Elastic Supply

The core function that periodically adjusts the token supply held in every wallet. A positive rebase (expansion) mints and distributes new tokens to holders when the market price is above the target. A negative rebase (contraction) burns tokens from all wallets when the price is below the target. This changes the token balance in your wallet but maintains your percentage share of the total supply.

Elastic tokens rely on an external price oracle (e.g., a decentralized price feed like Chainlink) to determine the current market price relative to its target. This target can be:

• A stable value (e.g., $1.00 for an algorithmic stablecoin).
• A growing value (e.g., a target that increases 0.1% per day). The rebase magnitude is calculated based on the percentage deviation from this oracle price.

The primary trade-off. The protocol sacrifices a fixed token supply to pursue price stability. Key concepts:

• Elasticity: The degree to which supply changes in response to price pressure. High elasticity means large rebases for small price deviations.
• Rebase Lag: A damping mechanism to prevent extreme, volatile supply changes in a single epoch.
• Slippage: In periods of high sell pressure, negative rebases can compound with market selling, creating a 'death spiral' risk if confidence is lost.

Supply adjustments do not occur continuously. They happen at predefined intervals called epochs (e.g., every 8 hours). This allows the market to absorb the new supply information. Actions to consider:

• Pre-rebase: Trading activity often increases as speculators anticipate the adjustment.
• Post-rebase: The new token balances are reflected in wallets, and the market price theoretically moves closer to the target.
• Epoch Snapshot: Your token balance for the rebase is calculated from a snapshot at the epoch's start.

A key design principle: all wallets participate proportionally in every rebase. This means:

• You maintain your % network ownership through expansions and contractions.
• It creates a shared incentive for holders to maintain the peg.
• Liquidity pool (LP) tokens are also rebased, meaning LP providers share in the supply adjustments, which impacts impermanent loss calculations.

Many elastic token designs incorporate protocol-owned liquidity (POL). Instead of relying on incentivized external LPs, the protocol itself controls a liquidity pool (e.g., on a DEX like Uniswap). This provides several benefits:

• Sustains rebases: Ensures a deep market exists to absorb supply changes.
• Captures fees: Trading fees from the POL accrue to the protocol treasury.
• Reduces volatility: A deep, protocol-controlled pool can dampen extreme price movements.

These were early algorithmic stablecoin experiments using seigniorage shares and bonding mechanisms. They aimed for a $1 peg without collateral by algorithmically expanding supply to reward stakers and contracting it via debt coupons (bonds) when below peg.

• Coupon System: Users could buy discounted future tokens (coupons) when price < $1, burning supply. These coupons redeemed when price returned above $1.
• DAO-Governed Parameters: Expansion/contraction rates and other parameters were controlled by token holders.

Elastic supply protocols primarily use two distinct mechanisms for supply adjustment:

• Rebasing (e.g., Ampleforth): A global balance adjustment where the token quantity in every wallet changes proportionally at set intervals. This changes the supply but not the user's percentage ownership of the network.
• Bonding (e.g., Olympus): A market-driven mint/burn process. New supply is minted and sold at a discount (bond) for specific assets, while supply contraction is incentivized through discounted future tokens (coupons). This directly targets liquidity and treasury growth.

Elastic supply models face significant systemic challenges that have led to the failure or instability of many projects:

• Reflexivity & Death Spirals: Downward price pressure can trigger supply contraction (via bonds/coupons), reducing liquidity and causing further sell pressure.
• Oracle Manipulation: Rebases reliant on DEX oracles are vulnerable to price manipulation attacks.
• Demand Dependency: Requires constant new demand to sustain expansion phases; models often collapse when growth stalls.
• Complex Game Theory: User behavior (e.g., staking vs. selling) is critical to stability, leading to volatile Ponzi-like dynamics.

