What are algorithmic stablecoins?
Algorithmic stablecoins are a type of cryptocurrency that stands apart from traditional stablecoins pegged to external assets such as fiat money. These stablecoins employ smart contracts and algorithms that seek to mitigate price volatility by dynamically adjusting the coin’s supply in response to market demand. TerraClassicUSD (TerraUSD) and Ampleforth (AMPL) are two examples of algorithmic stablecoins.
However, algorithmic stablecoins are not without risk, as the collapse of the Terra ecosystem showed. The decentralized finance (DeFi) platform encountered difficulties when the price of its own algorithmic stablecoin, TerraUSD (USDT), dropped precipitously.
A bank run on the Anchor Protocol, where a substantial percentage of UST was staked, and a crisis of confidence were caused by UST losing its peg to the United States dollar. The mint-and-burn arrangement between UST and LUNA caused hyperinflation, which sharply decreased the value of LUNA as UST’s value fell.
In response, the creator of Terra suggested giving up on the algorithmic stablecoin approach and building a new blockchain called Terra 2.0. The original blockchain was renamed Terra Classic, while UST became USTC, and LUNA became LUNA Classic (LUNC). The collapse exposed the risks associated with algorithmic stablecoins and significantly affected the cryptocurrency sector.
In response, the Frax community voted to shift to a fully collateralized stablecoin, citing the collapse of Terra as the primary trigger. The governance community approved in February 2023 to increase the collateral ratio of Frax’s stablecoin to 100%, eliminating the algorithmic component.
Frax, previously known for partial collateral backing and smart contract algorithms, has embraced complete collateralization. This strategic shift positions the Frax stablecoin, pegged to the U.S. dollar, as a highly scalable, trustless and ideologically on-chain stablecoin in the crypto space.
Various algorithmic stablecoin models
Algorithmic stablecoin concepts have emerged in the diverse landscape of cryptocurrencies to meet the demand for stability in the face of market volatility. Here are some examples of algorithmic stablecoin models:
Seigniorage-style stablecoins
These stablecoins operate on a seigniorage system, in which the coin’s supply is increased or decreased in response to market conditions. Basis was once a noteworthy project in this category; however, it was eventually shut down.
To keep its value stable, Basis used an algorithmic stablecoin model that involved issuing and redeeming three different kinds of tokens: Basis (BAC), Basis Shares (BST) and Basis Bonds. Nevertheless, the Basis team decided to wind down the project due to the regulatory environment and the ambiguous status of these tokens under securities laws.
Dual-token systems
Two tokens are used in dual-token stablecoin models: a stablecoin and a token that reduces price volatility. Frequently serving as a governance token, the secondary token grants holders the ability to vote or a share in the system’s profits. Based on this concept, Terra (LUNA) and TerraUSD (UST) operated, with LUNA being used to offset UST’s price volatility. However, the system collapsed in May 2022 due to a loss of confidence, leading to a massive sell-off.
Rebase mechanisms
Based on its market price, the stablecoin’s supply is periodically modified, or “rebased.” The supply rises when the price is too high. If it’s too low, the supply decreases. Ampleforth (AMPL) operates on this principle. It adjusts the supply of its tokens daily based on market conditions.
Instead of stabilizing AMPL’s price, this mechanism seeks to maintain its purchasing power. More tokens are issued when the price exceeds the target; conversely, some tokens are removed from circulation when the price falls below the target.
Collateralized debt position-based model
Users lock up collateral (usually another cryptocurrency) and mint the stablecoin against this collateral. Through mechanisms of liquidation and overcollateralization, the system remains stable. MakerDAO’s Dai (DAI) is an example of this model, where users lock up Ether (ETH) and other approved cryptocurrencies to mint DAI.
How do algorithmic stablecoins work?
To preserve price stability, algorithmic stablecoins use a special process that depends on smart contracts and algorithms. Algorithmic stablecoins, in contrast to conventional stablecoins pegged to external assets, dynamically modify their token supply in response to market demand. The algorithm sets off mechanisms to either raise or decrease the supply of tokens when the price of the currency deviates from the target value.
For example, if the price of the stablecoin is higher than the peg, the algorithm might produce more tokens, increasing the amount in circulation. This could help lower the price, bringing it back in line with the peg.
In contrast, the algorithm might reduce supply if the price is below the target, which would increase scarcity and drive up the price. The goal of this automatic modification is to return the stablecoin’s value to the peg.
These principles are applied by projects like TeraClassicUSD and Ampleforth, which aim to build a self-stabilizing system without requiring direct collateralization. While novel, algorithmic stablecoins carry some risk, as evidenced by periods of market volatility that call into question the algorithms’ efficacy.
