What are Algorithmic Stablecoins?

An algorithmic stablecoin is a type of cryptocurrency controlled by algorithms, specifically smart contracts, to manage and reduce the fluctuations in the price of a particular asset, like the U.S. dollar.

This means that this kind of stablecoin operates using an algorithm that can generate more coins if the price goes up and purchase coins back from the market if the price goes down.

This allows traders to enjoy the benefits of owning crypto assets like ETH and BTC without worrying about drastic price swings.

Key Takeaways

• A stablecoin is a cryptocurrency that is tied to the value of a tangible asset, like a fiat currency or gold.
• They’re very secure since they’re decentralized and utilize smart contracts to keep the stablecoin’s value in line with its underlying asset.

How Do Algorithmic Stablecoins Work?

To understand what algorithmic stablecoins are, a characteristic feature is a “two-coin” system. One stablecoin under this category is a cushion for market turbulence, while the other aims to maintain a value anchored to a physical asset.

The first is typically exchanged on DEX like Uniswap and is known as a balancer or share token (UNI). When Terra first started, it just used this two-coin system, but as a backup, it subsequently added Bitcoin (BTC) reserves.

Read More: How to trade Bitcoin.

Let’s look at the example of Terra’s network to understand how a two-coin system works. The Terra blockchain has two tokens: TerraUSD, a stablecoin, and Luna, a governance token.

The interaction between the two tokens is designed to maintain the value of TerraUSD at $1. If TerraUSD’s price goes above $1 due to increased demand, a Luna holder can exchange $1 worth of Luna for TerraUSD, profiting from the higher price.

Conversely, if the coin’s value drops, traders can exchange it for $1 worth of Luna, which decreases the supply and raises the price. However, algorithmic stablecoins require a certain level of demand support for the system to function.

If demand falls below a certain level, the entire system could fail. This was demonstrated when Fei’s USD-pegged token went significantly below its intended value in April 2021, resulting in an 80% drop in its buying price.

Additionally, algorithmic stablecoins depend on independent individuals to undertake price-stabilizing arbitrage to earn market incentives. However, relying on separate, market-driven actors to execute discretionary arbitrage without legal obligations is equally risky.

Key Features

Algorithmic stablecoins are designed to make trading more accessible and comfortable for new and experienced traders. Here are some key features of algorithmic stablecoins:

Limited Volatility Adds Value

Stablecoins are reliable coins based on value, and this is because they have limited prices, making them convenient.

This feature makes stablecoins useful for cross-border transactions and provides collateral diversification to resist hyperinflation and market instability.

Responsive Reactions to the Market

The smart contracts that code the algorithm into the stablecoin parameters ensure an automatic response to market data without manual intervention.

After analyzing the underlying market conditions, these parameters are designed to stabilize market supply and demand for these tokens.

Security

Stablecoins can be stored in virtual wallets to ensure security; a private stablecoin holder can only access the associated funds.

Network owners can also use advanced encryption technology to increase security levels.

What are Some Examples of Algorithmic Stablecoins?

When it comes to exploring these digital assets, there are a few examples that are explained below to help understand the Stablecoin supply.

Basis Cash (BAC)

Terra’s founder, Do Kwon, has had other attempts at stablecoins that didn’t work out, in addition to the recent success of LUNA. One of these attempts was called Basis Cash (BAC), one of the first algorithmic stablecoins.

BAC’s aim at inception was to maintain a stable price of a 1:1 dollar value. The protocol behind BAC was designed to adjust the supply of tokens to stabilize purchasing power, similar to how central banks trade fiscal debt without collateral.

BAC comprises three exchangeable tokens: Basis Share, Basis Bond, and Basis Cash.

However, Basis Cash failed to be a reliable stablecoin, as it depegged from the U.S. dollar. As a result, investors lost trust in the coin, and today, it trades below $0.01.

Ampleforth (AMPL)

Ampleforth is a protocol that operates on the Ethereum blockchain and aims to maintain the value of its cryptocurrency asset, AMPL, at an equal value to the U.S. dollar.

The team behind the project includes Evan Kuo, a serial entrepreneur, and Brandon Iles, an ex-senior software engineer at Google. The Ampleforth Foundation is the management and development firm for the protocol and has around a dozen team members listed on their LinkedIn page.

AMPL is a rebase stablecoin, meaning holders receive a fixed percentage of the total circulating base supply rather than a fixed number of tokens.

The total supply expands or contracts based on the current token price. If the AMPL price exceeds $1, the protocol increases the circulating supply and distributes newly minted tokens to existing holders. If the AMPL price drops below $1, the token supply decreases and all Ampleforth wallets are affected.

The percentage of tokens AMPL holders hold remains unchanged, even after a rebasing algorithmic stablecoins event. Rebase events happen once per day and are considered positive if the price rises above $1.06 and negative if it falls below $0.96.

The system’s overall goal is to create incentive mechanisms for the market forces to keep AMPL’s price stable at $1.

