Inelastic supply algorithms are mathematical functions that define token issuance. They operate on fixed rules, like a bonding curve or a rebase formula, which cannot adapt to sudden market shifts.
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Why Inelastic Supply Algorithms Always Break Under Pressure
A first-principles analysis of why algorithmic stablecoins with inelastic supply mechanics are structurally doomed to fail. We examine the fatal lag between evaporating demand and algorithmic response, using post-mortems from Terra, Iron Finance, and others.
introduction
THE INELASTICITY TRAP
The Fatal Flaw: Code is Slower Than Panic
Algorithmic supply mechanisms fail during crises because their deterministic logic cannot match the speed of human fear.
Human panic moves at mempool speed, while code executes at block time. A panic sell triggers a cascade of transactions that the algorithm processes sequentially, guaranteeing a lag that exacerbates the crash.
This created the death spiral for projects like OlympusDAO and its forks. The protocol's treasury-backed bonding mechanism was designed for steady growth, not a coordinated bank run from its own liquidity pools.
Evidence: During the May 2022 depeg, Terra's UST algorithmic stablecoin burned 11.3 billion LUNA in 72 hours trying to defend its peg. The code executed perfectly, but the sell pressure was faster.
key-trends
WHY ALGORITHMIC STABLECOINS FAIL
The Inelastic Death Spiral: A Three-Act Play
Inelastic supply algorithms are a systemic risk, creating predictable feedback loops that destroy protocols under stress.
01
Act I: The Peg is a Magnet for Attack
The promised $1 peg becomes a target, not a floor. Arbitrageurs and speculators front-run the protocol's own rebalancing mechanism, forcing it to mint its death-spiral token (e.g., LUNA, AMPL's rebase) into a collapsing market.\n- Key Flaw: The protocol must buy its own collapsing asset to defend the peg.\n- Outcome: Creates a reflexive, self-reinforcing sell pressure loop.
99%+
Collapse Speed
$40B+
Historical TVL Evaporated
02
Act II: Reflexivity Turns Users into Exit Liquidity
Holders of the 'stable' asset are unknowingly holding a call option on protocol failure. As the peg slips, rational actors race to redeem before the reserve asset depletes, accelerating the death spiral. This is the bank run problem, digitally encoded.\n- Key Flaw: User incentives are misaligned; stability requires collective faith during a crisis.\n- Outcome: The most rational action for any individual user is to trigger the protocol's failure.
Hours
Run Duration
0
Sustainable Equilibrium
03
Act III: The Oracle Death Blow
In a crisis, price oracles become the single point of failure. A lag of ~15 minutes (typical DEX oracle delay) is an eternity when the peg is breaking. The protocol reacts to stale data, executing rebalances at prices that no longer exist, guaranteeing massive arbitrage losses and irreversible capital destruction.\n- Key Flaw: The stabilization mechanism is slower than the market it's trying to correct.\n- Outcome: The protocol systematically bleeds value to MEV bots and arbitrageurs.
15 min
Critical Lag
100%
Inevitability
deep-dive
THE FUNDAMENTAL MISMATCH
First Principles: Velocity of Money vs. Velocity of Code
Inelastic supply algorithms fail because they ignore the fundamental difference between the velocity of financial assets and the execution speed of software.
Inelastic supply algorithms break because they treat token supply like a central bank treats currency, ignoring that on-chain assets move at network speed. A velocity of code mismatch occurs when automated monetary policy cannot react faster than capital flight during a crisis.
The 2022 UST depeg is archetypal. The algorithmic minting/burning feedback loop operated on a block-by-block cadence, but the velocity of speculative capital, routed through Curve pools and Anchor Protocol, was instantaneous. The code's execution latency created a fatal arbitrage window.
Proof-of-Stake security models face this. A validator's slashing conditions are code, but a market crash is capital velocity. If staked ETH liquidations cascade faster than the Beacon Chain's finality, the economic security assumption collapses, as seen in minor incidents on Solana and Avalanche.
The solution is elasticity with speed. Protocols like Frax Finance and MakerDAO succeed by backing their stablecoins with diversified, liquid collateral that can be automatically liquidated by keepers at market speed, aligning financial velocity with code execution.
INELASTIC SUPPLY
Post-Mortem: A Comparative Autopsy of Failed Algorithms
A forensic comparison of three major algorithmic stablecoin failures, analyzing the specific mechanisms that led to their collapse under market stress.
| Failure Mechanism | Terra UST (2022) | Iron Finance TITAN (2021) | Basis Cash (2020-21) |
|---|---|---|---|
Core Peg Mechanism | On-chain mint/burn via LUNA arbitrage | Partial collateral (USDC) + seigniorage share (TITAN) | Multi-token seigniorage shares & bonds |
Primary Stress Failure | Death spiral from $285M Anchor withdrawal | Bank run on USDC reserve after $TITAN sell-off | Failed bond auctions during bear market |
Critical Collapse Speed | < 72 hours (peg broke from $1 to $0.10) | < 48 hours (TITAN price dropped 100%) |
|
Max TVL Before Collapse | $18.7 Billion | $2.1 Billion | $190 Million |
Reflexivity Feedback Loop | LUNA hyperinflation (> 6.5T tokens minted) | TITAN sell pressure unbounded by reserves | No buy pressure for bonds without growth narrative |
Oracle Reliance for Stability | |||
Post-Collapse Recovery Attempt | Fork to Terra 2.0 (LUNA) | Protocol abandoned | Protocol abandoned |
Fundamental Flaw | Ponzi-like dependency on perpetual LUNA price appreciation | Insufficient collateral buffer (< 80% at stress) for redemptions | Demand for stability tokens is pro-cyclical |
case-study
WHY INELASTIC SUPPLY ALGORITHMS ALWAYS BREAK UNDER PRESSURE
Case Studies in Elastic Failure
From algorithmic stablecoins to lending protocols, fixed-supply mechanisms create predictable failure modes when demand shocks hit.
