Algorithmic stability is a mirage. It confuses price as a control variable, not a market signal. Systems like Terra's UST attempted to enforce a peg through arbitrage loops between LUNA and UST, but this created a reflexive feedback loop that amplified sell pressure.
algorithmic-stablecoins-failures-and-future
Blog
Why Algorithmic Elasticity Alone Is a Recipe for Disaster
A first-principles analysis of why supply adjustments based on price oracles create predictable MEV opportunities and destabilizing feedback loops, with evidence from UST, ESD, and the path forward via hybrid models.
introduction
THE RECKONING
The Fatal Flaw in Pure Algorithmic Design
Algorithmic elasticity, when untethered from real demand, creates death spirals instead of stable systems.
Elasticity requires inelastic demand. A token's supply can expand and contract, but without a fundamental utility sink like MakerDAO's DAI collateral or Frax Finance's hybrid model, the 'stable' asset has no intrinsic value anchor. The algorithm becomes the only buyer and seller.
Reflexivity guarantees instability. In a crisis, the rebasing mechanism itself broadcasts panic. As users sell the algorithmic asset, the protocol must mint more of its governance token to buy it back, diluting holders and accelerating the collapse. This is a mathematical certainty, not a bug.
Evidence: The $40B Terra collapse. UST's design assumed perpetual arbitrage demand for LUNA. When that demand vanished, the algorithmic mint/burn mechanism inverted, hyper-inflating LUNA's supply to zero. Every major 'algo-stable' since—Empty Set Dollar, Basis Cash—has followed this pattern.
key-trends
WHY ALGORITHMIC ELASTICITY ALONE IS A RECIPE FOR DISASTER
The Inevitable Failure Modes
Elastic supply tokens attempt to stabilize price via automated mint/burn rules, but history shows this creates predictable, catastrophic attack vectors.
01
The Reflexivity Death Spiral
Algorithmic stability creates a feedback loop where price drives supply, not the other way around. A price drop triggers contraction, which is perceived as failure, causing further selling.
- Terra/LUNA: The canonical failure: $40B+ TVL evaporated in days.
- Negative Reflexivity: The stabilizing mechanism becomes the primary source of volatility.
- No External Anchor: Without exogenous collateral or demand, the system has no reversion mean.
>99%
Collapse Speed
0
Successful Survivals
02
The Oracle Manipulation Attack
Elastic contracts rely on price oracles to trigger mints and burns. This creates a single, financially incentivized point of failure.
- Just-in-Time Liquidity: Attackers can drain reserves by manipulating the oracle price before a mint.
- Ampleforth & Empty Pools: Demonstrated vulnerability to flash loan-enabled oracle attacks.
- Centralized Oracle Risk: Delegates control to external data providers like Chainlink, introducing trust assumptions.
~30s
Attack Window
$M
Extractable Value
03
The Liquidity Fragility Problem
Elastic rebases or supply changes punish passive liquidity providers (LPs), leading to chronic capital flight and illiquid pools.
- LP Impermanent Gain/Loss: Rebasing changes pool composition, creating unpredictable LP P&L.
- Capital Efficiency < 10%: Most liquidity is defensive, not available for healthy trading.
- Death by AMM Math: As liquidity drains, slippage increases, accelerating the death spiral.
<10%
Usable Liquidity
100x
Slippage Spike
04
Frax Finance: The Hybrid Exception
Frax v1/v2 succeeded by layering algorithmic elasticity on top of a collateralized base, proving pure-algo models are fundamentally flawed.
- Fractional-Algorithmic Design: >90% collateralized during growth, algorithmic during stability.
- AMO Controllers: Algorithmic Market Operations programmatically manage collateral & liquidity.
- Demand-Driven Expansion: Growth comes from utility (e.g., Curve wars, Fraxchain), not pure speculation.
>90%
Collateral Backing
$2B+
Sustainable TVL
deep-dive
THE FEEDBACK LOOP
Oracles, Predictability, and the MEV Death Spiral
Algorithmic elasticity fails without external price data, creating predictable on-chain arbitrage that extracts value from the protocol itself.
Algorithmic elasticity is predictable. It relies on internal, on-chain price signals that are public and deterministic. This creates a perfectly transparent arbitrage loop that MEV bots can front-run with zero risk.
Oracles break the loop. External price feeds from Chainlink or Pyth introduce an unpredictable, off-chain data point. This prevents bots from perfectly anticipating the next rebase or mint, forcing them to compete on execution speed, not information.
Without oracles, you subsidize MEV. Rebasing tokens like Ampleforth demonstrated that purely algorithmic models become a sustainable revenue stream for searchers. The protocol's own mechanism becomes its primary extractable value.
Evidence: The 2020-2021 saga of ESD and Basis Cash showed death spirals where algorithmic stability mechanisms were fully gamed. Their on-chain TWAPs provided a roadmap for bots, not a defense.
