Vitalik strongly supports algorithmic stablecoins, is the true soul of DeFi embarking on a road to revival?

Author: Jae, PANews

What should “real DeFi” look like? When Ethereum co-founder Vitalik Buterin voted for algorithmic stablecoins, a renewed reflection on risk, governance, and monetary sovereignty was ignited.

A single tweet can shake a narrative worth hundreds of billions of dollars.

On February 9, Vitalik Buterin tweeted a compelling point: algorithmic stablecoins are the "real DeFi".

This is not a suggestion for technical tweaks to the current stablecoin landscape, but rather an authoritative affirmation of the underlying logic of DeFi. With centralized stablecoins like USDT and USDC dominating the market, Vitalik's remarks are like a bombshell, bringing the long-dormant algorithmic stablecoin sector back into the spotlight.

Stablecoin risk decoupling and de-dollarization define the standard of "true DeFi".

Vitalik’s definition of “real DeFi” is based on the decoupling of risk structures , and he divides algorithmic stablecoins into two models.

The first type is pure native asset collateral. The protocol uses ETH and its derivative assets as collateral. Even though 99% of the liquidity in the system comes from CDP (collateralized debt position) holders, its essence is to transfer the counterparty risk on the USD side to market participants and market makers.

There are no bank accounts that can be frozen, and no centralized institutions that can suddenly go bankrupt.

The second category is highly diversified RWA (Real-World Asset) collateral. Even if the protocol introduces RWA, as long as the risk of single-asset failure is hedged through asset diversification and over-collateralization, it can be considered a significant optimization of the risk structure.

If an algorithmic stablecoin can guarantee that the proportion of any single RWA does not exceed the system's overcollateralization ratio, then even if one of the assets defaults, the stablecoin holder's principal will still be safe.

A more forward-looking perspective is that Vitalik advocates for stablecoins to gradually move away from their peg to the US dollar. Given the potential long-term devaluation risks facing sovereign currencies, stablecoins should gradually evolve towards more universal, diversified indices-based units of account to reduce dependence on any single fiat currency, particularly the US dollar.

This also means that the concept of stablecoins is evolving, for example, from "price stability" to "purchasing power stability".

PANews has compiled a list of projects in the market that best meet Vitalik's definition of algorithmic stablecoins, but they generally face difficulties in user acquisition. This may be why Vitalik is once again advocating for such projects.

USDS: "The Dragon Slayer Becomes the Dragon Himself," Mainstream Expansion Sparks Controversy

After Vitalik tweeted, the price of MKR, the protocol token of MakerDAO, the leading first-generation algorithmic stablecoin, surged by as much as 18%.

Interestingly, the price of SKY tokens after the transformation remained relatively stable, and this deviation itself is an expression of market attitude.

As one of the most representative protocols in the history of DeFi development, MakerDAO officially changed its name to Sky Protocol in August 2024 and launched a new generation of stablecoin USDS, completing a final transformation called "Endgame".

USDS is positioned as an upgraded version of DAI and is Sky's flagship product. As of February 12, USDS has rapidly grown into the third largest stablecoin in the entire crypto market, with a market capitalization exceeding ten billion US dollars.

On the surface, this appears to be a successful evolution for a DeFi giant. However, at a deeper level, it is a costly "coming-of-age ceremony."

USDS's returns primarily come from the diversified allocation of underlying assets. Sky, through its Star modular ecosystem, or sub-DAO, distributes collateral to RWA, which includes short-term Treasury bonds and AAA-rated corporate bonds.

From a risk diversification perspective, this meets Vitalik’s second-class algorithmic stablecoin standard, but the problem lies in the shift in the center of gravity of the asset structure.

Although USDS has taken steps toward asset diversification, stablecoins (USDC) still account for nearly 60% of its reserves, far exceeding the overcollateralized portion (20%).

This means that the underlying value of USDS is essentially highly dependent on another centralized stablecoin. Therefore, the protocol's transformation has always been accompanied by controversy.

What makes it even more unacceptable to DeFi purists is the introduction of a "freeze function" in the protocol. This design allows Sky to remotely freeze USDS in users' wallets in the event of a legal order or a security incident.

