A stablecoin is a cryptocurrency designed to maintain a set value. While there are numerous types of stablecoins, this guide focuses on algorithmic stablecoins, which differ from other types of stablecoins in terms of functionality. Instead, they rely heavily on smart contracts and intelligent algorithms to maintain value.
Read on to learn how algorithmic stablecoins work, how they maintain their pegs like other collateralized digital assets, and how the crypto markets react to these special tokens.
KEY TAKEAWAYS
► Algorithmic stablecoins use smart contracts and algorithms to maintain price stability by adjusting supply and demand without relying on collateral.
► These stablecoins can be categorized into types like rebase and seigniorage, each using different mechanisms to stabilize around a target peg.
► The risks of algorithmic stablecoins include potential “death spirals” if demand falls, leading to de-pegging events as seen with TerraUSD (UST).
► In spite of failures, algorithmic stablecoins have received much criticism, influencing users to opt for asset-backed stablecoins instead.
What are algorithmic stablecoins?
Algorithmic stablecoins maintain price stability by using smart contracts to maintain the balance of supply and demand. These decentralized stablecoins tie their value to an asset like the U.S. Dollar.
In other words, an algorithmic stablecoin may hold its price at a dollar. If the price of the coin rises, then they use algorithms that can mint more coins (lower demand/increase supply) to drop the price back to a dollar. When the price drops, the algorithm burns some coins (e.g., removes them from circulation) to increase the price (lower supply/increase demand).
A critical note here is that algorithmic stablecoins, in their purest form, do not rely on collateral. They are not supported by any reserve asset, such as most stablecoins. They use algorithms instead, 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 manipulates the circulating supply to ensure that the coin’s price is stable around its peg.
What are stablecoins?
Stablecoins are stable crypto assets that tie their value to a tangible asset, including fiat, commodities, or other financial instruments.
Ideators develop Stablecoins to offer an alternative to the high volatility of cryptocurrencies, such as Bitcoin (BTC) or Ether (ETH). During highly volatile market trends, investors trade their highly volatile assets for stablecoins to maintain their purchasing power.
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).
How do stablecoins work?
How they maintain the peg determines their type! For example, asset-backed stablecoins maintain their peg through redemptions and arbitrage trades. This means that if you hold one stablecoin valued at a dollar, and the price drops to $0.90, you can redeem or trade that coin for $1. This would net you a profit of $0.10.
We refer to this scenario as an arbitrage trade. This process helps to maintain the price of a stablecoin at a dollar. In most cases, you wouldn’t necessarily trade a single coin, but trading millions or hundreds of thousands would give you a large profit margin.
Additionally, most stablecoin companies will handle dollar redemptions. This ensures that all coins are redeemable for exactly one dollar—no more, no less.
Different types of stablecoins
As simple as it may seem, the future of digital currency isn’t deterministic yet. Many believe that stablecoins should be considered legal tender and should not be controlled by any central authority such as central banks. However, based on how they stabilize their value, there is more than one type of stablecoin:
- Asset-backed stablecoins
- Collateralized by other cryptocurrencies
- Collateralized by an algorithmic ecosystem
Assets-backed stablecoins
These stablecoins have assets (fiat currencies, financial products, or commodities) to back them—such as the U.S. dollar—as collateral to ensure their value maintains a 1:1 ratio. Other popular collateral choices include precious metals such as gold and silver. However, most stablecoins are collateralized by fiat and a dollar peg.
These U.S. dollar reserves are managed by companies that 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. You can buy stablecoins on most exchanges.
Crypto-collateralized stablecoins
Stablecoins can also be crypto-collateralized— meaning they have the backing of other crypto assets. Because the reserve of the cryptocurrency backing the stablecoin may also be prone to high volatility, over-collateralization is often a norm for them. 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. MakerDAO’s stablecoin (DAI) is a prime example.
It maintains a dollar peg with Ether (ETH) reserves and other cryptocurrencies backing it. The protocol attempts to maintain the value of the reserves at 150% of the total supply of DAI stablecoins, give or take.
Algorithmic stablecoins
Another type of stablecoin 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. Smart contracts maintain the supply and demand cycle of algorithmic stablecoins.
As there is no central reserve in play, you can even term them decentralized stablecoins. Ecosystem participants can interact with a smart contract to exchange the stablecoin. By implementing complex algorithms and incentive mechanisms for holders, the protocol can expand or contract the total supply.
Algorithmic stablecoins 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 stablecoins — TerraUSD (UST) — lost its peg on May 9, 2022, causing the dramatic drop of Terra (LUNA).
How do algorithmic stablecoins work?
The main types of algorithmic stablecoins are seigniorage and rebase. While there are many different mechanisms that each stablecoin may use to implement these strategies, these are the general methods each may use.
Rebase stablecoins
How do rebase stablecoins work? To maintain the peg, rebase stablecoins change or rather stretch/contract the supply. You can also term rebase stablecoins as elastic tokens.
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 below $1. Despite the supply volatility, its price tends not to fluctuate, and it depends on the value of the asset it tracks.
Seigniorage stablecoins
Seigniorage stablecoins use a dual-token mechanism to maintain a stable price peg, usually $1, by balancing supply and demand through automated adjustments. In this model, the stablecoin system typically includes two tokens: a stablecoin and a governance token (yield-bearing).
How do seigniorage stablecoins work?