TerraUSD (UST)

TerraUSD (formerly Terra Classic) seeks to uphold a 1:1 peg to the US dollar with its stablecoin, TerraUSD (UST). It is intended to benefit the Terra ecosystem by offering a scalable solution for dApps. 2018 saw the creation of the UST by Terraform Laboratories under the direction of Do Kwon and Daniel Shin.

Based on a seigniorage mechanism, this stablecoin strives to maintain the peg to the US dollar through the efforts of arbitrageurs. In addition to serving as a network governance token, LUNA, Terra’s native unstable cryptocurrency, is employed to maintain regular pricing for the UST stablecoin.

UST closely collaborates with LUNA, an elastic token that adjusts its quantity to maintain the stability of the stablecoin and promote arbitrage. If you purchase UST stablecoin, they must first mint UST by exchanging their money for LUNA tokens. These LUNA tokens then go through a process known as burning crypto, reducing the amount of LUNA in circulation and somewhat raising the price.

On the other hand, minting LUNA requires converting UST stablecoins, which increases the cost of UST slightly.

USDD

USDD is a decentralized stablecoin for the Tron ecosystem, launched in May 2022 by Tron founder Justin Sun. It aims to provide users with a stable store of value and facilitate seamless transactions within the Tron network.

UXD

This Solana blockchain stablecoin is algorithmic and fully backed by a delta-neutral position.

Types of Algorithmic Stablecoins

There are three algorithmic stablecoins, each using a different algorithm to keep its value stable. Let’s look at the three most common types: rebase, seigniorage, and fractional.

• Rebase algorithmic stablecoins use a method where the supply of the stablecoin is adjusted to maintain its peg to the US dollar. If the price of the stablecoin rises above $1, new coins are minted, and if the price drops below $1, coins are burned.
• Seigniorage algorithmic stablecoins use a multi-coin system to stabilize the stablecoin price. This model usually combines protocol-based mechanisms with free market mechanisms that encourage market participants to buy or sell other coins to push the stablecoin’s price to maintain its peg.
• Fractional algorithmic stablecoins combine the previous two methods, partially backed by collateral and having an algorithm that adjusts the supply of stablecoins as needed. Frax Finance is a pioneer in this type of algorithmic stablecoin.

Advantages of Algorithmic Stablecoins

• Low fees: Algorithmic stablecoin projects offer lower costs than other financial products.
• Increased Privacy: Using a decentralized system, algorithmic stablecoins provide more Privacy for users.
• Global accessibility: Stablecoins can be accessed by anyone with internet access, making payments and investments worldwide more accessible.
• Speed and efficiency: Transactions are faster and more efficient than traditional currencies, allowing quick payments and investments without waiting for a third party.

Disadvantages of Algorithmic Stablecoins

• Price volatility: Stablecoins can still experience price fluctuations, making it difficult for users to predict their value.
• Regulatory uncertainty: Stablecoins are subject to the same regulations as traditional currencies, making it difficult for governments and regulators to monitor their use.
• Lack of liquidity: A stablecoin may need more liquidity if it is not widely traded or accepted, making it harder for users to exchange their holdings for cash or other assets.

Risks Associated With Algorithmic Stablecoins

Algorithmic stablecoins come with risks that could be tenuous during financial crises or periods of extreme volatility. Here are some potential dangers to stablecoin price:

Market Risk

Algorithmic stablecoins may be influenced by decreased or increased supply each time the market fluctuates. The algorithm generates more tokens if the coin’s price exceeds its value.

These tokens circulate on the network, and if the price drops below the certain value, the algorithm burns the tokens.

This reduction in supply is compensated for by offering bonds to buyers, who get paid only when the price rises above the valued price.

Oracle Smart Contract

Dependence on Oracle technologies causes a communication barrier, as blockchain technology cannot obtain data beyond their protocol.

Prices from exchanges are obtained by oracles, which are then compared, and necessary adjustments are made to keep the system in balance.

It is difficult to maintain the oracles’ accuracy, which is something developers or project managers must do.

Peg Separation

Peg break, or the risk of peg separation, occurs when a chain breaks away from the parent chain.

This is a worst-case scenario for any stablecoin, as it can destabilize the algorithmic stablecoins and cause price fluctuations that could potentially kill the entire project.

Are Algorithmic Stablecoins Safe?

Stablecoin investments might be dangerous and vulnerable to external shocks if not adequately backed because the stablecoin market is unregulated.

The risk of depreciation grows when stablecoin production is tied to the price of the blockchain’s governing token.

Before investing in stablecoins or other digital money, you must learn about and comprehend the token you buy.

Learn more about what Stablecoins are and how they work.

Uses for Algorithmic Stablecoins

Algorithmic stablecoins offer a decentralized alternative to traditional stablecoins by eliminating third-party involvement.

This allows for easy trading, staking, and lending on cryptocurrency networks without requiring large capital reserves.

They can also be traded on crypto exchanges, saving investors trading fees. By exchanging fiat money for a stablecoin, investors can then exchange it for other cryptocurrencies without first exchanging it for fiat currencies like U.S. dollars.