The primary benefit is creating a rebasing mechanism to dampen price volatility. When demand increases and the price rises above a target peg, the protocol mints and distributes new tokens to holders, increasing supply to push the price back down. Conversely, when the price falls below the peg, tokens are burned from wallets to reduce supply and increase scarcity. This creates a feedback loop aimed at maintaining a stable unit of account, distinct from algorithmic stablecoins which target a fiat peg.

Elastic supply models encode monetary policy rules—like expansion/contraction rates and target prices—directly into smart contracts. This creates a transparent and predictable system governed by code, not a central authority. Parameters are often set by on-chain governance, allowing token holders to vote on adjustments to the rebase function, interest rates (for lending protocols like Compound's COMP), or collateral factors, decentralizing control over the economic system.

By algorithmically adjusting supply in response to market conditions, these tokens can reduce impermanent loss for liquidity providers in automated market maker (AMM) pools. A more stable price around a target range means the pool's asset composition fluctuates less. Projects like Ampleforth (AMPL) use this to create a non-dilutive collateral asset, where your share of the total supply remains constant during rebases, making it potentially useful in decentralized finance (DeFi) money markets.

Elastic supply enables unique yield farming and staking designs. For example, in Olympus DAO (OHM), the protocol uses bond sales and staking rewards to manage its treasury-backed value. Stakers receive rebase rewards in new tokens, which are effectively a yield, while the protocol controls supply expansion. This creates a powerful incentive mechanism for long-term alignment, where rewards are directly tied to the protocol's treasury growth and market activity.

Advanced elastic supply models like Olympus and Frax Finance utilize Protocol-Controlled Value (PCV), where the treasury's assets (e.g., DAI, ETH, LP tokens) are owned and managed by the protocol itself, not users. This creates a permanent liquidity base and allows the protocol to act as its own market maker, using its assets to defend the token's price floor or peg. PCV turns the treasury into a strategic asset for sustainable, long-term growth.

As a base-layer monetary primitive, elastic supply tokens are highly composable. They can be integrated as collateral in lending protocols (e.g., using AMPL in Compound), used as a liquidity pair in AMMs, or wrapped for use in other chains. This interoperability allows them to function as building blocks within the broader DeFi ecosystem, enabling complex financial products and strategies that leverage their dynamic supply properties.

The core mechanism creates a reflexive feedback loop where price declines trigger supply contractions, which can exacerbate selling pressure. This can lead to a death spiral:

• Falling price → Protocol mints/burns tokens from holders.
• Negative rebase acts as a forced dilution, punishing holders.
• Panic selling increases, driving price further from peg.
• The system can fail to recover, as seen in early projects like Ampleforth during high volatility.

During a negative rebase (supply contraction), every holder's token balance decreases proportionally. This is a non-consensual dilution event that differs from a price drop:

• A user holding 100 tokens worth $1 each ($100 total) experiences a -10% rebase.
• Their balance becomes 90 tokens. If the price remains at $0.90, their total value is $81.
• This 'invisible' loss of principal can confuse users expecting a static token balance, leading to unexpected financial outcomes.

Elastic supply protocols are critically dependent on a secure price oracle (like Chainlink or a TWAP) to determine when to rebase. This creates attack surfaces:

• Oracle manipulation: An attacker could artificially inflate or deflate the reported price on a DEX to trigger an incorrect, profitable rebase.
• Front-running: Sophisticated bots can detect pending rebase transactions and trade ahead of them, extracting value from regular users.
• A compromised oracle would allow direct minting or burning of the supply, potentially draining the protocol.

Elastic tokens struggle with two core functions of money. As a unit of account, a constantly changing balance makes accounting, taxation, and invoicing complex. As a medium of exchange, merchants and users cannot reliably price goods, as the number of tokens required to represent a fixed dollar value changes daily. This volatility in quantity (not just price) limits practical utility for payments and DeFi collateral, where predictable collateral ratios are essential.

