Why Reflexivity Dooms Pure-Algo Stablecoins

Reflexivity is the flaw. A stablecoin's value depends on the demand for its governance token, whose value depends on the stablecoin's success. This creates a circular dependency where price discovery is impossible without external, non-speculative demand.

Terra's UST was the archetype. Its stability relied on arbitrage with its governance token, LUNA. This created a positive feedback loop during growth but a catastrophic death spiral during a loss of confidence, as seen in May 2022.

The counter-intuitive insight is that a stablecoin needs an exogenous asset for its peg mechanism. MakerDAO's DAI survived because its collateral (ETH, USDC) is valued independently of DAI's own ecosystem, providing a non-reflexive anchor.

Evidence: The $40B collapse of UST-LUNA is the definitive metric. Every major pure-algo stablecoin (Basis Cash, Empty Set Dollar) has failed or de-pegged, while collateralized models like DAI and Frax's hybrid design persist.

Reflexivity creates positive feedback. The value of a pure-algo stablecoin is backed only by the market's belief in its future demand. This belief is the collateral. When price falls, belief erodes, reducing demand and collateral value, which pushes price down further. This is the death spiral.

The peg is a Schelling point. A stablecoin's peg is a coordination game. For MakerDAO's DAI (now overcollateralized), the peg is anchored to real, exogenous collateral like ETH. For Terra's UST, the peg was anchored to the reflexive value of LUNA, making the system a circular reference.

Demand drives supply, not vice versa. A successful stablecoin needs exogenous demand sinks. Circle's USDC has demand from DeFi and CEXs. UST's primary demand was the Anchor Protocol yield, a subsidized incentive that vanished when the reflexive loop reversed.

Evidence: The Terra collapse demonstrated the loop. As UST depegged, the mint/burn mechanism with LUNA accelerated the supply death spiral, erasing $40B in value in days. No pure-algo design has survived a bear market.

Fractional-algorithmic models like Frax introduce collateral but retain a reflexive core. The protocol's algorithmic stablecoin (FRAX) minting depends on its own market price to determine the collateral ratio, creating a feedback loop. A price drop forces more collateralization, contracting the money supply and increasing sell pressure.

Synthetic dollar protocols like Ethena replace an algorithmic peg with a funding rate arbitrage derivative. This substitutes price reflexivity for basis trade and custodial risk. The stability now depends on perpetual swap markets and the security of off-chain collateral, which failed for Terra's Ozone hedge.

The core failure mode is reflexive governance. All models relying on native token incentives for stability create a circular dependency. The token value backs the system, but the system's demand props the token. This is the Terra/Luna death spiral in any asset wrapper.

Evidence: Frax's Depeg History. FRAX lost its $1 peg for over a month in 2022, trading as low as $0.89. The required collateral ratio surged above 90%, demonstrating the system's reactive, not proactive, stabilization. The 'algorithmic' component became a liability.