Why Algorithmic Stablecoins Need a Separation of Powers

Price feeds are the heart of any rebasing system. Centralized oracles like Chainlink are a trusted third party, while on-chain TWAPs (like Uniswap v3) are manipulable. A failure or attack here directly breaks the peg.

• Vulnerability: A manipulated feed can trigger mass, incorrect liquidations.
• Solution: Decentralized oracle networks or redundant, cross-verified data sources are non-negotiable.

Protocols like Frax and MakerDAO must choose between offering deep on-demand liquidity (a capital sink) or prioritizing peg stability via arbitrage (which can fail in a bank run). Concentrating both roles creates systemic conflict.

• Conflict: Defending the peg during a crisis requires restricting redemptions, destroying user trust.
• Solution: Separate the liquidity provider (LP pools, Curve) from the stability mechanism (algorithmic market operations).

A monolithic protocol's governance token (e.g., MKR, FXS) controls monetary policy, fee parameters, and collateral whitelisting. This creates a high-value target for attackers and whales, as seen in historical MakerDAO votes.

• Risk: A malicious or coerced governance vote can steal funds or break the peg.
• Solution: Enforce a separation of powers: independent risk committees, time-locked upgrades, and minimal-governance core mechanisms.

The protocol merged the minting and redemption functions into a single, on-chain arbitrage mechanism. This created a death spiral feedback loop where de-pegging triggered unlimited minting of the governance token (LUNA), collapsing the entire $40B+ ecosystem in days.

• Failure: No circuit breaker or independent stability module.
• Lesson: The entity managing the peg cannot also control the supply valve during a crisis.

Maker separates powers across three distinct entities: Vaults/Keepers (collateral management), MKR Governance (parameter control), and the PSM/DAI Savings Rate (direct peg defense). This allowed it to survive Black Thursday and the Terra collapse.

• Success: Governance can adjust risk parameters without touching core redemption logic.
• Evolution: The introduction of the PSM acts as a dedicated, simple stability layer.

Frax employs a multi-layered stability mechanism. The AMO (Algorithmic Market Operations Controller) autonomously manages expansion/contraction, but its actions are bounded by the Collateral Ratio, set by governance. This separates the execution of monetary policy from the setting of its constraints.

• Innovation: AMOs can perform open market ops (e.g., providing Curve liquidity) without governance micromanagement.
• Resilience: The fractional collateral base provides a non-algorithmic backstop.

Many "algorithmic" stablecoins are, in practice, governance-minted IOUs. A multisig or DAO directly mints/burns stablecoins to maintain peg, making the system a centralized fiat stand-in with extra steps.

• Failure: No separation between legislative (rule-setting) and executive (peg-keeping) functions.
• Risk: Creates a single point of failure—governance apathy, attack, or malice directly breaks the peg.

Price feeds are the bedrock of collateralized and algorithmic systems. A single compromised oracle can trigger catastrophic liquidations or mint unlimited synthetic assets.

• MakerDAO's 2020 Black Thursday was a $8.32M loss due to oracle latency during a market crash.
• Reliance on a single data source (e.g., one Chainlink feed) creates systemic risk, as seen in smaller protocols.

When token holders vote on critical parameters (stability fees, collateral ratios), the system is vulnerable to whale manipulation or apathetic voter turnout.

• Terra's UST depeg was exacerbated by the Luna Foundation Guard's centralized decision-making on reserve deployment.
• Maker's early days saw MKR whales able to vote in their own financial interest, a risk mitigated later by Governance Security Modules.

Algorithmic designs that use a native volatile token (e.g., LUNA, SPELL) as primary backing create a reflexive feedback loop. A falling native token price directly weakens the peg, triggering more selling.

• This is a fundamental design flaw, not an execution error. UST's collapse evaporated ~$40B in market cap in days.
• True separation requires exogenous, non-reflexive collateral or a circuit-breaker mechanism.

A robust system must separate the entities responsible for monetary policy (setting rates), risk assessment (evaluating collateral), and execution (oracle operations).

• MakerDAO's progression shows this: Risk Teams propose, MKR holders vote, Oracles (like Chainlink) feed, Keepers execute.
• The future is modular stability: dedicated oracle networks (Pyth, Chainlink), independent risk DAOs, and execution layers like Gelato.

Collapsing price oracle, governance, and minting/burning into a single protocol creates a fatal attack surface. A single point of failure allows for cascading liquidation spirals and governance capture.

• UST/LUNA: Oracle reliance on its own ecosystem created a death spiral.
• Frax v1: Early versions had governance control over both the peg mechanism and collateral parameters.
• Solution: Decouple these three critical functions into independent, adversarial modules.

Adopt a separation of powers model where independent modules compete to maintain system integrity, inspired by MakerDAO's progressive decentralization.

• Oracle Layer: Must be exogenous, battle-tested, and multi-source (e.g., Chainlink, Pyth).
• Governance Layer: Should control high-level parameters (e.g., stability fee, debt ceilings) but NOT real-time peg mechanics.
• Stability Engine: An automated, transparent, and governance-minimized module (like a PID controller) that executes mint/burn based solely on oracle input.

MakerDAO's evolution from a centralized foundation to a decentralized risk guild and finally to the Endgame Plan demonstrates the path. Success is measured in decades, not hype cycles.

• Progressive Decentralization: Start with necessary controls, but encode an irreversible path to full automation.
• Risk as a First-Class Citizen: Formalize risk teams (like BA Labs, Phoenix Labs) as adversarial auditors paid by the protocol.
• Transparent Collateral: Every asset must have publicly verifiable, on-chain risk parameters and liquidation data.

The governance token cannot be the primary collateral/backing. Its value must accrue from protocol cash flows, not ponzi-nomics. Investors must analyze the real yield model.

• Fee Distribution: Stability fees and liquidation penalties should flow to token stakers/lockers, not be recycled to prop the peg.
• Exit Liquidity ≠ Protocol Backing: The seigniorage model (UST/LUNA) uses token inflation as backing, which is inherently unstable. Collateralized models (DAI, FRAX) use external assets.
• Key Metric: Protocol-Controlled Value (PCV) growth and sustainable yield, not just TVL.

Every critical function requires a fallback. This applies to oracles, keepers, and even governance itself via emergency shutdown modules.

• Oracle Fallback: Implement a circuit breaker that freezes the system if oracle deviation exceeds a threshold, preventing flash loan attacks.
• Keeper Incentives: Design MEV-resistant liquidation mechanisms that don't rely on a few centralized actors (see Maker's Flash Mint Module).
• Governance Delay: Critical parameter changes must have a 48-72 hour timelock to allow for market and community reaction.

The ultimate goal is a stateless stability layer that can stabilize any asset basket. This turns the stablecoin into a primitive, not a product.

• Asset-Agnostic Vaults: The protocol should not care if collateral is ETH, BTC, or a RW A token. Risk parameters are everything.
• Algorithmic ≠ Uncollateralized: The algorithm manages a diversified, overcollateralized portfolio. See Frax v3's AMO design.
• Build for Black Swan Events: Stress-test for >80% collateral drawdowns and oracle failure. Surviving is the only feature that matters.