For Sky, this is a pragmatic compromise in dealing with global regulations: without compliance, there is no mainstream adoption. From a technical perspective, USDS's freezing function is designed to combat illicit activities such as hacking and money laundering, making it a compliant financial instrument in the eyes of regulators.

But for DeFi believers, this is an unforgivable "ceding of territory." Some community members believe that Sky has betrayed DeFi's initial promise of censorship resistance, and that once the protocol is given the power to freeze assets, USDS is essentially no different from USDC.

Clearly, the protocol is drifting further and further away from the direction Vitalik envisioned. Compared to Sky and USDS today, the market may have more nostalgia for MakerDAO and DAI of yesteryear.

LUSD/BOLD: Adhering to ETH standard and pursuing minimal governance.

If Sky chose to expand outward, then Liquity chose to dive deep inward.

Vitalik has repeatedly praised Liquity, noting that it represents a leading example of "minimal governance" in protocols, almost eliminating reliance on human governance in its design.

Liquity's stablecoin LUSD/BOLD is fully backed by ETH and its liquidity staking token (LST), making it the most typical representative of Vitalik's first algorithmic stablecoin category.

Liquity V1 established its authoritative position among ETH-collateralized stablecoins through its pioneering 110% minimum collateralization ratio and rigid redemption mechanism, but V1 also faces a trade-off between capital efficiency and liquidity costs:

1. Zero-interest rate: Users only need to pay a one-time borrowing fee (usually 0.5%) when borrowing, and do not have to repay interest accumulated over time. While zero interest is very attractive to borrowers, in order to maintain the liquidity of LUSD, the protocol must continuously pay out rewards (such as issuing new LQTY tokens), and this model lacks long-term sustainability.
2. 110% Minimum Collateralization Ratio: Through its instant liquidation system (stability pool), Liquity achieves higher capital efficiency than its competitors. If the price of ETH falls, the system prioritizes using LUSD in the stability pool to offset bad debts and allocate collateral.
3. Hard redemption mechanism: Any user holding LUSD can redeem an equivalent amount of ETH in the protocol at a fixed value of $1. This creates a hard price floor for LUSD, ensuring it remains pegged even under extreme market conditions.

However, the single collateral limit is a double-edged sword. Since LUSD only supports ETH collateral, with the Ethereum staking rate constantly rising, users face a significant opportunity cost—they cannot earn staking rewards while borrowing. This has led to a continuous decline in the supply of LUSD over the past two years.

To address the limitations of V1, Liquity launched V2 and the next-generation stablecoin BOLD, whose core innovation lies in the introduction of "user-defined interest rates".

In Liquity V2, borrowers can set their own borrowing rates based on their risk tolerance. The agreement sorts bond positions according to their interest rates, with lower-interest-rate positions having a higher risk of being "redeemed" (liquidated) first.

• Low-interest-rate strategy: Suitable for users who are sensitive to funding costs but are willing to accept the risk of early redemption.
• High-interest rate strategy: Suitable for users who wish to hold positions for the long term and mitigate the risk of redemption.

This dynamic game mechanism allows the system to automatically find market equilibrium without human intervention: borrowers tend to set higher interest rates to avoid passively losing collateral when ETH is depressed, and these rates flow directly to BOLD depositors, thus creating real returns without relying on token emissions.

Furthermore, V2 breaks the single-asset limitation, adding support for wstETH and rETH. In this way, users can continue to earn staking rewards while gaining BOLD liquidity.

More importantly, V2 also introduces a "one-click multiplier" feature, allowing users to leverage their exposure to ETH up to 11 times using cyclical leverage, significantly improving the system's capital efficiency.

The evolution of Liquity represents a solid step forward for algorithmic stablecoins from idealism to pragmatism.

RAI: A monetary experiment driven by industrial thinking, with excessively high opportunity costs for holding currency.

If Liquity is a pragmatist, then Reflexer is an absolute idealist.

The stablecoin RAI issued by the protocol is not pegged to any fiat currency, and its price is regulated by a PID algorithm derived from the field of industrial control.