WHY ALGORITHMIC ELASTICITY ALONE IS A RECIPE FOR DISASTER
Post-Mortem: Elastic Supply Mechanisms in Practice
A comparative autopsy of pure algorithmic stablecoins versus modern, collateralized alternatives, analyzing the fatal flaws of supply elasticity without a price floor.
| Critical Mechanism / Metric | Pure Algorithmic (e.g., Basis Cash, Empty Set Dollar) | Hybrid/Overcollateralized (e.g., MakerDAO DAI, Liquity LUSD) | Externally Pegged (e.g., USDC, USDT) |
|---|---|---|---|
Primary Price Stability Mechanism | Algorithmic supply rebasing (seigniorage) |
| Off-chain fiat/cash reserves + redemption |
Explicit Price Floor (Hard Backstop) | |||
Death Spiral Risk (Downward Peg Pressure) | Extreme: Reflexive sell pressure burns tokens | Managed: Liquidations defend peg, but systemic risk exists | Low: Dependent on issuer solvency & regulation |
Typical Collateral Ratio | 0% | 110% - 200%+ | 100%+ (off-chain) |
Liquidity During Contraction ("Bank Run") | Vaporizes: No assets to sell, only algorithmic burning | Stressed: Relies on liquidators & stability pool | High: Assumed 1:1 redeemability with issuer |
Historical Failure Rate (Projects Launched 2020-2021) |
| <5% (protocols survived, users liquidated) | ~0% (failure = regulatory, not mechanical) |
Key Dependency for Survival | Continuous, infinite growth demand | Collateral value stability & liquidator efficiency | Central issuer integrity & regulatory compliance |
Example of Catastrophic Depeg | ESD: -80% (Feb 2021), BAC: -70% (May 2021) | DAI: Brief depeg to $1.10 (Mar 2020 Black Thursday) | USDC: Brief depeg to $0.88 (Mar 2023 SVB crisis) |
counter-argument
THE ORACLE PROBLEM
The Steelman: Couldn't Better Oracles Fix This?
Even perfect price data cannot solve the fundamental coordination failure in algorithmic stablecoin design.
Oracles report history, not the future. A perfect Chainlink or Pyth Network feed provides the last traded price, not the price at which the next liquidation will execute. This lag creates a predictable arbitrage window during volatile market moves.
Elastic supply requires instantaneous coordination. The rebasing mechanism assumes the entire market will act on the same data at the same time. In reality, MEV bots front-run public oracle updates, extracting value from the stabilization mechanism itself.
This is a game theory failure, not a data problem. Protocols like Terra's UST and Ampleforth demonstrated that even with accurate oracles, the reflexive feedback loop between price and supply overwhelms the system. The oracle is a messenger, not a market maker.
case-study
WHY ALGORITHMIC ELASTICITY ALONE IS A RECIPE FOR DISASTER
Case Studies in Elastic Failure
Elastic supply mechanisms, from rebasing tokens to algorithmic stablecoins, consistently fail when they rely purely on code to maintain a peg without robust, real-world collateral or demand sinks.
01
TerraUSD (UST): The Death Spiral
UST's algorithmic peg to $1 relied on arbitrage with its sister token, LUNA. When confidence collapsed, the reflexive mint/burn mechanism created a hyperinflationary feedback loop.\n- $40B+ TVL evaporated in days\n- Anchor Protocol's 20% yield was an unsustainable demand sink\n- Zero exogenous collateral meant no floor during the bank run
-99.7%
UST Value
$40B+
TVL Lost
02
Ampleforth (AMPL): The Volatility Pump
AMPL's daily rebase targets a 2019 USD value, expanding/shrinking supply in all wallets. This creates perverse user experience and speculative cycles.\n- Supply changes up to +/- 10% daily punish passive holders\n- No native yield or utility beyond the rebase mechanic\n- Price-agnostic elasticity fails to create stable unit of account
±10%
Daily Rebase
~90%
From ATH
03
OlympusDAO (OHM): The Ponzi-Nomics Trap
OHM's (3,3) game theory used protocol-owned liquidity and high staking APY to back its treasury. Elastic bonding created a death spiral when inflows stopped.\n- APY peaked at >7000%, unsustainable without perpetual new capital\n- Treasury backing ≠liquidity; massive sell pressure crushed price\n- Algorithmic 'backing' proved worthless during the bear market
>7000%
Peak APY
-98%
From ATH
04
The Iron Triangle of Elastic Tokens
Algorithmic elasticity forces a fatal trade-off between three properties: Price Stability, Capital Efficiency, and Decentralization. You can only optimize for two.\n- UST chose Stability & Efficiency → collapsed from lack of decentralized collateral\n- AMPL chose Efficiency & Decentralization → failed at Stability\n- A robust stablecoin (e.g., DAI, FRAX) accepts lower Efficiency to secure Stability & Decentralization
3
Properties
Pick 2
Trade-Off
future-outlook
THE REALITY CHECK
The Hybrid Future: Blunting the Algorithm's Edge
Algorithmic stablecoins fail without a robust, real-world asset backstop to absorb extreme volatility.
