Why Algorithmic Stablecoins Failed as Money But Might Succeed as Derivatives

Algorithmic stablecoins failed as money because they attempted to replicate central bank policy without the sovereign power to enforce it. Protocols like Terra/Luna and Frax v1 proved that on-chain seigniorage and reflexive collateral are unstable under stress, creating death spirals instead of reliable pegs.

The core flaw was monetary, not technical. A stablecoin is a liability, not an asset. Without real-world revenue or exogenous collateral (like USDC), the system's stability depends purely on perpetual growth faith, a Ponzi-like structure that inevitably collapses.

The successful pivot is to derivatives. Projects like Ethena's USDe and Mountain Protocol's USDM explicitly frame themselves as delta-neutral synthetic dollars. They are structured products built on perpetual futures funding rates and Treasury bills, not pretend currencies.

This reframes the value proposition. As a derivative, the goal is capital efficiency and yield, not daily transactions. The risk shifts from 'will it break peg' to 'can the hedge hold', a quantifiable engineering problem familiar to TradFi.

Algorithmic stablecoins failed as money because they promised a stable unit of account and store of value without the requisite collateral or demand stability of Tether (USDT) or USD Coin (USDC). Their peg relied on reflexive, game-theoretic mechanisms that collapsed under stress, as seen with TerraUSD (UST) and its death spiral.

They succeed as derivatives when marketed as synthetic dollar instruments, not money. Protocols like Abracadabra's MIM or Ethena's USDe are transparently overcollateralized or delta-hedged synthetic assets. This reframes user expectation from 'permanent peg' to 'efficiently engineered financial instrument'.

The market demands this distinction. A derivative's value is its utility within a specific DeFi system (e.g., collateral on Aave, liquidity on Curve), not its universal acceptance. This aligns with the success of Liquity's LUSD, a resilient but floating stable asset designed explicitly as a borrowing tool, not global cash.

Algorithmic stablecoins failed as money because their reflexive collateral loops create death spirals. The core design flaw is a circular dependency: demand for the stablecoin directly supports its collateral value, which collapses when demand falls. This is a structural failure of the monetary feedback mechanism, not a failure of the underlying synthetic asset concept.

The pivot is to derivatives. Framing these assets as volatility or yield derivatives changes the risk profile. Protocols like Ethena's USDe and Mountain Protocol's USDM are not money; they are synthetic dollar positions that package staking yield and funding rates. Their value proposition is explicit yield, not price stability.

This isolates the failure mode. A derivative can trade at a discount without systemic collapse because its peg is not a promise. The risk is transferred to the holder, not the protocol's solvency. This is the model of Lyra Finance for options or Synthetix for synthetic assets, applied to yield-bearing dollar instruments.

Evidence: Ethena's $2B TVL. The rapid growth of Ethena's USDe demonstrates market demand for a synthetic dollar derivative that captures stETH yield and perpetual swap funding. Its success is measured by synthetic yield generation, not by perfect peg maintenance, which redefines the success metric for the entire category.

Algorithmic stablecoins failed as money because their peg mechanisms required reflexive, faith-based demand. This created a death spiral feedback loop where de-pegging triggered mass redemptions, collapsing the system as seen with Terra/Luna.

They succeed as yield-bearing derivatives when decoupled from payment utility. Protocols like Ethena's USDe treat the stablecoin as a delta-neutral synthetic dollar position, capturing funding rates from perpetual futures on exchanges like Binance and Deribit.

This transforms the stablecoin into a yield token, a core building block for structured products. DeFi protocols like Pendle and Morpho can bundle these yield streams with options or leverage to create custom risk-return profiles for users.

The evidence is in TVL and product design. Ethena's rapid growth to multi-billion dollar TVL demonstrates demand for the primitive, while the proliferation of yield-tranching vaults across DeFi confirms the market for structured yield.