😵 Malt Leaves Investors Hungover as Algo Stable Depegs on Day 2

Hello Defiers! This week’s guest opinion piece is a dispatch from Algo Season 2.0. Our intrepid correspondent reports on the wild rollout of the Malt Protocol over the weekend. This latest algorithmic stablecoin made quite a splash in the market, so much so that trouble ensued and the protocol couldn’t keep its head above water.

We’ll save the juicy details for the article itself but suffice it to say that algo stables are bucking their monikers with loads of drama. Kind of makes sense, though, with so much action moving into that quadrant amid the larger crypto selloff. Author yyctrader explains the design limitations on Malt that led to congestion on Polygon, and how a nice little gas war cranked up the torque on this latest algo stable. Great stuff…

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Malt Leaves Investors Hungover as Algo Stable Depegs on Day 2

By yyctrader

Who doesn’t love a money printer? Algo Season 2.0 is here.

Last Friday, Malt Protocol launched the latest entry in the algorithmic stablecoin market. This summer, investors have flocked to this corner of the DeFi space to ride out the selloff in the larger crypto universe. Polygon is currently the favored choice of yield farmers with its lucrative farms and affordable transactions.

And why wouldn’t investors be excited? Malt Protocol aims to create a ‘capital-efficient token that can be pegged to any value, initially $1’, by drawing on design elements from other algorithmic stablecoins that came before it:

• Uncollateralized like ESD and Basis Cash.
• Liquidity Extension (LE) is Malt’s version of Protocol Controlled Value (PCV), a concept pioneered by FEI protocol. It is funded by 20% of expansion profits. These funds are intended to be used to support the price of MALT (the stablecoin) during contractions.
• During supply expansions, MALT is minted and sold for DAI, which in turn is rewarded to those providing liquidity for trading between MALT and DAI (liquidity providers, or ‘LPs’). Issuing rewards in DAI instead of the native token is expected to attenuate selling pressure on MALT.
• Instead of fixed-rate coupons/bonds, Malt uses ‘Arbitrage Auctions’ in which DAI can be pledged for ‘arb tokens’ that can be redeemed at a premium upon a return to peg.

Sure enough, within 24 hours Malt Protocol was sporting more than $50M in Total Value Locked, a key metric for protocol activity. Early users pocketed outsized gains as the supply of MALT, the stablecoin itself, rapidly expanded.

That’s when it all started going wrong…

Bots Step on the Gas

As fresh capital flowed into MALT and pushed its price above $1, the protocol’s ‘Stabilizer’ proceeded to mint MALT and sell it for DAI as planned. LPs who entered at launch received an eye-popping 500,000% APR.

The designers clearly did not anticipate the ape frenzy that followed, as the stabilizer contract offered a very generous 5% bounty to anyone who called it. This means that for every 100 MALT minted and sold, 5 DAI would go to the user who called the contract. While this may have made sense on Ethereum where gas fees are significant, nearly-free transactions on Polygon made it a ripe target for enterprising bot masters.

A single bot claimed over 339K DAI in Stabilizer rewards! Not bad for a day’s work.

A gas war ensued as more bots joined the fray, causing congestion on the Polygon network. Users may have noticed delays and an increase in failed transactions. The spike is clearly visible in the graph below from Nansen.

Leaky Casks

The team subsequently reduced the Stabilizer rewards, but the protocol ran into trouble when inflows stopped and a wave of heavy selling pushed MALT down to $0.40.

Further bugs were discovered in the liquidity mining contract, leaving some investors who previously unbonded their tokens or reinvested their rewards unable to withdraw their funds. The first series of arbitrage auctions, coupled with market buys of MALT from the liquidity extension, managed to push MALT back up to $0.985. But the damage had been done. Liquidity providers who were able to withdraw their funds quickly sold their MALT, and the protocol was unable to recover.

Approximately $17M of LP funds remain locked in the MALT mining contract. The team has shown their willingness to compensate users using funds from the protocol’s Treasury, previously allocated for further project development. Early indications suggest that users could recover a substantial portion of their invested capital if such a plan is implemented.

In the dark forest of DeFi where rug-pulls are increasingly the norm, it’s refreshing to see a team stepping up to compensate users. We hope that the team and community can come together to find a solution that’s fair to everyone while allowing for development of an improved MALT v2.

There’s already a lot of action pointing the way. Iron Finance, a partially-collateralized stablecoin, has seen its TVL skyrocket over 7x in June to nearly $1.8B. At the time of writing, investors had deployed over $1.1B into the two IRON-USDC pools as yields remain extremely lucrative.

Ampleforth kicked off Algo Season in July 2020 during the heady days of DeFi summer. The self-rebasing token based on ‘Hayek Money’ saw its marketcap explode by 30x that month.

Empty Set Dollar (ESD) and Dynamic Set Dollar (DSD) came next, with two-token models inspired by Robert Sams’ paper on ‘Seigniorage Shares’. Basis Cash took the concept further with its three-token model that spawned a wave of forks on Ethereum and BSC and continues to serve as a foundation for many stablecoin projects that followed.

A Trip Down Algo Lane

The projects mentioned so far are uncollateralized, meaning that they rely completely on market forces to maintain their pegs to $1. While their goal was to maximize capital efficiency, their contractionary mechanisms (coupons/bonds) turned out to be inadequate once fresh capital stopped flowing into the system. All are now trading below their pegs and are looking for ways to reinvent themselves.

FRAX was the first partially-collateralized algo-stablecoin to launch on Ethereum in December 2020, and it has been able to maintain its peg quite well, recovering quickly from the major crypto selloffs we’ve seen this year. Iron Finance on Polygon is based on the FRAX design. Critics argue that this design is neither truly algorithmic nor decentralized, as FRAX is 85% collateralized by USDC. However, it does offer greatly improved capital efficiency when compared to over-collateralized DeFi alternatives like DAI and sUSD.

TerraUSD is another stablecoin that has gained traction this year, with nearly $2B currently in circulation. Check out our Algo Stable Breakdown to read more about it.

More recently, FEI Protocol introduced the concept of Protocol Controlled Value (PCV), in which the protocol itself owns the majority of FEI-ETH liquidity. The protocol is able to support its peg to $1 through periodic ‘re-weights’, using ETH to purchase FEI on the market when it trades below $1.

Potential Rewards

As Vitalik said in this post: “The goal of algorithmic stablecoins is to try to be maximally censorship-resistant and robust by being free of dependencies to the ‘fiat world’.”

A lofty goal to be sure, and one that’s sure to foster continued innovation in the space as DeFi projects seek the perfect formula. The potential rewards are great, as total stablecoin supply continues to grow, now exceeding $100B. A viable decentralized alternative to USDT and USDC that proves resilient to all market conditions can emerge, and the team that figures it out will undoubtedly be immortalized in DeFi lore.

Disclaimer: The author is a core contributor at Basis Cash and may hold positions in the projects discussed.

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