Pure algorithms are fragile. An on-chain feedback loop, like those in Terra/Luna or Empty Set Dollar, cannot create value from nothing during a bank run. The system requires an external asset sink to break the death spiral.
Hybrid models dominate. Protocols like Frax (partial collateralization) and MakerDAO (RWA-backed DAI) succeed because they blend algorithmic elasticity with verifiable, off-chain value. The algorithm manages efficiency; the collateral guarantees the floor.
The market demands proof of reserves. Users and integrators like Circle or Aave will not adopt a stablecoin without transparent, auditable backing. An algorithm alone is an IOU; collateral is a balance sheet.
Evidence: The total collapse of the ~$40B TerraUSD (UST) ecosystem versus the resilience of MakerDAO's DAI during the 2022 bear market proves that over-collateralization and RWAs are non-negotiable for stability at scale.
takeaways
WHY ALGORITHMIC ELASTICITY ALONE FAILS
TL;DR for Protocol Architects
Pure algorithmic stablecoins like Basis Cash and Empty Set Dollar have repeatedly collapsed. Here's why isolated elasticity is insufficient for real-world adoption.
01
The Reflexivity Death Spiral
Algorithmic elasticity creates a reflexive feedback loop where price drives supply, not demand. A price drop triggers contraction, which is perceived as failure, causing further selling.\n- No exogenous demand anchor like real-world assets or fees.\n- Ponzi-nomics: Growth depends solely on new entrants buying the token.\n- Empirical Proof: ~100% of major algo-stables have de-pegged during bear markets.
100%
De-peg Rate
<1%
Survival Rate
02
The Oracle Problem is Fatal
Elastic supply mechanisms are critically dependent on a single, manipulable price feed. A delayed or corrupted oracle signal can trigger catastrophic, irreversible supply changes.\n- Single Point of Failure: Exploits on Chainlink or Pyth can bankrupt the system.\n- Front-running: Bots anticipate and exploit supply change transactions.\n- Solution Path: Requires redundant oracle design and circuit breakers, as seen in MakerDAO's robust risk framework.
1
Fault Tolerance
~3s
Attack Window
03
Missing the Utility Layer
Elasticity is a monetary feature, not a product. Successful stable assets like DAI and USDC are successful because they are useful—they are the default liquidity in Uniswap pools and collateral in Aave.\n- Adoption Driver: Utility creates organic demand that absorbs supply shocks.\n- Real-World Lesson: Frax Finance succeeded by layering algorithmic elements atop a core utility (AMM, lending) and partial collateralization.\n- Pure algo-coins have $0 sustainable fee revenue.
$0
Protocol Revenue
100%+
Collateral Backing
04
The Liquidity Black Hole
Elastic rebasing mechanics fragment and destroy liquidity. Constant supply changes make providing liquidity in AMMs like Curve or Uniswap V3 risky and capital-inefficient, leading to shallow pools.\n- LP Impermanent Loss on Steroids: Supply changes act as a direct, unpredictable transfer from LPs.\n- Negative Flywheel: Low liquidity increases slippage, reducing utility, further lowering demand.\n- See: The Empty Set Dollar liquidity death spiral, where TVL evaporated in weeks.
-90%
TVL Drop
>50%
Slippage
05
Regulatory & Psychological Anchor
Users and institutions need a clear, non-psychologically demanding claim to value. A purely algorithmic token has no legal or psychological anchor, making it unfit as a unit of account.\n- No Redemption Right: Unlike USDC, you can't redeem for a dollar at a licensed entity.\n- Cognitive Overhead: Users won't adopt a 'stable' asset whose supply changes in their wallet.\n- Hybrid Model Mandatory: Successful systems (MakerDAO, Frax) use clear, auditable collateral backstops.
0
Legal Claim
100%
Trust Required
06
Frax Finance: The Hybrid Blueprint
Frax v1/v2 succeeded where pure algo-stables failed by combining algorithmic elasticity with collateral backing and protocol-owned liquidity. It's a three-layer system:\n- Collateral Buffer: Starts partially backed (e.g., 80% USDC, 20% algorithmic).\n- Utility Engine: Fraxswap AMM and Frax Lending generate real yield.\n- Elastic Layer: Algorithmic Frax Shares (FXS) adjusts the collateral ratio dynamically based on market confidence.\n- Result: Survived multiple bear markets while maintaining peg.
~90%
Collateral Ratio
$2B+
Peak TVL
ENQUIRY
Get In Touch
today.
Our experts will offer a free quote and a 30min call to discuss your project.
NDA Protected
Confidentiality24h Response
Time to ValueDirectly to Engineering Team
No Sales Fluff10+
Protocols Shipped
$20M+
TVL Overall