Algorithmic stablecoins are the ultimate innovation of decentralized finance that promises to upgrade how stablecoins work. Without the need for central banks, stablecoins and cryptocurrencies are able to support the ever-expanding financial markets through transparent smart contracts.
Let’s dig deeper to explore how stablecoins work, how they maintain the peg to the U.S. dollar, and how the crypto markets react to these special tokens.
Table of contents
- What are stablecoins?
- Different types of stablecoins
- What are algorithmic stablecoins?
- How do algorithmic stablecoins work?
- What are some examples of algorithmic stablecoins?
- Do algorithmic stablecoins have a future?
- Frequently asked questions
What are stablecoins?
Stablecoins are a special kind of cryptocurrency whose value is pegged or tied to another currency, commodity, or financial instrument. Stablecoins are designed to offer an alternative to the high volatility of most cryptocurrencies, such as bitcoin (BTC) or ether (ETH). Oftentimes, during highly volatile market trends, investors trade their highly volatile assets for stablecoins to maintain the value of their portfolios.
Most stablecoins represent a way to earn a passive income from your crypto holdings. There are many platforms that offer great interest rates for stablecoins (much better than anything offered by traditional finance).
Different types of stablecoins
As simple as it may seem, the future of digital currency is not yet fully determined. Many believe that stablecoins should be considered a legal tender, not controlled by any central authority such as central banks. However, based on how they stabilize their value, there is more than one type of stablecoins:
- Fiat-collateralized stablecoins
- Collateralized by other cryptocurrencies
- Collateralized by an algorithmic ecosystem
Stablecoins that are collateralized by fiat have a reserve of a fiat currency or currencies, such as the U.S. dollar, as collateral to ensure its value. Other popular collateral could be precious metals such as gold and silver. However, most stables that are collateralized by fiat have U.S. dollar reserves.
These U.S. dollar reserves are managed by independent custodians who are periodically audited. For instance, Tether (USDT) and TrueUSD (TUSD) are two popular stablecoins that are backed by U.S. dollars and are paired at a 1:1 ratio.
Stablecoins can also be crypto-collateralized, which means that they are backed by other cryptocurrencies and not by fiat currency. Because the reserve of the cryptocurrency backing the stablecoin may also be prone to high volatility, such stablecoins are over-collateralized. This means that the value of cryptocurrency held in reserves exceeds the value of the stablecoins issued.
For instance, to protect against a 50% drop in the price of the stablecoin, the crypto reserve could be as much as double the value of the issued stablecoins. One of these crypto-collateralized stablecoins is MakerDAO’s DAI stablecoin (DAI), which is pegged at the U.S. dollar. It is backed by ethereum and other cryptocurrencies that are worth 150% of the total supply of DAI stablecoin.
Another type of stablecoin that has been gaining popularity over the last couple of years is the algorithmic stablecoin. These stablecoins may also lock down some assets to collateralize the value of the stable, but they mostly rely on an algorithm. The total supply of the algorithmic stablecoins is controlled by an algorithm, and participants can interact with a smart contract to exchange the stablecoin. By selling or buying the algorithmic stablecoin to the system, the total supply is expanded or contracted.
Algorithmic stables are not that different from currency issued by central banks, which may not depend on a reserve asset for keeping the currency’s value stable. This type of stablecoin started to attract more attention, as one of the most popular algorithmic stablecoin, the TerraUSD (UST), lost its peg on May 9, 2022, and caused the dramatic drop of Terra (LUNA), which almost reached zero. This is an exceptional example of what can happen when an algorithmic stablecoin is being manipulated.
What are algorithmic stablecoins?
An algorithmic stablecoin is designed to maintain price stability by actively balancing the circulating supply of the currency, according to supply and demand. These types of currencies are not tied to a reserve asset like the U.S. Dollar. In other words, it uses an algorithm that can mint more coins when its price rises and then buy them off and burn them when the price falls.
A critical note here is that algorithmic stablecoins are completely uncollateralized in their purest form. They are not supported by any external asset. They use algorithms, which are specific instructions or rules that must be followed to produce a result. These computer algorithms are designed to encourage market participants to trade stablecoins according to supply and demand. This action will manipulate the circulating supply to ensure that any coin’s price is stable around its peg.
Stablecoin traders expect the security of cryptocurrency, without having to worry about price volatility.
Benefits of algorithmic stablecoins
Algorithmic stablecoins could increase the popularity of cryptocurrency as a medium of exchange for financial transactions and other purposes.
These applications include the use of stablecoins for trading, using them to run DAOs (decentralized autonomous organizations), and providing incentives for holders.
Similar to the way central banks issue new coins, algorithmic stablecoins are designed to expand or contract their total supply to maintain their peg. But in the case of stablecoins, the token holders are the ones to benefit from the price difference and not a central entity. Another benefit would be the exact utility of the token. Usually, these stablecoins are not only a medium to exchange value, but can also be used in certain decentralized protocols. Staking stablecoins is one of the most popular use cases.
