Despite the collapse of TerraUSD (UST) and the “many flawed” stablecoins on the market, the industry should not abandon projects in this category. This was stated by the founder of Ethereum Vitalik Buterin.

Two thought experiments to evaluate automated stablecoins: https://t.co/gqPKb42tL8

— vitalik.eth (@VitalikButerin) 26 May 2022

According to Buterin, the UST collapse sparked increased interest in DeFi financial mechanisms and crypto models that promise greater returns to users. He stressed that he welcomes this, but disagrees that all stablecoins are “cut with the same brush.”

“We dont need empowerment or extreme pessimism about stablecoins, instead a return to principle-based thinking,” he wrote.

The founder of Ethereum said that the stability of a “stable coin” can be determined using two thought experiments.

According to him, the first question worth answering is whether a stablecoin can safely “roll” to zero users? He explained that if activity in the project’s markets drops to “almost zero”, owners should be able to deduce the fair value of their investment from the token.

Buterin cited UST as an example of an entity that failed this test. This is due to the stablecoin collateral structure based on LUNA quotes. In his opinion, the latter is obliged to maintain its price and user demand, otherwise the project will collapse.

“Price goes down first [актива обеспечения]. The shock is then transferred to the stablecoin itself. The system seeks to support stablecoin demand by issuing more collateralized coins. Since the trust in the system is low and the number of buyers is low, the price [актива обеспечения] falls quickly. When the price of the latter is close to zero, the stablecoin crashes,” he explained.

The Ethereum founder emphasized that UST-like assets could undergo a thought experiment if demand gradually falls. However, such a situation is “very unlikely”.

Buterin named RAI from Reflexer Labs as a stablecoin being tested. It works similarly to DAI and is an over-collateralized stablecoin in ETH.

“The security of RAI depends on an asset outside of the stablecoin (ETH) system, so it is much easier for RAI to safely terminate activities,” he said.

The second question to assess the stability of a stablecoin, according to Buterin, is what happens when it is tied to an index with a 20% increase per year.

The founder of Ethereum noted that in such a case, the project behind the stablecoin must be able to set a negative interest rate, otherwise it will turn into a Ponzi scheme.

“There are two scenarios for a stablecoin trying to track such an index. It charges its holders a negative interest rate, which essentially offsets the growth rate. […]. It turns into a Ponzi and provides stablecoin holders with incredible income for a while,” he wrote.

Buterin stressed that negative interest rate could happen in RAI. There was no such possibility in the UST.

However, he added that meeting this condition does not make the asset “safe”:

“It may still be unstable for other reasons (e.g. insufficient margin), there may be bugs or vulnerabilities associated with the management mechanism.”

Recall that former Tether CTO Paolo Ardoino called TerraUSD a “badly designed” product.