To stabilize the value of the stablecoin, the system uses a governance token that can be staked to earn rewards when demand rises. When the stablecoin’s price is above its peg, the system mints new stablecoins to curtail demand and bring the price back to target.
Holders of the governance token, who assume more risk, receive rewards in the form of the newly minted stablecoins, incentivizing demand for the governance token itself.
If the stablecoin’s price falls below the peg, a mechanism encourages users to exchange governance tokens for stablecoins, reducing the stablecoin’s supply through a burning process. This dual-token system, where governance token demand is paired with a burn mechanism, enables a balance of supply and demand to retain the stablecoin’s peg.
What happens when a stablecoin loses its peg?
Sometimes, a drop in an algorithmic stablecoin’s value can result in a death spiral. This is a slightly trickier situation. For example, in a seigniorage mechanism with a dual token market, the algorithm relies heavily on the demand of both tokens.
Without going into specifics, if the demand for one token drops, the demand for the other token is supposed to increase, and vice versa. This is how the stablecoin maintains its peg.
However, when the demand for both tokens decreases, the protocol cannot maintain the incentive mechanisms (e.g., redemptions and staking), and the price continually drops. We refer to this event as a death spiral.
Pros and cons of algorithmic stablecoins
Algorithmic stablecoins could increase the popularity of cryptocurrency as a medium of exchange for financial transactions and other purposes. But what are the benefits and risks of using them?
| Pros | Cons |
|---|---|
| It can be used to maintain purchasing power | Do not hold any assets in reserves for redemptions |
| Decentralized and not controlled by central parties | Often suffer from death spirals |
| Benefits users rather than banks | |
| Can be used in DeFi protocols |
Benefits of algorithmic stablecoins
Some applications include the use of stablecoins for trading, using them to run DAOs (decentralized autonomous organizations), and providing incentives to 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 these algorithmic stablecoins, the token holders are the ones to benefit from the price difference and not a central entity.
Another benefit is the exact utility of the token. Usually, these stablecoins are not only a medium to exchange value but can also play a part in certain decentralized protocols. Staking stablecoins is one of the most popular use cases.
The basics of stablecoins are fairly easy to understand, but like with all things crypto, the deeper you go, the more there is to process. Learn everything you need to know at the BeInCrypto Telegram group.
Risks of algorithmic stablecoins
New investors may think that algorithmic stablecoins are low-risk. It’s important to remember that algorithmic stablecoins have no specific backing.
The design of algorithmic stablecoins aims to maintain price stability through the actions of users who interact with the system. If there is no big incentive for investors to buy the secondary tokens that could bring the price of the stablecoin back up to its peg, the contraction mechanism could fail.
There is a possibility that the stablecoin never manages to maintain the peg. This happens when the stablecoin burning frequency is low, and the investors keep selling. This approach can cause depegging, leading to a “death spiral.”TerraUSD (UST) is an excellent example of a stablecoin that experienced a death spiral in 2022.
What are some examples of algorithmic stablecoins?
Let’s shed some light on how exactly algorithmic stablecoins work, with the help of examples of the most popular ones. Here are the top algorithmic stablecoins that can help you understand their functionality.
Basis Cash (BAC) — Do Kwon’s first stablecoin project
Do Kwon, Terra’s creator, also has other failed stablecoins apart from LUNA. He released Basis Cash (BAC) under the Rick Sanchez pseudonym. It was one of the first algorithmic stablecoins. BAC’s goal was to maintain a 1:1 dollar peg.
The BAC protocol was created to contract and expand supply in a manner similar to that of 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) depegged from the U.S. dollar, and thus it failed to be a reliable stablecoin.
Ampleforth (AMPL)
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.
Evan Kuo, a serial entrepreneur, and Brandon Iles, an ex-Google senior software engineer, ideated Ampleforth. The Ampleforth Foundation is the management and development firm behind the Ampleforth protocol.
The AMPL stablecoin came forth as a rebase 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.
TerraUSD (UST)
TerraUSD (UST) is the Terra blockchain’s failed algorithmic stablecoin. It was a yield-bearing, scalable coin that aimed to be pegged to the U.S. dollar. TerraUSD was designed to provide value to the Terra community and offer a scalable solution to DeFi protocols.
Terraform Labs developed the UST in 2018 — in a project led by Do Kwon and Daniel Shin. TerraUSD (UST) came forth as a seigniorage stablecoin with the aim of maintaining its peg to the U.S. dollar through the work of arbitrageurs.
In this case, Terra’s blockchain native coin, LUNA, was the volatile cryptocurrency used to balance the price of UST stablecoin while also functioning as a governance token for the network.
Terra’s UST worked closely with LUNA, an elastic token that expands and contracts its total supply to maintain the stablecoins’ equilibrium and encourage arbitrage.
For instance, if you want to buy UST stablecoin, you 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 need to convert UST stablecoins. UST prices rise slightly as a result.
Do algorithmic stablecoins have a future?
Algorithmic stablecoins are innovative mechanisms that can elevate decentralized finance. However, most of the algorithmic stablecoins have failed to date because of their experimental nature. So far, the main use case for these types of stablecoins has been speculative trading.
However, algorithmic stablecoins, for now, feature as opportunities 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?
Is UST an algorithmic stablecoin?
Is DAI an algorithmic stablecoin?
How is DAI pegged to USD?
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