Cryptocurrencies are highly volatile, depending on factors such as market conditions and the supply and demand of the cryptocurrency. For these reasons, the level of risk can be frightening for some people. Algorithmic stablecoins, a subspecies of stablecoins, a class of crypto assets that have become an integral part of the ecosystem over the past few years, use technology to help automate the trading process.
What is a stablecoin?
Stablecoin is a type of cryptocurrency that offers better stability compared to its peers, as it derives its price from the value of another asset. The process of pegging a stablecoin to an underlying asset is the main reason for its growing popularity in the crypto world. Reports show that the total supply for stablecoins has grown by 493%, from $5.9 billion in 2020 to over $35 billion in early 2021. Meanwhile, stablecoin usage increased by 500% between October 2020 and October 2021.
Stablecoins facilitate trading on crypto exchanges, including staking and lending activities in the crypto network. In addition, stablecoins can also be used to reduce trading fees on most exchanges, as there are no fees.
Traders have the option to exchange the fiat currency for a stablecoin and then exchange the stable currency for another cryptocurrency, thus saving on transaction fees. Rather than buying Bitcoin directly with the fiat currency (for example, the US dollar), traders often exchange the fiat currency for a stablecoin and then make a trade for another cryptocurrency such as Bitcoin with the stablecoin.
Most traditional stablecoins are managed by a de facto central governing authority. When you buy a stablecoin, you agree that the issuer has sufficient assets pegged to the stablecoin. A stablecoin’s value will not fluctuate much over time if pegged to a relatively less volatile commodity. To understand the value of a stablecoin, here is a simple explanation:
USDT is a stablecoin pegged to the US dollar. If you keep 1 USDT in your wallet, its value is 1 USD. You can then trade stablecoins for any cryptocurrency without the risk of incurring huge losses associated with market fluctuations.
Algorithmic Stable Coins
Algorithmic stablecoins do not have any collateral attached to them. For this reason, they are referred to as “unsecured” stablecoins. They are decentralized in nature and adapted to improve market price stability without involving a central authority, this is often done by “preprogramming” supply to meet demand for the asset. This is done using predetermined stabilization measures coded into smart contracts in Ethereum.
The underlying algorithm of these stablecoins is programmed to increase the money supply if there is a “deflationary trend” in the token and to decrease the money supply if there is a “decrease in purchasing power”. The way these algorithmic stablecoins respond to market events with automated stabilization measures gives rise to a smart, responsive currency that is not controlled by a single institution, similar to the central bank’s operating model, enhancing their decentralized nature.
These purely algorithmic stablecoins expose the internal logic of the tokens and any collateral used to protect the token value, thus maintaining transparency in the network.
How Do Algorithmic Stablecoins Work?
- An algorithmic stablecoin stabilizes the market through mechanisms to buy and sell the referenced asset or derivatives. It uses an Ethereum-based cryptocurrency protocol that prints money when the price rises and buys from the market when the price falls.
- Algorithmic stablecoins work like this:
- An oracle contract is required to help the smart contract communicate outside the blockchain. This oracle contract helps to get the algorithmic stablecoin price from different exchanges.
- This stablecoin price is then transferred periodically (every 24 hours) to a restructuring contract so that the contract can determine whether the supply needs to be expanded or reduced.
- The contract then starts counting the number of tokens that must be burned and minted from the wallet of each user associated with the contract. The basic logic used is that if the price of the coin rises from the predefined fixed value, the algorithm will start burning the tokens. Conversely, if the price of the token falls below the predefined fixed value, the algorithm will issue new tokens.
Main Features
Some features of algorithmic stablecoins include
1. Limited Price Fluctuation = Value Added
Stable cryptocurrencies are stores of value due to their associated limited price volatility and ease of use. Thus, stablecoins can be easily used for cross-border transactions. These stablecoins also unlock collateral diversity, creating resilience to hyperinflation and market instability.
2. Market Sensitive Responses
The parameters of the hard-coded algorithm to smart contracts enable automatic response to market data without direct manual intervention. These parameters aim to balance the market supply and demand for these tokens after examining the underlying market conditions.
3. Security
Using a private key, stablecoins can be stored in virtual wallets to ensure security. Only the stablecoin holder can access the relevant funds. Advanced encryption technology can be leveraged for additional levels of security.
Uses of Algorithmic Stable Coins
Algorithmic stablecoins among traditional stablecoins It provides true decentralization in the stablecoin market by eliminating third-party interference, a popular mechanism. These stablecoins eliminate the problems associated with raising enough capital to serve as a reserve.
Algorithmic stablecoins can be used to trade on crypto exchanges, including staking and lending on crypto networks. Investors can avoid transaction fees imposed by most exchanges when exchanging the US dollar for a stablecoin. Instead, they can exchange the fiat currency for a stablecoin and then exchange the stable currency for another cryptocurrency.
Types of Algorithmic Stable Coins
Although different algorithmic decentralized stablecoins have various features or attributes, they generally follow the same protocols. Below are the different types of algorithmic stablecoins.
1. Algorithmic Stable Coins Reprint
By algorithmically rebasing stablecoins, the supply regulates their value. The algorithm in the restart mechanism automatically reduces the supply of coins when their price drops below a threshold and issues additional coins when they rise above a certain level. This mechanism maintains the value of the coin regardless of market conditions. The idea is to make sure that if you own 1% of the supply before rebase, you will have 1% after the supply, even if the number of tokens in your wallet fluctuates. This means that you protect your share of the network regardless of the local token’s price.
