The world of cryptocurrencies has been growing rapidly in recent years, and with it, the need for stablecoins has become increasingly important. Stablecoins are designed to maintain a stable value relative to another asset, such as the US dollar or a basket of commodities. One type of stablecoin that has gained popularity in recent years is algorithmic stablecoins.
In this blog post, we will explore everything you need to know about algorithmic stablecoins. We will cover, their benefits and drawbacks, and some of the most popular algorithmic stablecoins available today. By the end of this post, you should have a better understanding of algorithmic stablecoins and their potential to shape the future of the crypto space.
What is an Algorithmic Stablecoin?
Algorithmic stablecoins are a type of cryptocurrency that aims to maintain a stable value by using algorithms and smart contracts. Unlike traditional cryptocurrencies such as Bitcoin, algorithmic stablecoins are not subject to extreme price volatility. Instead, they aim to maintain a stable value by adjusting their supply based on changes in demand. These stablecoins can be used for a variety of purposes such as trading, lending, and payments, as their value remains relatively stable compared to other cryptocurrencies.
Algorithmic stablecoins are also known as “non-collateralized” stablecoins because they do not rely on any collateral to maintain their stability. Instead, they use mathematical algorithms to regulate the supply of tokens in circulation and stabilize their market price.
Algorithmic stablecoins are decentralized, which means that they are not backed by a centralized authority, but instead, rely on a network of users to maintain their stability. Algorithmic stablecoins are also designed to be more resistant to market volatility and to offer greater efficiency and cost-effectiveness for cross-border payments.
After looking at what is an algorithmic stablecoin, let’s look at its types.
Types of Algorithmic Stablecoins
Algorithmic stablecoins come in different types, each with its own unique features and traits. Here is an overview of the distinct types of algorithmic stablecoins:
1. Rebasing Algorithmic Stablecoins
In this type of algorithmic stablecoin, the supply adjusts automatically based on the current price of the coin. For example, if the price of the coin falls below the pegged value, the supply will decrease to bring the price back up. Similarly, if the price goes above the peg, the supply will increase to bring the price down. This mechanism is often achieved through a “rebase” function that adjusts the supply on a regular basis.
2. Over-collateralized Algorithmic Stablecoins
This type of algorithmic stablecoin relies on a large reserve of other cryptocurrencies to back the stablecoin. The idea is that if the value of the stablecoin drops, the reserve can be used to buy back the stablecoin and support the price. MakerDAO’s DAI stablecoin is an example of an over-collateralized algorithmic stablecoin, with Ether (ETH) being used as collateral.
3. Fractional Algorithmic Stablecoins
Fractional algorithmic stablecoins are partially collateralized by a reserve of assets, but the remainder of the value is maintained through algorithmic mechanisms. This can help reduce the amount of collateral needed and increase the efficiency of the stablecoin. One example is Ampleforth (AMPL), which uses an algorithm to adjust the supply of tokens in response to changes in demand.
4. Seigniorage Algorithmic Stablecoins
Seigniorage algorithmic stablecoins use a two-token system to maintain stability. One token is used as the currency, while the other is used as a sort of “bond” that can be purchased to earn rewards. The bond token is used to incentivize users to buy or sell the currency token as needed to maintain the stablecoin’s peg. The Basis stablecoin was an example of a seigniorage algorithmic stablecoin, although it was ultimately shut down due to regulatory concerns.
Mechanisms Used to Maintain Stability
1. Issuance and Burning of Tokens
Algorithmic stablecoins can maintain their stability by adjusting the supply of tokens in circulation based on changes in demand. For example, if demand for the stablecoin increases, the algorithm may issue new tokens to increase the supply and maintain the stablecoin’s peg to the underlying asset. Conversely, if demand decreases, the algorithm may burn tokens to decrease the supply and maintain the peg.
2. Stability Fees
Another mechanism used to maintain the stability of algorithmic stablecoins is stability fees. Stability fees are fees that are charged to users who hold the stablecoin in order to incentivize them to sell their tokens if the price of the stablecoin deviates from its peg. For example, if the price of the stablecoin rises above its peg, stability fees may be charged to holders of the stablecoin to incentivize them to sell their tokens and bring the price back down to the peg.
Algorithmic Stablecoin Lists
DAI is a popular algorithmic stablecoin that is backed by Ethereum. DAI maintains its stability through a mechanism called a “decentralized autonomous organization” (DAO), which is a set of smart contracts that adjust the supply of tokens in circulation based on changes in demand.