Risks of algorithmic stablecoins
New investors may think that algorithmic stablecoins are low-risk. While they are certainly less volatile than popular cryptocurrencies, it’s important to remember that algorithmic stablecoins are not backed by anything.
In the case of algorithmic stablecoins, their design aims to maintain price stability through the actions of the users who interact with the system. However, the contraction mechanism could fail, as there isn’t a big incentive for investors to buy the secondary tokens that could bring the price of the stablecoin back up to its pegged value. There is a possibility that the stablecoin will never recover its pegged value. This will happen when not enough of the stablecoin is burned, and when investors continue to sell it. This is known as the “death spiral.”
TerraUSD (UST) is an excellent example of a stablecoin that recently experienced the death spiral. To maintain its USD valuation, it uses Terra’s native cryptocurrency, LUNA, as a secondary token. Each time the UST goes over $1, investors will sell it to the system and get LUNA tokens in return. When the UST price dips below $1, users can sell LUNA tokens and get $1 worth of UST. The algorithm will always value UST at $1, regardless of the market conditions at that time. This is a great incentive for crypto arbitrage, as the price difference can generate a profit. But as users lost faith in the Terra system when UST depegged, both of these tokens collapsed, and investors got liquidated.
Some other risks are similar to those associated with cryptocurrency in general, including security and storage. Users need to store them on a trusted cryptocurrency wallet and only use reputable exchange platforms when trading them.
How do algorithmic stablecoins work?
The main types of algorithmic stablecoins are seigniorage and rebase.
How do rebase stablecoins work? To maintain a stablecoin’s peg, rebase stablecoins alter the supply. The rebase stablecoin is often referred to as an elastic token.
Typically, rebase tokens are pegged to another asset. Instead of using reserves to keep the peg in place, rebase tokens automatically put tokens into circulation by minting new tokens when the price drops below their pegged value of $1. The algorithm also burns tokens when the value of the pegged token drops under the $1 value. Although the supply of a rebase token is highly volatile, its price tends not to fluctuate, and it depends on the value of the asset it tracks.
The second type of algorithmic stablecoins is the seigniorage stablecoins. In traditional finance, seigniorage means the difference between the face value of coins and their production costs. The point is to make a profit from the price difference by those who hold the token that acts as a share or bonds of the system.
How do seigniorage stablecoins work?
While the mechanics of a seigniorage stable can vary from project to project, the principles are the same. The stablecoin financial system can perform automatic actions, to counteract the different possibilities — to lower or to increase the value of the stable and get it back to its pegged value. Usually, the system needs a few tokens — the stablecoin, a token to act as shares, and another one to act like bonds. The shares and the bonds are used to adapt and control the supply of the stablecoin.
What happens when the stablecoin’s value is above its peg? The system mints more stablecoins automatically to meet the current demand and retain the peg to the value of $1. This is known as the expansion mechanism. Here, the users holding the token that acts as shares will receive a corresponding percentage of the newly minted stablecoin quantity. That’s a reword for the share token holders, as they bear the riskiest asset in this stablecoin mechanism. Of course, these holders can then sell their newly received stablecoins, which will result in a decrease in the stablecoin’s price.
What happens when a stablecoin’s loses its peg?
This is a slightly trickier situation, and the system will try to burn the excess stablecoin to reduce the total supply and restore the pegged value. This is called a contraction mechanism.
If the stablecoin’s value is under $1, the algorithm will allow users to exchange the stablecoin for the token that acts as bonds, therefore decreasing the supply of the stablecoin. The system also guarantees that users will get more than 1 bond token for each stablecoin. When the stablecoin restores its peg, users will be able to redeem one bond token for one stablecoin. Thus, they will make a profit.
What are some examples of algorithmic stablecoins?
Let’s share some light on how exactly algorithmic stablecoins work, with the help of examples of the most popular ones. Here are the top algorithm-backed stablecoins that can help you understand the functionality of these stablecoins.
Basis Cash (BAC) — Do Kwon’s first stablecoin project
Do Kwon, Terra’s creator, also has other failed stablecoins in the portfolio, other than the recently released LUNA. Under the Rick Sanchez pseudonym, he released Basis Cash (BAC), one of the first algorithmic stablecoin. BAC’s goal was to be pegged to the U.S. dollar on a 1:1 ratio.
The protocol of BAC was created to contract and expand supply in a manner similar to central banks trading fiscal debt to stabilize purchasing powers without collateral. The Basis Share, Basis Bond, and Basis Cash were all intended to be exchangeable. Do Kwon intended to distribute BAC tokens via yield farming and liquidity to BAC-DAI.
However, Basis Cash (BAC) failed to maintain its peg to the U.S. dollar, and thus it failed to be a stablecoin. Today, the coin trades below $0.01, and it lost support from investors (and their trust).
Ampleforth is an Ethereum-based protocol that aims to maintain the value of the AMPL cryptocurrency asset at an equal value to the U.S. Dollar.
