Why Algorithmic Stablecoins Are a Legal Fantasy

Algorithmic stablecoins are securities. The SEC's actions against Terraform Labs established that an algorithmic stablecoin like UST is an investment contract. Its design promised returns via the LUNA staking mechanism, creating an expectation of profit from a common enterprise.

The 'algorithm' is a legal liability. Protocols like Terra and Frax argue code replaces central issuers. Regulators see this as a marketing gimmick for decentralization, not a legal defense. The controlling development team and promotional activities create a centralized 'effort' that defines a security.

Stable value is a regulated promise. Maintaining a 1:1 peg is a financial guarantee. In traditional finance, this is a banking or money transmission activity. An algorithm managed by a DAO or foundation lacks the legal charter to make this promise, inviting regulatory action.

Evidence: The SEC's $4.47 billion settlement with Terraform Labs and the criminal conviction of Do Kwon demonstrate that algorithmic design does not circumvent securities law. The Frax Finance team's ongoing regulatory scrutiny confirms this is a sector-wide issue.

The legal definition of 'security' is the primary obstacle. The Howey Test defines a security as an investment of money in a common enterprise with an expectation of profits from the efforts of others. Algorithmic stablecoins like TerraUSD (UST) were explicitly marketed as yield-bearing instruments, with their stability mechanism (e.g., mint/burn with LUNA) framed as a profit-generating arbitrage system. This is a textbook security.

The 'sufficient decentralization' defense fails. Projects argue their code is autonomous, removing a central promoter. However, legal precedent from cases like SEC v. Kik Interactive shows that initial promotion and marketing create an 'ecosystem' that satisfies the 'common enterprise' prong. Founders like Do Kwon were the undeniable promoters whose efforts were essential for the network's success and the asset's value.

Stability is a regulated financial promise. A peg is a price guarantee. In traditional finance, entities making such guarantees (e.g., money market funds, banks) are licensed and regulated. Algorithmic models attempt to outsource this promise to code, but the legal liability for the failure of that promise does not disappear; it flows to the developers and promoters who designed and launched the flawed system.

Evidence: The SEC's case against Terraform Labs. The regulator's successful litigation did not hinge on the final crash. It focused on misrepresentations about UST's stability and the Chai payment network's usage during the promotion phase. This established the investment contract and the central role of the promoters, rendering the algorithmic mechanism legally irrelevant.

No Centralized Management Exists. The Howey Test's 'common enterprise' prong requires a promoter's managerial efforts to drive profits. Protocols like MakerDAO's DAI or Frax Finance distribute governance to token holders, creating a legal gray area where no single entity is legally responsible for the peg.

Profit Expectation is Decoupled. Investors buy LUNA for yield or FRAX for utility, not from a promoter's efforts. The UST collapse proved profits came from market dynamics, not Terraform Labs' direct actions, undermining the 'expectation of profits' argument.

The Code is the Manager. Smart contracts like Curve's AMM pools or Chainlink oracles autonomously enforce the peg. This shifts legal liability from a human promoter to an immutable protocol, a distinction current securities law does not recognize.

Evidence: SEC's Ambiguous Actions. The SEC sued Terraform Labs for UST and LUNA as securities, but has not pursued similar action against DAI or FRAX, highlighting the regulatory arbitrage created by credible decentralization.

Stablecoins are legally securities. The Howey Test hinges on investment contracts with profit expectation from a common enterprise. Algorithmic designs like UST or FRAX create explicit profit mechanisms via arbitrage and staking rewards, satisfying the test. The SEC's case against Terraform Labs established this precedent.

Decentralization is not a legal shield. Builders argue that sufficient decentralization removes the 'common enterprise' element. This fails because the initial launch, token distribution, and core development team constitute a centralized effort. The SEC targets the founding entity, not the protocol's later state.

On-chain collateral doesn't change the calculus. Projects like MakerDAO's DAI or Ethena's USDe use crypto collateral, but their governance tokens (MKR, ENA) and yield mechanisms still create profit expectations. The stablecoin itself may be a commodity, but the system's investment contract is the security.

Evidence: The SEC's 2023 complaint against Terraform Labs explicitly categorized UST as a security, citing its algorithmic design and the promotional promises of yield. This legal framework applies to any similar model promising stability through arbitrage incentives.