Ampleforth is an algorithmic stablecoin that uses an “elastic supply” mechanism to maintain its stability. Elastic supply involves adjusting the supply of tokens in circulation based on changes in demand, but instead of issuing or burning tokens, Ampleforth increases or decreases the token balance of users’ wallets.
FRAX is a relatively new algorithmic stablecoin that is backed by a basket of stablecoins and other assets. FRAX uses a mechanism called “fractional-algorithmic” stabilization, which involves adjusting the supply of tokens in circulation based on changes in demand. It also uses stability fees to incentivize users to hold or sell their tokens to maintain the stablecoin’s peg.
Terra is a blockchain platform that aims to create a global payment system powered by a family of stablecoins that are pegged to the value of various fiat currencies, including the US dollar, Korean won, and Mongolian tugrik. Terra’s stablecoins are designed to be used for everyday transactions, and they are backed by a reserve of collateral held in a decentralized finance (DeFi) platform called Anchor Protocol. Terra’s stablecoins are maintained through a combination of algorithmic and collateralized mechanisms, and they are designed to be fast, affordable, and scalable.
5. Empty Set Dollar (ESD)
Empty Set Dollar (ESD) is an algorithmic stablecoin that aims to maintain its value through a combination of seigniorage shares and bonds. It is designed to be flexible and adaptable, with the ability to adjust its monetary policy parameters in response to market conditions.
ESD is a decentralized and permissionless stablecoin, meaning that it is not controlled by any central authority or institution. Instead, it is maintained by a community of users and developers who are incentivized to keep the stablecoin stable through a system of rewards and penalties.
This small list of algorithmic stablecoins has some of the most popular stablecoins.
Read More: Stablecoin Taxes
Benefits of Algorithmic Stablecoins
Algorithmic stablecoins offer a number of benefits over traditional stablecoins and other cryptocurrencies. Some of the key benefits include:
1. Resilience to Market Volatility
Algorithmic stablecoins are designed to be more resilient to market volatility than traditional stablecoins. This is because they are not backed by any central authority or collateral, and instead, rely on a network of users and mathematical algorithms to maintain their stability. This can make them more attractive to investors and traders who are looking for a stable store of value that is less vulnerable to market fluctuations.
2. Decentralization and Regulatory Advantages
Algorithmic stablecoins are decentralized, which means that they are not subject to the same regulatory constraints as traditional stablecoins that are backed by a central authority. This can make them more attractive to users who are concerned about government oversight or censorship. Additionally, algorithmic stablecoins can offer greater transparency and security, as they are often built on open-source blockchain technology.
3. Efficiency and Cost-effectiveness for Cross-border Payments
Algorithmic stablecoins can offer greater efficiency and cost-effectiveness for cross-border payments compared to traditional payment methods. This is because they can be transferred quickly and easily over the Internet, without the need for intermediaries such as banks or payment processors. Additionally, because algorithmic stablecoins are not tied to any particular fiat currency, they can be used for cross-border payments without incurring currency conversion fees or other costs.
Drawbacks of Algorithmic Stablecoins
While algorithmic stablecoins offer several benefits, there are also some drawbacks to consider.
1. Dependency on Algorithms and Potential for Instability
One of the main drawbacks of algorithmic stablecoins is their dependency on algorithms. If the algorithm is poorly designed or not updated in response to changing market conditions, it can lead to instability in the value of the stablecoin. This was seen in the case of the Basis Protocol, which shut down in 2018 due to regulatory concerns and issues with its algorithm.
Additionally, the complex mechanisms used to maintain stability in algorithmic stablecoins can make them difficult to understand for the average user, which could limit their adoption.
2. Vulnerability to Market Manipulation
Algorithmic stablecoins are vulnerable to market manipulation, just like any other cryptocurrency or financial instrument. In particular, seigniorage-style algorithmic stablecoins, which rely on supply and demand to maintain their stability, can be more susceptible to manipulation than collateralized stablecoins.
For example, in November 2020, the price of the seigniorage-style algorithmic stablecoin Basis Cash (BAC) experienced a sharp increase in price due to market manipulation by a group of anonymous traders. This led to the collapse of the stablecoin’s value and ultimately the project’s shutdown.
In this blog post, we have covered the definition of algorithmic stablecoins, their importance in the crypto space, and the mechanisms used to maintain their stability. We have also discussed the benefits and drawbacks of algorithmic stablecoins and the different types of algorithmic stablecoins.
Algorithmic stablecoins have the potential to revolutionize the crypto space by providing a stable and reliable alternative to traditional cryptocurrencies. They use sophisticated algorithms and smart contracts to maintain a stable price, without relying on collateral.