What are collateralized stablecoins, and how do they work?
Collateralized stablecoins are intended to keep their value steady by being pegged to an underlying asset reserve. Typically, these reserves consist of cryptocurrencies, conventional fiat currencies or a mix of the two.
Fiat-collateralized stablecoins are a common type of collateralized stablecoin whose value is directly pegged to a certain quantity of fiat money held in reserve. Tether (USDT), USD Coin (USDC) and TrueUSD (TUSD) are examples of collateralized stablecoins. These stablecoins peg their value to the U.S. dollar through corresponding reserves.
Crypto-collateralized stablecoins are another type, as exemplified by MakerDAO’s DAI. In this model, stablecoins are backed by a pool of various cryptocurrencies maintained in a decentralized collateralized debt position (CDP) mechanism. CDP involves using digital assets as collateral to generate stablecoins or borrow funds in a DeFi system.
As a result, users have a decentralized substitute for fiat-backed stablecoins due to the collateral, which offers stability and dynamic adjustment. Through the use of collateral reserves, these collateralized stablecoins seek to combine the advantages of cryptocurrencies with price stability.
Differences between algorithmic and collateralized stablecoins
Algorithmic stablecoins and collateralized stablecoins represent two distinct approaches to obtaining stability in the turbulent cryptocurrency market. Algorithmic stablecoins rely on smart contracts and algorithms to dynamically modify their token supply. When the price deviates from the target, the algorithm autonomously increases or decreases the token supply to restore stability, frequently without direct collateralization.
In contrast, collateralized stablecoins maintain stability by pegging their value to an underlying reserve of assets. These stablecoins provide a more straightforward pegging method with a clear reserve backing, whereas algorithmic stablecoins aim for decentralization and independence from traditional assets.
Advantages and disadvantages of algorithmic stablecoins
Algorithmic stablecoins offer an innovative method of preserving price stability in the volatile realm of cryptocurrencies. One obvious benefit is their ability to function independently of conventional collateral, providing a more decentralized and international substitute. Theoretically, algorithmic stability mechanisms can dynamically adjust token supplies in response to market demand, attaining stability without requiring large reserves.
Algorithmic stablecoins, however, are not without risk. The efficacy of these strategies relies on the precision of the underlying algorithm, and unexpected changes in the market may present difficulties. As a caution, the failure of Terra shows that algorithmic stability methods might not be able to withstand highly volatile market conditions.
Additionally, algorithmic stablecoins may exhibit complex behavior, making it difficult for consumers to anticipate and comprehend how they will react to changes in the market. Algorithmic stablecoins, despite their novel features, need to be examined closely, their risks carefully evaluated, and they must be continuously improved to fix flaws and strengthen their resistance to volatile market events.
Advantages and disadvantages of collateralized stablecoins
There are pros and cons to collateralized stablecoins regardless of whether they are backed by fiat or cryptocurrency, such as DAI or USDT. From a positive standpoint, they offer a simple mechanism for maintaining price stability because their value is linked to the reserves of various cryptocurrencies or conventional fiat currencies. Users may easily confirm the assets supporting the stablecoin thanks to this direct collateralization, which fosters transparency and confidence.
However, collateralized stablecoins are not without difficulties. Fiat-collateralized stablecoins must have their reserves managed by dependable custodians and could come under regulatory scrutiny. Despite being more decentralized, cryptocurrency-collateralized stablecoins expose users to the inherent volatility of the cryptocurrency market.
Furthermore, it might be challenging to maintain a 1:1 peg, mainly when there is a lot of market volatility. In addition, the requirement for collateralization imposes a dependency on outside resources, which can restrict blockchain technology’s ability to achieve decentralized goals. Finding the ideal balance between decentralization, stability and risk reduction is still crucial to creating and using collateralized stablecoins.
The future of stablecoins
The future of stablecoins holds promising developments as the cryptocurrency space evolves. Greater adoption is anticipated as a result of more well-defined regulations, giving these digital assets a solid foundation. Central bank digital currencies (CBDCs), with the backing of sovereign entities, may become an integral part of the digital payments landscape.
Technological developments and new algorithms may strengthen the resilience of algorithmic stablecoins, addressing existing flaws. Furthermore, stablecoins may play a crucial role in a variety of financial activities, including lending, borrowing and liquidity provision, with continued DeFi innovation. As the market matures and addresses current challenges, stablecoins are poised to play an essential role in shaping the future of digital finance.