Why Algorithmic Credit Systems Must Escape the Stablecoin Death Spiral

Algorithmic stablecoins like TerraUSD (UST) fail because their primary utility is maintaining a peg, not creating value. The system's sole incentive is reflexive arbitrage, which collapses under stress.

• Reflexive Collapse: De-pegging triggers a death spiral as arbitrageurs extract value from the system.
• Zero Intrinsic Yield: The asset's only job is to be $1.00, creating no productive economic activity to sustain it.
• Vulnerable TVL: Systems with $10B+ TVL can evaporate in days when the reflexive loop reverses.

The solution is a credit system whose value is derived from the yield of its underlying collateral and utility, not a peg. Think MakerDAO's DAI post-2022, moving towards a 'savings coin' backed by real-world assets.

• Yield-Bearing Collateral: Value is backed by productive assets (e.g., US Treasury bills), not a volatile governance token.
• Floating Value, Stable Utility: The unit of account can float while its purchasing power for protocol fees or services remains stable.
• Sustainable APY: Systems can generate a 3-5% native yield from collateral, paid directly to holders.

Future systems will use credit as a routing layer for intent-based transactions, abstracting liquidity sourcing. This mirrors the evolution from Uniswap v2 to UniswapX and CowSwap.

• Credit as a Primitive: Users transact on credit, with the system optimally sourcing settlement liquidity across L2s and bridges like Across and LayerZero.
• Monetizing Flow: The protocol earns fees on the routing, not from maintaining a peg.
• Capital Efficiency: Enables 10-100x higher volume throughput for the same locked capital versus AMM pools.

A 'stablecoin' is a security. A 'utility token' for a credit network is not. The key is designing a system where the token's primary function is access to a service, not a store of value.

• Utility-First Design: Token grants rights to discounted fees, governance, or credit lines within a specific economic niche (e.g., trade finance).
• Composability Shield: Integration with DeFi legos like Aave and Compound creates organic demand beyond speculation.
• Legal Moats: A functionally complex system is harder for regulators to classify and attack, unlike a simple pegged asset.

Algorithmic stablecoins like UST used their own governance token (LUNA) as the primary backstop, creating a reflexive feedback loop. A price dip triggers mint/burn arbitrage, which dilutes the backing asset, accelerating the collapse.

• Reflexivity: Collateral value is a function of demand for the stablecoin itself.
• No Circuit Breakers: Death spiral mechanics are encoded in the protocol's core mint/burn logic.
• ~$40B: Market cap evaporated in the UST/LUNA collapse, demonstrating systemic scale.

Escape reflexivity by backing credit with external, volatile assets (e.g., ETH, staked assets). The system must be engineered to withstand 80%+ drawdowns in collateral value without entering a death spiral.

• Exogenous Backing: Collateral value is independent of protocol demand.
• Dynamic LTVs & Circuit Breakers: Risk parameters auto-adjust based on volatility and liquidity.
• Liquity (LUSD) Model: Proven resilience backed purely by ETH, surviving multiple >50% ETH crashes.

The post-peg reality demands minimum 150-200% collateralization ratios for algorithmic credit, even for 'stable' assets. This capital inefficiency is the non-negotiable price of trustless stability.

• Capital Buffer: Absorbs volatility without immediate liquidation.
• Liquidation Incentives: Must be large enough to ensure keeper profitability during black swan events.
• MakerDAO's Evolution: Moved from single-asset (ETH) to diversified collateral (RWA, LSTs) to mitigate correlated drawdowns.

All algorithmic systems are only as strong as their price feeds. Manipulating a critical oracle (e.g., Chainlink) for the collateral asset can trigger unjust liquidations or mask insolvency.

• Single Point of Failure: Reliance on a handful of oracle nodes.
• Time-Lagged Data: Stale prices during high volatility create arbitrage gaps.
• Solution Stack: Requires decentralized oracle networks (Chainlink, Pyth), TWAPs, and circuit breakers that halt operations during feed divergence.

A protocol can be technically solvent but practically dead if users cannot exit. Deep, resilient liquidity pools (e.g., Curve 3pool, Uniswap V3) are critical secondary backstops.

• Exit Liquidity: Must be 10-20% of circulating supply to prevent slippage-induced depegs.
• Incentive Alignment: Liquidity mining must be sustainable, not inflationary.
• Frax Finance Model: Uses its AMO (Algorithmic Market Operations) to dynamically manage pool liquidity and arbitrage.

Post-UST, regulators (SEC, EU's MiCA) now explicitly target 'algorithmic stablecoins'. New systems must be architected as collateralized debt positions or overcollateralized synthetic assets to avoid the 'unbacked' security designation.

• Legal Design: Documentation must emphasize the collateral vault, not the algorithmic mechanism.
• Transparency: Real-time, on-chain proof of reserves is mandatory.
• MakerDAO's Precedent: Successfully framed DAI as a collateralized loan receipt, not a security.

All previous systems like Terra/Luna and Iron Finance were doomed by a single, fatal feedback loop: the collateral is the debt.\n- Death Spiral: A drop in the stablecoin's peg triggers arbitrage to burn it, which dilutes the collateral token, collapsing the entire system.\n- Zero Exogenous Value: The 'collateral' has no utility or cash flow outside the system, making it purely reflexive.

The only viable path is to back credit with assets that have value and yield independent of the system's own token.\n- Real Yield Backstop: Use LSTs (e.g., stETH), LRTs, RWA vaults, or even MakerDAO's DAI savings rate as the foundational collateral layer.\n- Break the Loop: The collateral's price is determined by external markets (e.g., ETH staking), severing the reflexive link with the credit token.

Forget 'capital efficiency' marketing. For algorithmic credit, high overcollateralization (200%+) is the primary security model.\n- Dynamic Stability Fees: Borrowing rates must algorithmically adjust based on peg pressure, not just utilization.\n- Protocol-Controlled Liquidity: A portion of yield from collateral must fund a permanent liquidity pool (like Frax Finance's AMO) to defend the peg directly.

When the peg breaks, you need orderly exits, not a bank run. This requires mechanisms borrowed from TradFi and other DeFi primitives.\n- Basket Redemption: Allow users to redeem the stablecoin for a basket of the underlying collateral assets, not just a single volatile token.\n- Time-Weighted Peg: Implement a Curve Finance-style EMA oracle or a Euler Finance-style guarded launch to slow down panic-driven arbitrage.