Why Algorithmic Stability is Fundamentally at Odds with Endogenous Assets

The Reflexivity Trap is the core flaw. An algorithmic stablecoin's value is pegged to an external asset (e.g., USD), but its collateral is its own volatile governance token. This creates a reflexive feedback loop where price movements in one directly impact the other.

Downward Spiral Mechanics are deterministic. A drop in the stablecoin's peg triggers arbitrage mechanisms that mint more governance tokens, increasing supply and diluting holders. This pushes the collateral's price down, further eroding the stablecoin's backing and confidence.

Terra/Luna is the canonical case study. UST's depeg triggered the minting of billions in new LUNA, collapsing its price from $80 to near zero in days. The system's endogenous collateral had no exogenous value anchor to halt the feedback loop.

Contrast with Exogenous Models. MakerDAO's DAI uses diversified, exogenous collateral (ETH, USDC, RWAs). Frax Finance evolved from partial-algo to a majority exogenous reserve model. These systems break the fatal loop by anchoring value outside their own tokenomics.

Endogenous collateral creates reflexive risk. A protocol like Terra used its own governance token, LUNA, to back UST. This created a death spiral feedback loop where a drop in LUNA's price eroded confidence in UST, forcing more LUNA to be sold.

Stability is an information problem. An endogenous system has no external price signal. The oracle is the market itself, making the system purely reflexive and prone to speculative attacks, as seen with Iron Finance's TITAN.

Exogenous assets break the reflexivity. A stablecoin backed by off-chain assets (USDC) or a diversified basket (DAI's USDC+ETH) imports a stable price signal. This external anchor prevents the internal doom loop.

Evidence: The collapse of UST erased $40B. In contrast, DAI survived the 2022 bear market because its exogenous collateral (USDC, RWA) comprised over 50% of its backing, decoupling it from pure crypto volatility.

Endogenous assets lack an anchor. An asset whose value is defined solely by the system's own rules creates a circular reference problem. Unlike MakerDAO's DAI, which is pegged to exogenous collateral (e.g., ETH, USDC), a pure algorithmic coin's target is its own market price—a feedback loop with no stable setpoint.

Control theory demands an oracle. A stable control system requires an external, independent signal. Terra's UST and Frax's early design used their governance token (LUNA, FXS) as the sole stabilizer, creating a reflexive, pro-cyclical death spiral. The 'peg' was a consensus belief, not a measurable external reality.

Reflexivity guarantees instability. In a crisis, the mechanism's corrective actions (minting/burning) amplify the initial shock. The Iron Finance collapse demonstrated this: redemptions increased supply, crashing the price, which triggered more redemptions. The system's logic accelerated its own demise.

Evidence: The Reflexivity Multiplier. During Terra's death spiral, for every $1 of UST sold, the protocol minted ~$1 of LUNA to absorb it, diluting LUNA's value and increasing sell pressure. This created a negative feedback loop that erased $40B in days.

Seigniorage is a liability. Protocols like Terra/Luna and Frax demonstrate that minting a stable asset against a volatile one creates a reflexive feedback loop. The stablecoin's demand directly inflates the volatile collateral's value, creating a circular dependency that amplifies volatility in both directions.

Volatility harvesting is a myth. The promised yield from arbitrage is not a sustainable revenue stream. It is a zero-sum transfer from speculators to the protocol, which collapses when the arbitrage opportunity disappears or reverses. This is not yield farming; it is risk underwriting.

Endogenous assets lack an exit. Unlike MakerDAO's DAI, which is backed by exogenous assets like ETH, an algorithmic stablecoin backed by its own governance token has no external value anchor. The entire system's collateral is its own market cap, making it a closed financial loop vulnerable to death spirals.

Evidence: The UST depeg was not a black swan. It was the inevitable result of this design. The Iron/Titan collapse followed the identical pattern, proving the failure is a feature of the mechanism, not the implementation.