Top Algorithmic Stablecoins to Consider

If you’re looking for some of the best algorithmic stablecoins that are popular right now and won’t go down the same path as TerraUSD, here are some options to consider:

DAI

DAI is one of the most popular algorithmic stablecoins available today. It’s an Ethereum-based stablecoin that utilizes the Maker Protocol and the MakerDAO decentralized autonomous organization to issue and develop DAI.

This decentralized and automated model makes it a go-to choice among algorithmic stablecoins. DAI’s soft peg to the US dollar is a clear advantage for users, and a mix of many different cryptocurrencies backs it.

Frax

Frax is another excellent example of an algorithmic stablecoin that can be better than TerraUSD.

The Frax Protocol is one of the first algorithmic stablecoin systems that work as an open-source and permissionless cryptocurrency entirely on the Ethereum blockchain.

The Frax protocol aims to provide a highly decentralized, algorithmic, and scalable stablecoin that serves the DeFi money market.

You can mint, redeem, and stake Frax as it uses two stable assets: Frax stablecoin and Frax Shares utility and governance tokens.

Empty Set Dollar (ESD)

Empty Set Dollar, or ESD, is a decentralized, oracle-oriented stablecoin that combines multiple advantages, including new protocol mechanisms, composability, and decentralization.

It’s a promising contender from the list of algorithmic stablecoins for the DeFi sector. ESD token holders can avoid actively maintaining the price peg by using it in dApps, and it’s also a stablecoin that doesn’t require committing funds to a centralized provider.

Magic Internet Money

Magic Internet Money is another algorithmic stablecoin worth trying. You can find it on crypto exchanges like Curve Finance, Uniswap, and PancakeSwap.

The platform allows users to deposit their interest-bearing assets and use them as collateral for borrowing the stablecoin.

Also Read: Best Cryptocurrency apps

Factors That Influence Algorithmic Stablecoins’ Effectiveness

To determine the effectiveness of algorithmic stablecoins, it’s essential to consider certain factors and metrics that evaluate their performance.

Let’s take a look at some of the factors that influence the effectiveness of algorithmic stablecoins and their price stability:

Governance

Most algorithmic stablecoins operate as Decentralized Autonomous Organizations (DAO), but only a few have an active community that consistently implements improvement proposals.

Smart contract governance has become a popular choice for algorithmic stablecoins. Ensuring fair token distribution and offering governance rights to every stakeholder is crucial.

Some algorithmic stablecoins have started to follow centralized governance.

Read More: What is a Governance Token?

Incentives

Some algorithmic stablecoins use rebase mechanisms to incentivize traders. This same mechanism adjusts the number of tokens in circulation without changing the token’s value.

Other protocols offer rewards and benefits for participating in alternative investments, such as burning coupons or adding supply if there is too much demand.

Rebase Mechanism

This mechanism automatically adjusts the number of tokens in circulation based on the token’s price fluctuations.

Token Adoption Rate

The token adoption rate is essential when choosing an algorithmic stablecoin to invest in. Most protocols are adopted by a few decentralized finance (DeFi) projects, but Automated Market Makers (AMM) are not among them.

This potentially decreases the utility of algorithmically-based tokens. A limited token adoption rate might introduce a limited period to maintain price stability because of slower liquidity growth.

Case Study: TerraUSD (UST)

In April 2022, the crypto market experienced one of its worst crashes, the TerraUSD Crash. As of May 20, 2022, the market is still struggling to recover.

Many cryptocurrencies experienced significant losses during this crash, but stablecoin TerraUSD (UST) and its sister token, Terra blockchain’s native token LUNA, were hit particularly hard.

UST, an algorithmic stablecoin, saw its value drop from $19 billion to $1 billion in just one week. As news of the crash spread across various crypto-related sites, the topic of algorithmic stablecoins became a hot topic.

People had previously held UST because of the Anchor Protocol, which acted like a “savings account” for cryptocurrency and paid a high, steady interest rate of 20%. Many people had parked their UST with Anchor Protocol.

However, in March of that year, news broke that Anchor Protocol would replace the 20% rate with a variable one.

This led to a mass exit from the Anchor Protocol, with large amounts of UST being withdrawn simultaneously.

In a panic, traders started selling off their UST and LUNA tokens. Another group of investors began swapping their UST for other stablecoins on Curve Finance. Additionally, UST was burned in exchange for more LUNA, with this combination causing the supply of LUNA to skyrocket and its price to plummet.

In its purest form, this series of events led to the mass dumping of UST which caused the UST-LUNA balancing mechanism to malfunction, and both coins lost most of their value.

It was reportedly unsuccessful when the Terra ecosystem’s Luna Foundation Guard (LFG) reserve fund tried to maintain the UST peg with a $3B attempt.

Final Thoughts on the Future of Algorithmic Stablecoins

Despite algorithmic stablecoins appearing to be a good idea, much work must be done by the ecosystem before they can be trusted as a source of stable value.

This is because no algorithmic stablecoin has been able to ensure price stability continuously. This is why speculative arbitrage traders are more likely to use them than long-term investors.