The Hidden Risks of Algorithmic Stablecoins and Elastic Supplies

Algorithmic stability is a myth. These systems rely on reflexive feedback loops between a stablecoin and a volatile governance token, creating a death spiral when confidence wanes. The collapse of Terra's UST and the repeated depegs of ESD/DSD prove the model fails under stress.

Elastic supply is a tax on volatility. Protocols like Ampleforth and Olympus Pro's (OHM) rebase mechanism attempt to stabilize price by algorithmically adjusting token supply. This creates a negative user experience where a holder's token count changes unpredictably, destroying its utility as a unit of account or medium of exchange.

The fundamental flaw is incentive misalignment. These systems require perpetual growth to sustain their peg or treasury. When the growth narrative stalls, as seen with Wonderland (TIME), the only exit for the governance token is downward, breaking the stabilizing mechanism.

Evidence: The $40B collapse of Terra in May 2022 is the canonical case study, but smaller-scale failures are routine. Frax Finance survives only by progressively layering in real-world asset (RWA) collateral, moving away from pure algorithmics.

Exogenous Anchors create reflexive risk. A stablecoin pegged to the price of ETH or a basket of crypto assets inherits the volatility of its collateral. This creates a death spiral feedback loop where price drops trigger liquidations that cause further price drops, as seen with Terra's UST and its LUNA anchor.

Elastic supply tokens are not stable. Projects like Ampleforth and OlympusDAO's OHM attempt stability through rebasing mechanics and protocol-owned liquidity. Their value is anchored to internal protocol metrics, not external fiat, making them volatile assets masquerading as stable stores of value.

The only viable anchor is exogenous demand. True stability requires an off-chain, non-crypto price feed or a deeply liquid, diversified asset pool. MakerDAO's DAI moved from pure ETH collateral to including real-world assets (RWAs) like US Treasury bills to mitigate this exact endogenous risk.

Evidence: The Terra collapse erased over $40B in value. The fundamental flaw was UST's sole reliance on LUNA's market cap for its peg, a purely endogenous and reflexive system with no external stabilization mechanism.

Reflexivity is the core flaw. A falling token price triggers a protocol's contraction mechanism, which increases sell pressure and accelerates the decline. This creates a death spiral where the system's defense mechanism becomes its primary failure vector.

Elastic supply fails under stress. Protocols like Ampleforth and Empty Set Dollar demonstrated that rebasing supply to target a price peg does not work during a market-wide liquidity crunch. Users flee the volatility, breaking the peg permanently.

Collateral quality dictates survival. The 2022 collapse of Terra's UST proved that an algorithmic stablecoin backed by its own volatile governance token (LUNA) is a circular reference. The system lacked a hard asset anchor to absorb the shock.

Evidence: UST's depeg burned over $40B in market cap in days. The reflexive mint/burn mechanism between UST and LUNA created hyperinflation, rendering the latter worthless.

Hybrids are complexity arbitrage. Models like Frax's fractional-algorithmic design or MakerDAO's multi-collateral DAI replace single points of failure with oracle and governance risk. The system's stability depends on the real-time accuracy of price feeds for a basket of assets, creating a larger attack surface.

Elastic supply tokens fail under stress. Protocols like Ampleforth or OlympusDAO's (3,3) model rely on speculative demand for rebasing. During a downturn, the promised yield becomes a death spiral as sell pressure overwhelms the algorithmic mint/burn mechanism, proven in the 2022 crypto winter.

The peg is a coordination problem. A stablecoin's value is a Schelling point. Hybrids fragment this coordination by asking users to trust a dynamic, opaque collateral mix and a governance process, unlike the simple, verifiable 1:1 backing of USDC or USDT.

Evidence: Frax v2's shift from algorithmic to fully collateralized and MakerDAO's repeated governance crises over collateral types demonstrate that hybrids converge on over-collateralization or centralized assets to maintain trust.