Does Vitalik support algorithmic stablecoins, and is DeFi truly on the path to revival?

Author: Jae, PANews

What should “true DeFi” look like? When Ethereum co-founder Vitalik Buterin cast his vote for algorithmic stablecoins, a reflection on risk, governance, and monetary sovereignty was reignited.

A single tweet is enough to shake a narrative worth hundreds of billions of dollars.

On February 9, Vitalik Buterin tweeted a decisive statement: algorithmic stablecoins are the “true DeFi.”

This is not a technical tweak to the current stablecoin landscape, but an authoritative redefinition of DeFi’s underlying logic. In a market dominated by centralized stablecoins like USDT and USDC, Vitalik’s words are like a deep-water bomb, bringing the long-dormant algorithmic stablecoin track back into the spotlight.

Decoupling risk and de-dollarization as standards for “real DeFi”

Vitalik’s definition of “genuine DeFi” is based on risk structure decoupling, dividing algorithmic stablecoins into two models.

First, pure native asset collateralization. Protocols use ETH and its derivatives as collateral. Even if 99% of liquidity comes from CDPs (Collateralized Debt Positions), fundamentally, this shifts counterparty risk from the dollar side to market participants and market makers.

There are no frozen bank accounts, nor sudden collapses of centralized institutions.

Second, highly diversified RWA (Real World Asset) collateralization. Even if RWA is introduced, as long as risk is hedged through diversification and over-collateralization, it can be seen as a significant risk structure improvement.

If an algorithmic stablecoin can ensure that no single RWA exceeds the system’s over-collateralization ratio, then even if one asset defaults, the principal of stablecoin holders remains safe.

A more forward-looking view is that Vitalik advocates gradually moving stablecoins away from dollar pegs. Given the long-term potential devaluation risks of sovereign currencies, stablecoins should evolve toward more universal, diversified index-based units of account, reducing reliance on any single fiat currency, especially the US dollar.

This also means the connotation of stablecoins is evolving—from “price stability” to “purchasing power stability.”

Regarding Vitalik’s definition of algorithmic stablecoins, PANews has curated the most market-representative projects that meet these standards, though they generally face user acquisition challenges. This may also be why Vitalik is once again rallying for such projects.

USDS: “The Dragon Slayer Becomes the Dragon,” Mainstream Expansion Sparks Controversy

After Vitalik’s tweet, the price of MKR, the protocol token of the original leading algorithmic stablecoin MakerDAO, surged by 18%.

Interestingly, the price of its transformed SKY token remained calm, and this divergence itself reflects market sentiment.

As one of the most iconic protocols in DeFi history, MakerDAO officially rebranded to Sky Protocol in August 2024, launching a new generation stablecoin USDS, completing a “final game” transformation called “Endgame.”

USDS is positioned as an upgraded version of DAI and is Sky’s flagship product. As of February 12, USDS rapidly became the third-largest stablecoin in the entire crypto market, with a market cap exceeding one billion dollars.

On the surface, this appears to be a successful evolution for DeFi giant MakerDAO. But at a deeper level, it’s a costly “coming of age.”

The returns of USDS mainly come from diversified underlying assets. Sky’s modular ecosystem, Star, involves sub-DAOs allocating collateral into RWA including short-term government bonds and AAA corporate bonds.

From a risk diversification perspective, this aligns with Vitalik’s second category of algorithmic stablecoins, but the issue lies in the shift of asset structure focus.

Although USDS has taken steps toward asset diversification, nearly 60% of its reserves are USDC, far exceeding the portion backed by over-collateralization (20%).

This means that the underlying value support of USDS is fundamentally highly dependent on another centralized stablecoin. Therefore, the protocol’s transformation has always been controversial.

More troubling for DeFi purists is that the protocol has introduced a “freezing function.” This design allows Sky to remotely freeze USDS in user wallets upon receiving legal instructions or in the event of security incidents.

For Sky, this is a pragmatic compromise to global regulation: without compliance, mainstream adoption is impossible. Technically, the freezing feature aims to counteract hacking, money laundering, and other illegal activities, making USDS a compliant financial tool in the eyes of regulators.

But for DeFi believers, this is an unforgivable “territory sacrifice.” Some community members argue that Sky has betrayed DeFi’s original promise of censorship resistance. Once the protocol is given the power to freeze assets, USDS essentially becomes indistinguishable from USDC.

Clearly, the protocol is drifting further from what Vitalik envisioned. Compared to today’s Sky and USDS, the market may be more nostalgic for the days of MakerDAO and DAI.

LUSD/BOLD: Upholding ETH as the core, pursuing minimal governance

While Sky chose outward expansion, Liquity opted for inward deepening.

Vitalik has repeatedly praised Liquity, which exemplifies a “minimal governance” approach, designed to almost eliminate reliance on human governance.

Liquity’s stablecoin LUSD/BOLD is fully backed by ETH and its staked tokens (LST), representing the most typical example in Vitalik’s first category of algorithmic stablecoins.

Liquity V1, with its pioneering 110% minimum collateral ratio and rigid redemption mechanism, established its authority among ETH-backed stablecoins. But V1 also faced trade-offs between capital efficiency and liquidity costs:

1. Zero interest rate: Users pay a one-time borrowing fee (usually 0.5%) at the time of borrowing, with no interest accruing over time. While attractive to borrowers, the protocol must continuously pay rewards (like minting LQTY tokens) to maintain liquidity, which raises questions about long-term sustainability.
2. 110% minimum collateral ratio: Through an instant liquidation system (stability pool), Liquity achieves higher capital efficiency than competitors. If ETH prices fall, the system first uses LUSD from the stability pool to offset bad debt and distribute collateral.
3. Hard redemption: Any LUSD holder can redeem ETH at a fixed value of $1, creating a price floor for LUSD and maintaining its peg even in extreme market conditions.

