first type of purely algorithmic stablecoin is increasingly losing credibility, but the second type of semi-algorithmic stablecoin is still being attempted by some.

However, in my opinion, both types of algorithmic stablecoins are ultimately difficult to succeed.

Because as long as what maintains the value of the stablecoin is not over-collateralization, its highest price is the value of the US dollar. However, the price of any asset will fluctuate. Once it fluctuates, the price of the collateral will be lower than the US dollar. Regardless of how this price difference is compensated, it will require the introduction of additional valuable "collateral".

Of course, this additional "collateral" can take various forms: either centralized assets or crypto assets with strong consensus.

It is difficult for algorithms or trading to sustainably and continuously compensate for this price difference.

Therefore, I believe that although the pursuit of the ideal of algorithmic stability is noble, financial laws cannot be violated. Just as the ideal of creating a perpetual motion machine is noble, but the laws of physics cannot be violated.

In the crypto world, the approach of breaking free from over-collateralization and seeking other algorithmic stablecoins is probably just a utopia.

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