Ampleforth (AMPL) was created by Evan Kuo, a serial entrepreneur and Brandon Iles, an ex-Google senior software engineer. The Ampleforth Foundation is the management and development firm behind the Ampleforth protocol, and the team has around a dozen members, per their LinkedIn page.
The AMPL stablecoin is a rebase type of algorithmic stablecoin. This means that instead of owning a fixed number of AMPL, the holders own a fixed percentage of the total AMPL circulating supply. The total supply contracts or expands according to the current token price. If the AMPL price is over $1, the protocol increases the circulating supply and distributes the newly minted tokens to existing holders. However, the AMPL token supply decreases when the AMPL price drops below $1.
All Ampleforth wallets will be affected by this change. Their wallet balances will be adjusted in proportion. AMPL holders will retain the same token supply, regardless of this change. This means that even if you had 1% of AMPL tokens prior to a rebasing, you would still have the same percentage of the total supply after the rebasing.
This is called a “rebase,” and it occurs once per day. A positive rebase is when the price rises above $1.06, and a negative one is if it falls below $0.96. The system’s overall purpose is to provide incentives to drive AMPL’s market price back down to $1.
TerraUSD (UST) is the algorithmic stablecoin of the Terra blockchain. It is a yield-bearing, scalable coin that aims to be value-pegged to the U.S. dollar. TerraUSD was designed to provide value to the Terra community and offer a scalable solution to DeFi applications.
The Terra ecosystem was created by Terraform Labs in 2018 and was founded by Do Kwon and Daniel Shin. Remember that Do Kwon was also the founder of Basis Cash (BAC) stablecoin.
TerraUSD (UST) is a seigniorage stablecoin that aims to maintain its peg to the U.S. dollar through the work of arbitrageurs. In this case, Terra’s blockchain native coin LUNA is the volatile cryptocurrency that is used to balance the price of UST stablecoin, while also functioning as a governance token for the network.
Terra’s stablecoin UST relies on its native token, LUNA, which is an elastic token, that expands and contracts its total supply to maintain the stablecoins’ equilibrium. It also encourages arbitrage. For instance, if you want to buy UST stablecoin, you will need to mint UST by paying with LUNA tokens. This protocol burns those LUNA tokens, constricting the total supply and causing a slight increase in the price of LUNA. To mint LUNA, you will need to convert UST stablecoins. UST prices rise slightly as a result.
How does UST work?
What are the reasons to exchange UST for LUNA? Because there is an arbitrage opportunity. Arbitrageurs help keep UST’s price pegged to the U.S. dollar by selling LUNA for UST when the price of UST is below $1 and buying LUNA when UST is worth more than $1.
Users can exchange 1 UST for $1 of Luna and the other way around at any given time. If you sell LUNA for UST, UST is minted, and LUNA is burned. If you exchange 1 UST for $1 of LUNA, then UST is burned, and LUNA is minted. In theory, this should work just fine, if UST is stable.
For example, if UST falls to $0.95, traders can buy a lot at that price and then sell it for $1 of LUNA. Consequently, UST supply decreases, and the price goes back up.
However, the TerraUSD (UST) became global news when it depegged and entered the death spiral in May 2022. The founders tried to stabilize it by selling some of their reserve assets, but the algorithm acted against them, and the total supply of LUNA reached 6.5 trillion as investors continued to dump the tokens. Consequently, the value of the LUNA token dropped by 99.99%, and the value of UST plummeted to around $0.10. This event is called hyperinflation.
Do algorithmic stablecoins have a future?
Algorithmic stablecoins are innovative mechanisms that can elevate decentralized finance. But all the existing algorithmic stablecoins have proven to be experimental, as they all failed to maintain their pegged value. So far, the main use case for algorithmic stablecoins has been speculative trading.
However, algorithmic stablecoins are seen as an opportunity for innovation and expansion of the DeFi space. At the same time, many countries are now researching stablecoins in a quest to regulate them and even issue their own stablecoins as an alternative to government-based financial systems.
Frequently asked questions
What are algorithmic stablecoins?
Algorithmic stablecoins do not have a collateral — such as fiat or other assets — to back them up. Instead, it acts as a cryptocurrency, and it relies on an algorithm to constantly adjust the total supply and regain the peg of the stablecoin.
Is UST an algorithmic stablecoin?
TerraUSD (UST) is an algorithmic stablecoin that uses the seigniorage system. It relies on another token (LUNA) to adjust the total supply and regain its pegged value of $1.
Is DAI an algorithmic stablecoin?
Yes, DAI is an algorithmic stablecoin of the MakerDAO protocol that is based on the Ethereum network.
How is DAI pegged to USD?
Users can generate and borrow DAI by opening a Maker collateral vault using the Oasis Borrow protocol, in which Ethereum assets are needed as collateral. The value of the collateral must be over the value of the DAI received. If the value of the collateral drops under the value of DAI, then the Maker collateral vault is liquidated.