While designed for stability, elastic supply tokens often fail to maintain a tight peg during sustained market stress. The peg is a long-term target, not a short-term guarantee. Key issues include:

• High volatility around the peg: Prices can oscillate widely (e.g., +/- 20%) before a rebase is triggered.
• Lagging mechanism: Rebase occurs at set intervals (e.g., daily), allowing significant deviation between epochs.
• Insufficient demand elasticity: The model assumes buying/selling pressure will correct price; during a market-wide downturn, sell pressure can overwhelm the rebase incentive.

The unique mechanics create significant regulatory gray areas and tax complications. Authorities may struggle to classify them:

• Is a rebase taxable income? The IRS could view a positive rebase (new tokens) as income, even if the user's USD value hasn't changed.
• Is it a security? The algorithmic, profit-seeking nature of some designs may attract scrutiny under the Howey Test.
• Accounting complexity: Tracking cost basis across changing token balances is a significant burden for individuals and institutions, with no clear guidance from tax authorities.

A rebasing mechanism is the core protocol function that automatically adjusts the token supply held in all wallets. Instead of changing the token's price, the quantity of tokens in each holder's wallet is proportionally increased or decreased. This is achieved through a smart contract that periodically calls a rebase function, often based on oracle price feeds. Key characteristics include:

• Supply Elasticity: The total supply expands or contracts.
• Proportional Adjustment: All holders' balances change by the same percentage.
• Price Target: The mechanism aims to move the market price toward a predefined target, like 1 USD.

In the context of elastic supply tokens, seigniorage refers to the profit generated when the protocol creates new tokens. This concept is borrowed from traditional finance, where it describes the difference between a currency's face value and its production cost. In algorithmic stablecoin models like Ampleforth's, seigniorage occurs during supply expansions: when the token price is above its target, new tokens are minted and often distributed to specific stakeholders (e.g., liquidity providers in a treasury or bonding mechanism) as a reward for participating in the ecosystem. This creates an incentive structure for maintaining price stability.

An algorithmic stablecoin is a type of cryptocurrency that uses on-chain algorithms, rather than collateral reserves, to maintain a stable value peg. Elastic supply is a primary mechanism for many algorithmic stablecoins, such as Ampleforth (AMPL). These assets do not promise redemption for an underlying asset; instead, stability is engineered through code that manipulates supply in response to market demand. They contrast with:

• Collateralized Stablecoins (e.g., USDC, DAI): Backed by off-chain or on-chain assets.
• Fiat-Collateralized Stablecoins (e.g., USDT): Backed by bank-held reserves. Their stability depends entirely on the robustness of the algorithm and market participation.

An oracle price feed is a critical external data source that provides the real-time market price of the elastic supply token to its smart contract. The rebasing mechanism is triggered based on deviations from the target price reported by this oracle. Using a decentralized oracle network like Chainlink is common to avoid manipulation and ensure data integrity. The frequency and source of the price feed directly impact the protocol's reactivity and security. A delayed or corrupted price feed can cause incorrect rebases, leading to arbitrage opportunities or a loss of peg.

Volatility decoupling is a hypothesized property of some elastic supply tokens, where the asset's price volatility becomes less correlated with the broader cryptocurrency market (like Bitcoin or Ethereum). The theory suggests that because the token's supply adjusts to demand, its price may stabilize independently of market cycles. However, in practice, this decoupling is often imperfect. During extreme market conditions, elastic tokens can exhibit high price volatility alongside supply changes, and their value is still influenced by overall crypto market sentiment, liquidity, and the specific mechanics of the rebasing protocol.

It is essential to distinguish between supply elasticity and price elasticity.

• Supply Elasticity (Elastic Supply): The quantity of the token in circulation is variable. The protocol changes the total supply.
• Price Elasticity of Demand: An economic concept measuring how much the quantity demanded changes in response to a price change. In traditional markets, a product is elastic if demand changes significantly when price changes. In elastic supply tokens, the protocol manipulates supply elasticity in an attempt to influence the market's price elasticity of demand, aiming to anchor the price to a target. The success of this is not guaranteed and is a subject of ongoing economic experimentation.