Securing Digital Rights for Communities (Game Theory and Governance of Scalable Blockchains for Use in Digital Network States)
Chapter 17. Algorithmic Stablecoins on Layer 1
17.1 Why We Need a Truly Decentralised Stablecoin
Many blockchains rely on centralised stablecoins (like Tether or USDC) that hold reserves in fiat accounts. These assets can be seized, frozen, or regulated at any time. A censorship-resistant blockchain must have an algorithmic stablecoin backed only by digital value that no single entity can control or confiscate.
17.2 Backing the Stablecoin with Digital Real Estate (Social Tokens and Bandwidth in the Ecosystem)
A stablecoin has to be backed or collateralised by something. In a censorship-resistant system, backing cannot be gold, dollars in a bank, or any physical good vulnerable to seizure. Instead, it should be backed by a layer-1 governance token that represents valuable digital real estate or
bandwidth to post data on chain, relative to other users or apps also wishing to post data to chain.
The governance token should grant:
- Access to on-chain resources (e.g., text storage, zero-fee transactions otherwise known as bandwidth access to upload to the database).
- Payouts in newly minted tokens for community contributions.
- Proof-of-stake governance with strong parameters to prevent takeovers.
This “digital real estate” has fundamental demand because it secures data availability (free speech) and zero-fee transactions. The main token can then back or over collateralise an on-chain stablecoin, algorithmically pegged to the dollar without the need to hold collateralising assets in a traditional bank, which are subject to seizure or censorship.
17.3 How It Works
Pegging to the Dollar
The stablecoin maintains a target value of one US dollar. It does so by letting holders redeem the stablecoin for one dollar’s worth of the base token. As long as the base token has a higher market cap than the total stablecoin supply, redemption is secure and the stable asset remains adequately over collateralised.Haircut Rule
To avoid the fate of projects like Terra/Luna, a debt limit or “haircut” parameter is set (often around 20–30%). If the stablecoin supply approaches such a set percentage of the base token’s market cap, the chain stops issuing new stablecoins. This prevents the stablecoin’s market cap from exceeding its collateral.Delayed Conversions
Attacks happen when a stablecoin is instantly swapped for the governance token and dumped on the market. To counter this, conversions take place over a few days (3.5 days is typical). Large conversions face time risk and possible fees, making quick takeovers highly risky for the attacker and most likely unprofitable.Fee or “Haircut” on Bulk Conversions on the Base Layer
A small fee (e.g., 5%) can apply to mass conversion, discouraging sudden attacks. Genuine users pay the fee only when moving large sums, while attackers find it prohibitively expensive to destabilize the system.Reward Pool Funding
These stablecoins often emerge via new token minting to a daily rewards pool that the community competes for. The more stake weighted votes your contributions receive, the more of the rewards pool you receive in turn: half of the daily rewards go to users in stablecoins, and half in the base governance token. This slow, steady issuance avoids reliance on centralised reserves. Over time, the stablecoin organically expands alongside the flow of tokens to the community.
17.4 Infinite liquidity Through Base-Token Conversion
Even if centralised exchanges list only small amounts of the on-chain stablecoin, true liquidity can be effectively unlimited. A large holder can:
- Buy the Base Token On the Open Market
Purchase the governance token on open markets. - Convert Over Time
Convert that token supply into stablecoins via the protocol’s built-in mechanism on Layer 1. - Haircut Rule Enforcement
If the conversion is large, the base token’s price likely rises. This increase keeps the ratio below the debt limit, preserving stability, in fact it may lower the debt limit as the supply of the stable coin is increased, since in this scenario it is likely that the market cap of the base layer token being bought on the open market and used to convert to stable coins will increase at a higher rate than the increase in supply of the new stable coins being created by those conversions.
This process mirrors how centralised stablecoins work except there’s no single issuer to “call” for a mint or redemption. The protocol itself autonomously executes conversions.
17.5 Example: Hive Backed Dollars (HBD)
- Non-Custodial
No single wallet, company, or government can KYC, freeze HBD or seize its collateral. - Three-Second Confirmations
Transactions are nearly instant and effectively fee-less thanks to resource staking. - Parameter Rules
- 30% Debt limit (Haircut): If HBD nears 30% of the governance token’s market cap (Hive), no more HBD is issued.
- Conversion Delay: Converts from HBD to Hive (or vice versa) take several days and may incur a fee.
- Organic Expansion
HBD supply grows through daily new tokens mints which are allocated to content creators and community members via decentralised community, stake-weighted voting systems.
If large financial players want millions in decentralised stablecoins, they simply acquire Hive on the open secondary market, then convert day by day into HBD. This pushes Hive’s price up such that its market capitalisation increases more than the newly minted stable coins, lowering the debt ratio. Thus the stable coin issuance system scales while maintaining an adequate collateral buffer.
17.6 Resilience Against Attack
Comparisons to Failed Models
Un-parameterised algo stablecoins like Terra/Luna had no effective cap on supply or redemptions. When attackers mass-converted the stablecoin to Luna, it collapsed the token’s value. In contrast, parameterised systems employ:
- Haircut thresholds
- Delayed conversions
- Optional conversion fees
These dampen flash manoeuvrers, vastly increase financial risk to the attacker and reduce exploit potential.
Fork-Out Option
Even if a large actor gains a huge stake, reputation based, censorship-resistant communities can fork the chain and exclude hostile balances. This threat deters malicious governance attacks.
17.7 Toward a Parallel Dollar Economy
A reliable Layer 1 stablecoin sets the stage for a true parallel economy, allowing everyday people to:
- Transact globally with no KYC
- Store value in a stable currency
- Move into or out of local currencies without permissioned gateways
- Access zero-fee settlement in seconds
Because these stablecoins are algorithmic and fully on-chain, they also enable advanced financial instruments like bonds and collateralized loans mirroring “pristine collateral” (akin to US Treasuries) but free from legacy banking restrictions. Over time, such systems can mirror or replace major components of traditional Euro Dollar international finance system without centralised reserves or permissioned intermediaries.
Conclusion
- No Physical Reserves
Backing must be purely digital, immune to seizure or control by a single entity. - Parameter-Based Algorithm
Enforce haircut rules, delayed conversion, and optional fees to maintain the peg and prevent sudden attacks. - Infinite liquidity
As long as the governance token is valuable (due to real utility), large amounts of stablecoins can be created by buying the base token. - Stable, Parallel Currency
Distributed newly minted tokens and community-driven enforcement produce a sustainable on-chain dollar for everyday use and financial services.
Algorithmic stablecoins on Layer 1 are an essential pillar for any genuinely decentralised blockchain ecosystem, powering commerce, savings, and economic growth outside centralised oversight.