01
Terra's UST: The Death Spiral Archetype
The Problem: An algorithmic peg reliant on a volatile governance token (LUNA) for arbitrage.\n- $40B+ TVL evaporated in days when the arbitrage feedback loop reversed.\n- The "elastic" mint/burn mechanism became a one-way street during a bank run.
99.7%
Depeg
3 Days
To Collapse
02
Iron Finance (TITAN): The First Major Run
The Problem: A partial-collateral stablecoin (IRON) with an algorithmic token (TITAN) backing the uncollateralized portion.\n- A >70% price drop in TITAN triggered mass redemptions, exhausting the collateral pool.\n- Proved that elastic supply tokens cannot withstand reflexive selling pressure.
~$2B
TVL Lost
100%
TITAN Crash
03
Compound's cToken Oracle Failures
The Problem: Inelastic oracle price feeds during a liquidity crisis.\n- A $90M COMP whale was liquidated based on stale DAI/USDC prices on a single DEX.\n- Highlighted that "elastic" lending markets are only as strong as their most brittle data source.
$90M
Bad Liquidation
~$0
Actual Price Impact
04
The Solution: Demand-Responsive Elasticity
The Fix: Protocols like Frax Finance (hybrid model) and MakerDAO (PSM) incorporate direct demand sinks and hard collateral buffers.\n- Frax's AMO dynamically adjusts supply against verifiable on-chain demand, not just price.\n- Maker's PSM uses infinite, fee-gated liquidity pools of stable assets to absorb shocks.
>90%
Collateralization
Zero
Algorithmic Runs
counter-argument
THE FUNDAMENTAL FLAW
Steelman: Could Faster Algorithms or Better Design Save It?
Inelastic supply algorithms are structurally flawed, and no optimization can fix their core vulnerability to demand shocks.
Algorithmic speed is irrelevant. The core failure mode is not latency but a fundamental mismatch between supply and demand. A faster rebase mechanism on Terra or a more complex bonding curve on Olympus would not have prevented the death spiral; it would have accelerated it.
Better design shifts, not solves, the problem. Projects like Frax Finance use partial collateralization to create a hybrid stability mechanism, but this merely transfers the inelasticity risk to a smaller, more volatile reserve asset. The system's stability becomes a function of its collateral's liquidity, as seen in MakerDAO's reliance on centralized stablecoin reserves.
The evidence is in the carcasses. Every major failure—from Basis Cash to Iron Finance—demonstrates that inelastic supply cannot absorb panic selling. The sell pressure creates a negative feedback loop that no algorithmic tweak can interrupt because the fundamental promise (a stable peg) is mathematically impossible without an exogenous backstop.
takeaways
WHY INELASTIC SUPPLY ALWAYS BREAKS
TL;DR for Protocol Architects
Inelastic tokenomics create fragile systems that fail under real-world volatility, leading to death spirals and protocol capture.
01
The Death Spiral: Rebasing & Seigniorage
Algorithms like Ampleforth or OlympusDAO's (3,3) try to peg via supply changes, ignoring demand. Under sell pressure, the rebasing mechanism becomes a positive feedback loop.\n- Negative Rebase punishes holders, accelerating exits.\n- Reflexivity turns token price into the only protocol metric, decoupling from utility.
-99%
Drawdowns
>90%
TVL Evaporation
02
The Oracle Attack Surface
Inelastic pegs (e.g., UST, IRON Finance) rely on external price feeds for stability logic. This creates a single point of failure.\n- Oracle latency allows arbitrage at the protocol's expense.\n- Manipulation of the feed (e.g., via low-liquidity pools) can trigger unwarranted mint/burn cycles, draining reserves.
~60B
UST Collapse
Seconds
Attack Window
03
The Liquidity Black Hole
To maintain a peg, inelastic systems must outbid market forces, consuming finite reserves. This turns the protocol into the market's counterparty of last resort.\n- Reserve Drain: See Frax Finance v1's struggle before adopting hybrid design.\n- Reflexive Collateral: Falling token price weakens the collateral backing it, accelerating the crash.
100%+
APY to Attract LP
Inevitable
Reserve Depletion
04
The Solution: Elastic *Demand*, Not Supply
Sustainable stability comes from creating real utility demand that outlasts mercenary capital. Focus on protocol revenue and fee sinks.\n- MakerDAO's DAI: Peg defended by liquidation engines and yield-bearing collateral.\n- Liquity's LUSD: Minimum 110% collateral ratio and Stability Pool absorb shocks without governance.
$5B+
DAI Supply
0%
LUSD Depeg (Historic)
05
The Solution: Overcollateralization as a Circuit Breaker
Demand elasticity is slow. Overcollateralization provides a non-reflexive buffer. It turns a price drop into a solvency problem, not a supply crisis.\n- Absorbs Volatility: Excess collateral is burned before the peg breaks.\n- Aligns Incentives: Liquidators profit from restoring health, not betting on failure.
>150%
Typical Safety Margin
Automatic
Risk Management
06
The Solution: Hybrid Models & Exit Games
Pure algorithms fail. Hybrid systems like Frax v2 (partial collateralization) or Ethena's USDe (delta-neutral backing) acknowledge this. Design for graceful failure modes.\n- Redemption Mechanisms: Allow direct swap for underlying assets at a known ratio (e.g., LUSD for ETH).\n- Explicit Backstops: Clearly defined fallbacks (insurance, treasury) prevent total loss of confidence.
~92%
Frax Collat. Ratio
Trustless
Redemption
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