2. Seigniorage Algorithmic Stable Coins
In the Seigniorage Algorithmic Stablecoin model, instead of a “rebasing” currency, there are two tokens: a supply-flexible currency and investment shares of the network. The holders of the latter are the sole recipients of inflationary rewards and the sole bearers of the debt burden.
3. Over-collateralized Algorithmic Stables
Over-collateralized stablecoins require a large number of cryptocurrency tokens held as backups to issue fewer stablecoins. This is done as a buffer against price fluctuations. An example of an overcollateralized stablecoin is MakerDAO’s ETH cryptocurrency-collateralized DAI. This stablecoin requires a minimum margin of 150%. This means that if the price of the underlying cryptocurrency drops enough, stablecoins will be automatically liquidated.
4. Fractional Algorithmic Stable Coins
Fractional algorithmic stablecoins are partially collateralized and supported by both asset collateral and cryptographic algorithms. This protocol uses two different assets, the Frax (FRAX) stablecoin (1:1 to the US dollar) and the Frax Share (FXS) governance and utility token. A user can issue FRAX by providing the USDC stablecoin as collateral along with the FXS token in accordance with the amount determined by the Frax margin rate (CR).
Potential risk
The potential risk associated with algorithmic stablecoins is that they can be weak during times of financial crisis or extreme volatility. Here are some of these risks.
1. Affected by Market Risk
Algorithmic stablecoins are at risk of decreasing and increasing supply each time the market fluctuates. In cases where the price of the digital asset exceeds the valued price, more tokens are generated by the algorithm. The newly created tokens circulate on the network to be purchased by potential traders. If the price drops below the valued price, the algorithm burns the tokens. This reduction in supply is compensated for by offering bonds to buyers who receive payments only when the price rises above the value price.
2. Oracle Smart Contract
Relying on Oracle technologies creates an information bottleneck because blockchains cannot access data outside of their protocols. Oracles are used to get quotes from exchanges, compare those prices and adjust the system to maintain balance. In addition, the data obtained must be accurate with respect to the current price. Maintaining the accuracy of Oracles is a challenge for developers or project managers.
3. Peg Separation
When a chain breaks from the main chain, there is a risk of Peg Separation (peg breakage). This is the worst case scenario for any stable currency as it can destabilize algorithmic stablecoins and cause price fluctuations that can eventually kill the entire project.
Best Algorithmic Stable Coins
1. DefiDollar (DUSD)
DefiDollar protects users from counterparty risk, holdings seizure risk and bank run risk etc. It aims to be a stablecoin index that uses decentralized finance (DeFi) primitives while subsidizing the collateralization rate to protect it. DefiDollar indexes floating stablecoins with a single token (DUSD) where investors protect users from the fundamental risks associated with such tokens.
2. Empty Set Dollar (ESD)
Empty Set Dollar (ESD) offers a combination of decentralization, new protocol mechanisms, and composability that makes it a central part of the DeFi space. ESD is a decentralized oracle-focused stablecoin that uses new protocol mechanics to overcome the declines of other rebasing tokens. Token holders who do not wish to actively maintain price fixation can use ESD in DApps or hold it as a stablecoin without needing a counterparty or depositing funds in a CDP and worrying about the amounts in their wallets changing.
3. Frax (FRAX)
Frax provides liquidity provider (LP) tokens to various trading pairs on Uniswap, a DeFi money market including services such as staking as well as minting and using the FRAX stablecoin serves as The Frax crypto protocol uses two different stable assets: Frax stablecoin (FRAX) and Frax Shares (FXS) governance and utility token, pegged at 1:1 USD.
4. Ampleforth (AMPL)
Ampleforth is a decentralized stablecoin that maintains price stability with a flexible supply. Rebase is used by the base protocol to adjust the daily AMPL supply. This provides better price stability compared to fixed-supply cryptocurrencies. Ampleforth’s stable coin, AMPL, is flexible and non-dilutive.
Are Algorithmic Stable Coins a Good Investment?
Algorithmic stablecoins aim to offset market volatility by using coded smart contracts to automatically reduce or increase the supply of cryptocurrencies according to market conditions. This emerging technology is considered by many investors as a potential breakthrough in the crypto world. The stablecoin market is expected to reach $1 trillion in the next two years.
In a centralized stablecoin system, investors are open to interference by government regulations in the jurisdictions they are involved in. If the government decides to freeze the issuers’ bank accounts for any reason, the stablecoin’s redeemability will be zero, thus negating its value.
Undoubtedly, the UST-LUNA collapse shook the crypto industry. Some regulatory experts say this could mark the end of algorithmic stablecoins; indeed, the future of algorithmic stablecoins looks rather bleak. For now, investors and institutions need to stay away from algorithmic stablecoins and wait for their future
Final Words
Stablecoins are a new and safer crypto investment ever accepted form. However, algorithmic stablecoins are somewhat of an exception, as they “rely [rely] on complex financial engineering to keep their value stable.” The UST-LUNA incident highlighted some potential areas of concern. Maybe the current technology is not sophisticated enough and some regulation/control is needed… Even for stable coins.
