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 was enough to shake a narrative worth hundreds of billions of dollars.

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

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

Decoupling Risks and De-Dollarization as Standards for “True DeFi”

Vitalik’s definition of “genuine DeFi” is based on risk structure decoupling. He categorizes 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), the essence is transferring counterparty risk on the dollar side to market participants and market makers.

There are no bank accounts that can be frozen, nor centralized institutions that can suddenly collapse.

Second, highly diversified RWA (Real-World Asset) collateralization. Even if a protocol introduces RWAs, as long as it hedges the risk of individual asset failure through diversification and over-collateralization, it can be considered a significant risk structure improvement.

If an algorithmic stablecoin can ensure that no single RWA exceeds the system’s over-collateralization rate, 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 their dollar peg. 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.”

In response to Vitalik’s definition of algorithmic stablecoins, PANews has identified projects in the market that best meet these standards, though they generally face user acquisition challenges. This may also be why Vitalik is once again championing such projects.

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

Following Vitalik’s tweet, the price of MKR, the protocol token of the pioneering algorithmic stablecoin MakerDAO, surged by 18%.

Interestingly, the price of its transformed SKY token remained largely unchanged, and this divergence itself reflects a market attitude.

As one of the most representative protocols in DeFi history, MakerDAO officially rebranded as Sky Protocol in August 2024, launching a new generation of stablecoins called USDS, completing a decisive “Endgame” transformation.

USDS is positioned as an upgraded version of DAI and is Sky’s flagship product. As of February 12, USDS rapidly grew to become 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. But at a deeper level, it’s a costly “coming of age.”

USDS’s revenue mainly derives from diversified underlying assets. Sky’s Star modular ecosystem, where sub-DAOs allocate collateral into RWAs including short-term government bonds and AAA corporate bonds.

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

While 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 the fundamental value support of USDS heavily depends on another centralized stablecoin. Therefore, the protocol’s transformation has always been controversial.

What’s even more unacceptable to DeFi purists is that the protocol introduced a “freeze function.” This design allows Sky to remotely freeze USDS in user wallets upon receiving legal orders 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 freeze function aims to combat 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 ceding.” Some community members argue that Sky has betrayed DeFi’s original anti-censorship promise. Once the protocol is empowered to freeze assets, USDS essentially becomes indistinguishable from USDC.

Clearly, the protocol is moving further away from what Vitalik envisions. Compared to today’s Sky and USDS, the market may be more nostalgic for MakerDAO and DAI.

LUSD/BOLD: Upholding ETH-Centricity and Pursuing Minimal Governance

If Sky chose outward expansion, Liquity chose inward deepening.

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

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-collateralized stablecoins. But V1 also faced trade-offs between capital efficiency and liquidity costs:

Zero interest rate: Users only pay a one-time borrowing fee (usually 0.5%) at the time of borrowing, with no accruing interest over time. While attractive to borrowers, the protocol must continuously pay rewards (like issuing LQTY tokens) to maintain liquidity, which lacks long-term sustainability.

110% minimum collateral ratio: Through an instant liquidation system (stability pool), Liquity achieves higher capital efficiency than competitors. If ETH prices fall, the system prioritizes using LUSD from the stability pool to offset bad debt and distribute collateral.

Hard redemption mechanism: 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-asset collateral model is a double-edged sword. Since LUSD only supports ETH collateral, rising ETH staking rates impose significant opportunity costs—borrowers 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, introducing the core innovation of “user-set interest rates.”

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

Low-interest strategy: suitable for users sensitive to capital costs but willing to accept early redemption risk.

High-interest strategy: for users aiming to hold positions long-term and resist redemption.

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

Additionally, V2 supports wstETH and rETH, allowing users to earn staking rewards while maintaining BOLD liquidity.

Most importantly, V2 introduces a “one-click multiplier” feature, enabling users to leverage their ETH exposure up to 11 times through recursive borrowing, significantly boosting capital efficiency.

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

RAI: An Industrial-Driven Monetary Experiment with High Opportunity Cost

If Liquity is pragmatic, Reflexer is an uncompromising idealist.

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

RAI does not aim for a fixed $1 peg but seeks extremely low price 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 minting and selling RAI for profit.

Negative deviation: market price < redemption price → redemption rate becomes positive → redemption price rises → debt increases, encouraging market buybacks and liquidations.

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

User perception barrier: RAI is nicknamed “bloodletting coin” because its persistent negative interest rates cause holder assets to shrink over time.

Liquidity scarcity: Without a fiat peg, RAI struggles to be widely adopted in payments and trading, limiting its use as collateral to niche crypto enthusiasts.

Complexity: Compared to Liquity’s constant $1 peg, RAI’s PID adjustment model is difficult for investors to predict.

RAI demonstrates the theoretical elegance of algorithmic stablecoins but also 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 intensify, a more radical stablecoin paradigm called 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) lose value in inflationary environments. If the dollar’s purchasing power declines by 5% annually, holders of traditional stablecoins suffer hidden capital losses. In contrast, Flatcoins track independent cost-of-living indices (CPI) and dynamically adjust their face value.

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

Target asset: a basket including food, housing, energy, and transportation indices.

Purchasing power parity: if the index shows a 5% increase in living costs in the US, Nuon’s target price will also rise by 5%, ensuring that one Nuon in the future can buy the same amount of goods and services.

Mechanism: Nuon employs over-collateralization. When inflation data changes, the algorithm automatically adjusts minting/burning logic to protect holders’ real value.

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

While the concept is forward-looking, practical implementation faces significant technical risks. The composition of the cost-of-living index is complex, and data authenticity heavily depends on oracle robustness.

Moreover, on-chain inflation data becomes a target for manipulation. Small manipulations of data sources could instantly erode holders’ purchasing power.

Additionally, Flatcoins require sufficient liquidity for dynamic balancing. 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 challenges.

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

Currently, algorithmic stablecoins still face capital efficiency issues, liquidity shortages, and user experience hurdles. Yet, their core principles—risk decoupling, minimal governance, and monetary sovereignty—remain the holy grail of DeFi.

The revival of algorithmic stablecoins has only just begun.