Explain the Concept of a “Death Spiral” in Algorithmic Stablecoins.
A death spiral occurs when an algorithmic stablecoin begins to de-peg and its stabilizing mechanism fails. As the price falls, the protocol mints and sells more of its volatile governance or seigniorage token to buy back the stablecoin.
This floods the market with the governance token, causing its price to crash. The collateral's falling value further exacerbates the stablecoin's de-peg, leading to a vicious, irreversible downward cycle.
Glossar
Collateral Asset
Asset ⎊ A collateral asset is an item of value pledged by a borrower to a lender to secure a loan or a financial obligation.
Algorithmic Stablecoin
Anchor ⎊ A collateralization scheme or algorithmic feedback loop designed to enforce a stable relationship between the asset's market price and a fiat currency or basket of assets.
Seigniorage Token
Mechanism ⎊ Seigniorage tokens, within the cryptocurrency ecosystem, represent a protocol’s capacity to generate new units of currency, effectively capturing the difference between the cost of producing those units and their face value.
Stabilizing Mechanism
Framework ⎊ The concept of a stabilizing mechanism, within cryptocurrency derivatives, options trading, and broader financial derivatives, fundamentally addresses the mitigation of systemic risk and price volatility.
Algorithmic Stablecoins
Architecture ⎊ Algorithmic stablecoins represent a class of cryptocurrencies designed to maintain a stable value, typically pegged to a fiat currency like the US dollar, through algorithmic mechanisms rather than relying on collateralization by traditional assets.
Fractional Reserve
Concept ⎊ Fractional reserve is a banking concept adapted to the cryptocurrency space, particularly in stablecoin design, where the entity holds only a fraction of the total outstanding digital currency value in actual reserves.