RAI is not pursuing a fixed price of $1, but rather extremely low price volatility.

When the market price of RAI deviates from its internal "redemption price", the PID algorithm automatically adjusts the redemption rate, which is the effective interest rate within the system.

• Positive deviation: Market price > Redemption price → Redemption rate becomes negative → Redemption price decreases → Borrower's debt decreases, incentivizing them to mint and sell RAI for profit.

• Negative deviation: Market price < redemption price → Redemption rate becomes positive → Redemption price rises → Borrower's debt increases, incentivizing them to buy back RAI in the market to close out their positions.

Despite receiving numerous praises from Vitalik, RAI's development path has been fraught with difficulties.

1. User cognitive bias: RAI is jokingly called "bleeding coin" because its long-standing negative interest rate phenomenon often causes the asset value of RAI holders to shrink continuously over time.
2. Liquidity shortage: Because it is not pegged to the US dollar, RAI is difficult to be widely adopted in payment and transaction scenarios, and its use as collateral is limited to a narrow circle of geeks.
3. Computational complexity: Compared to Liquity's constant $1 peg, RAI's PID regulation model is difficult for investors to build predictive models for.

RAI has demonstrated the theoretical elegance of algorithmic stablecoins, but it has also exposed the harsh reality of user adoption.

Nuon: A parity coin pegged to purchasing power index, highly dependent on oracles.

As global inflationary pressures intensify, a more radical stablecoin paradigm—flatcoins—may emerge. These stablecoins do not aim to be pegged to a paper currency, but rather to real-world living costs or purchasing power.

The purchasing power of traditional stablecoins (USDT/USDC) diminishes in an inflationary environment. Assuming the purchasing power of the US dollar declines by 5% annually, holders of traditional stablecoins are effectively suffering implicit capital losses. In contrast, Flatcoins dynamically adjusts its face value by tracking an independent cost-of-living index (CPI).

Take Nuon, the first Flatcoin protocol based on the cost of living, as an example. It will dynamically adjust its anchor target by accessing real-time inflation data that has been verified on-chain.

1. Target assets: A basket of consumer indices including food, housing, energy, and transportation.
2. Purchasing power parity: If index data shows that the cost of living in the United States has increased by 5%, the target price of Nuon will also increase by 5% accordingly, thus ensuring that one Nuon in the holder's hand can still buy the same amount of goods and services in the future.
3. Mechanism Logic: Nuon adopts an overcollateralization mechanism. When the inflation index changes, the algorithm will automatically adjust the minting/burning logic to ensure that the actual value of the holders is not eroded.

For residents of high-inflation countries like Turkey and Argentina, while traditional US dollar stablecoins can alleviate the pressure of local currency depreciation, they still cannot escape the "hidden tax" of dollar inflation. The emergence of Flatcoins provides a new non-dollar, decentralized option for combating inflation and maintaining purchasing power.

While Flatcoins' design philosophy is highly forward-thinking, it carries significant technical risks in practice. The composition of the cost of living index is quite complex, and its data accuracy largely depends on the robustness of the oracle system.

However, the process of putting inflation data on-chain has become a breeding ground for attackers. Any slight manipulation of the data source could directly cause the purchasing power of Flatcoins holders to evaporate instantly.

Furthermore, Flatcoins' dynamic equilibrium requires ample liquidity. Whether arbitrageurs will be willing to maintain a continuously rising anchor target under extreme market conditions remains to be seen.

Flatcoins represent a bold leap forward in the narrative of algorithmic stablecoins, but the transition from concept to adoption is fraught with a significant gap between technology and finance.

From Liquity's adherence to its core principles to Reflexer's monetary experiments and Flatcoins' radical attempts, the landscape of algorithmic stablecoins is showing unprecedented diversity and intellectual depth.

Currently, algorithmic stablecoins are still constrained by capital efficiency, insufficient liquidity, and user experience, but the risk decoupling, governance minimization, and monetary sovereignty they represent remain the holy grail of DeFi.

The revival of algorithmic stablecoins has only just begun.