However, the single collateral type is a double-edged sword. Since LUSD only supports ETH collateral, users face high opportunity costs as ETH staking rates climb, meaning they cannot earn staking rewards while borrowing. This has led to a continuous decline in LUSD supply over the past two years.

To address V1’s limitations, Liquity launched V2 and the new stablecoin BOLD, with core innovation in “user-set interest rates.”

In Liquity V2, borrowers can set their own interest rates based on their risk appetite. The protocol sorts debt positions by interest rate, with lower rates being more likely to be “redeemed” (liquidated).

• Low-interest strategy: suitable for users sensitive to capital costs but willing to accept early redemption risk.
• High-interest strategy: suitable for users aiming for long-term positions and resisting redemption risk.

This dynamic mechanism allows the system to automatically find market equilibrium without manual intervention: Borrowers, to avoid losing collateral passively during ETH downturns, tend to set higher interest rates, which directly benefit BOLD depositors, creating real yields without token issuance.

Additionally, V2 breaks the single-asset limitation by supporting wstETH and rETH. This allows users to earn staking rewards while maintaining BOLD liquidity.

Most importantly, V2 introduces a “multiplication” feature, enabling users to leverage their ETH exposure up to 11 times through looping, greatly improving capital efficiency.

Liquity’s evolution marks a solid step from idealism toward pragmatism in algorithmic stablecoins.

RAI: An industrial-mind-driven monetary experiment with high opportunity costs

If Liquity is pragmatic, then Reflexer is a pure idealist.

The protocol’s stablecoin RAI is not pegged to any fiat currency, and its price is regulated by a PID algorithm borrowed from industrial control theory.

RAI does not aim for a fixed $1 price but seeks extremely low volatility.

When RAI’s market price deviates from its internal “redemption price,” the PID algorithm automatically adjusts the redemption rate, i.e., the effective interest rate within the system.

• Positive deviation: market price > redemption price → redemption rate becomes negative → redemption price drops → debt decreases for borrowers, incentivizing them to mint and sell RAI for profit.
• Negative deviation: market price < redemption price → redemption rate becomes positive → redemption price rises → debt increases, encouraging borrowers to buy back RAI to close positions.

Despite receiving praise from Vitalik multiple times, RAI’s development path is fraught with difficulties.

1. User perception barrier: RAI is nicknamed “bleeding coin” because its long-term negative interest rate causes holder assets to shrink over time.
2. Liquidity scarcity: Without a fiat peg, RAI is hard to adopt widely in payments and trading, and its use as collateral is limited to niche geek circles.
3. Complex calculations: Compared to Liquity’s constant $1 peg, RAI’s PID control model is difficult for investors to predict or model.

RAI demonstrates the elegance of algorithmic stablecoins in theory but exposes the harsh reality of user adoption.

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

As global inflation pressures mount, a more radical stablecoin paradigm—Flatcoins—may emerge. These stablecoins aim not to peg to a fiat currency but to real living costs or purchasing power.

Traditional stablecoins (USDT/USDC) see their purchasing power erode in inflationary environments. If the dollar’s value drops by 5% annually, holders of traditional stablecoins suffer implicit capital losses. In contrast, Flatcoins track independent cost-of-living indices (CPI), dynamically adjusting their face value.

Take Nuon, the first protocol based on a cost-of-living index, as an example. It connects to on-chain verified real-time inflation data to dynamically adjust its peg.

1. Target asset: a basket including food, housing, energy, and transportation indices.
2. Purchasing power parity: if the index shows a 5% increase in living costs in the US, Nuon’s target price also rises by 5%, ensuring that one Nuon in the future can buy the same amount of goods and services.
3. Mechanism: Nuon employs an over-collateralization model, where the algorithm automatically adjusts minting/burning logic as inflation data changes, protecting holders’ real value.

For residents in high-inflation countries like Turkey or Argentina, traditional dollar stablecoins can mitigate local currency devaluation but cannot escape the “hidden tax” of dollar inflation. Flatcoins offer a decentralized, non-dollar alternative to fight inflation and preserve purchasing power.

Despite its innovative concept, Flatcoins face significant technical risks. The composition of the cost-of-living index is complex, and the data’s authenticity depends heavily on oracle robustness.

Moreover, the on-chain process of inflation data is a tempting target for attackers. Small manipulations of data sources could instantly wipe out holders’ purchasing power.

Additionally, Flatcoins’ dynamic balance requires ample liquidity. In extreme market conditions, whether arbitrageurs will sustain a constantly rising peg remains uncertain.

Flatcoins represent a bold leap in the narrative of algorithmic stablecoins, but from concept to adoption, there are deep technical and financial chasms to cross.

From Liquity’s steadfastness, Reflexer’s monetary experiment, to the radical Flatcoins, the landscape of algorithmic stablecoins is unfolding with unprecedented diversity and depth of thought.

Currently, algorithmic stablecoins still face constraints in capital efficiency, liquidity, and user experience, but their core ideals—risk decoupling, minimal governance, and monetary sovereignty—remain the holy grail of DeFi.

The revival of algorithmic stablecoins has only just begun.