Why Elastic Supply Needs a Collateral Backstop to Survive

Elastic supply is a promise. Protocols like Ampleforth and OlympusDAO issue tokens that algorithmically expand and contract supply to target a price. This rebasing mechanism functions only as long as market participants believe the peg is credible.

Rebasing is not collateral. The core failure is mistaking a governance rule for financial backing. A smart contract that mints or burns tokens to chase a price oracle is not a balance sheet. It is a rule that breaks when confidence evaporates.

Confidence is volatile collateral. Every elastic token's history shows the death spiral dynamic. Downward price pressure triggers a supply contraction, which is perceived as dilution, causing further selling. This positive feedback loop destroys the system.

Evidence: OlympusDAO's (OHM) fall from $1,300 to $10 demonstrated this. Its treasury-backed model was insufficient; during a crisis, the market priced the token below its backing per OHM, proving that perceived future cash flows, not just assets, determine value.

Redemption is the arbitrage floor. Without a direct, on-chain mechanism to burn tokens for underlying collateral, the peg relies solely on speculative demand. This creates a fragile system vulnerable to the reflexivity seen in failed algorithmic stablecoins like Basis Cash.

Collateral backstops are non-negotiable. A protocol like Frax succeeds where Ampleforth struggles because its fractional-algorithmic model guarantees a minimum redemption value. This transforms the token from a pure volatility game into a hardened financial primitive.

The mechanism defines the asset class. Compare MakerDAO's DAI (redeemable for collateral) to a purely rebasing token. The former is a stablecoin; the latter is a speculative derivative. Redemption anchors the long-term valuation, separating money from memes.

Evidence: Frax Finance's stability during the 2022 depeg crisis, where its redemption mechanism absorbed sell pressure, contrasts with the collapse of purely algorithmic models that lacked a tangible backstop.

Reflexivity is a terminal condition. An elastic supply token's price is its only fundamental. A price drop triggers a supply contraction, which is perceived as dilution, causing further selling. This creates a positive feedback loop with no external anchor to halt the descent.

Collateral acts as a circuit breaker. Protocols like Frax Finance and Ampleforth learned that a hard asset reserve (e.g., USDC, ETH) provides a non-reflexive valuation floor. This backstop absorbs selling pressure before the rebase mechanism engages, preventing panic.

Compare MakerDAO vs. Empty Rebasing. Maker's DAI has a collateralized debt position (CDP) system where liquidation auctions convert ETH to DAI to maintain the peg. A pure rebaser like the original Basis Cash had only algorithmic promises, which the market correctly priced at zero.

Evidence: Frax's shift to a hybrid collateral model (now Frax v3) increased its market cap stability during the 2022 bear market, while purely algorithmic stablecoins like TerraUSD (UST) demonstrated the catastrophic endpoint of the death spiral.

Reflexivity guarantees failure. A pure algorithmic design relies on market participants to maintain the peg, but their incentives invert during stress. The death spiral is a mathematical certainty, not a risk, as seen in the collapse of Terra's UST.

Elastic supply is pro-cyclical. Rebase mechanisms that expand supply during a price drop increase sell pressure, creating a positive feedback loop. This is the opposite of a central bank's counter-cyclical mandate.

Collateral is a circuit breaker. A backstop like MakerDAO's DAI model or Frax's hybrid design absorbs volatility. It provides a non-reflexive price floor, breaking the feedback loop that destroys pure algorithmic systems.

Evidence: Every major pure-algorithmic stablecoin has failed. UST's $40B collapse is the canonical case. Ampleforth's AMPL, despite surviving, has experienced volatility exceeding 50% from its target, rendering it useless as a stable medium of exchange.