How Algorithmic Stablecoins Work: A Beginner’s Guide to Understanding Crypto Stability
Following the recent SEC Lawsuit against Paxos the issuer of BUSD — the third biggest stablecoin, there might be a major shift towards a more decentralized version of Stablecoins — the Algorithmic Stablecoins.
Algorithmic Stablecoins aims to provide price stability to users by using mathematical algorithms instead of traditional collateralized reserves. Algorithmic stablecoins have gained significant attention in recent years as they offer the potential for a stable and decentralized financial system.
In this article, we’ll explore the following:
- What Algorithmic Stablecoins are,
- How Algorithmic Stablecoins work,
- Types of algorithmic stablecoins,
- Benefits of Algorithmic Stablecoins, and
- Risks associated with Algorithmic Stablecoins.
What are Algorithmic Stablecoins?
Algorithmic stablecoins are cryptocurrencies designed to maintain a stable value relative to a specific benchmark or asset. They are called “algorithmic” because their price stability is achieved through the use of complex algorithms that adjust the supply and demand of the stablecoin to maintain a target price.
Unlike traditional stablecoins that are backed by fiat currency or other physical assets, algorithmic stablecoins are not pegged to any tangible asset. Instead, they use a combination of market mechanisms and mathematical formulas to keep their value stable.
One of the most common approaches used by algorithmic stablecoins is the use of an “elastic supply” mechanism. This mechanism involves the issuance and burning of tokens based on the demand for the stablecoin. If the price of the stablecoin is above its target value, the algorithm will trigger a supply expansion by minting new tokens. Conversely, if the price falls below the target, the algorithm will trigger a supply contraction by burning existing tokens thereby maintaining its peg.
How Algorithmic Stablecoins Work
Algorithmic stablecoins use a decentralized approach to maintaining supply, demand, and target price without regulatory or centralized involvement.
Algorithmic Stablecoins use an Ethereum-based cryptocurrency protocol to prevent price de-pegging. A smart contract/ algorithm fetches the price from different exchanges, which is passed to a rebase contract every 24 hours to determine if the supply needs to be expanded or decreased.
The algorithm then burns or mints tokens based on the current price, with burning occurring if the price increases from the stable value and minting occurring if the price drops below it.
The role of smart contracts in maintaining algorithmic stablecoins stability
Smart contracts are an integral part of algorithmic stablecoins, ensuring their stability by automating the processes that govern the supply and demand of the stablecoin. The smart contract is responsible for executing the algorithm that adjusts the supply of the stablecoin in response to changes in demand, ensuring that its value remains stable. It also ensures that the stablecoin is backed by sufficient collateral, which can be in the form of other cryptocurrencies or assets like fiat currency or commodities. Smart contracts use advanced cryptographic techniques to secure transactions and ensure that they are transparent and immutable, which makes them a vital component of algorithmic stablecoins.
The role of the market in maintaining algorithmic stablecoins stability.
The market plays a critical role in maintaining the stability of algorithmic stablecoins. The stability of an algorithmic stablecoin is dependent on the demand and supply of the stablecoin in the market as any significant changes in demand or supply can impact its stability.
If the demand for the stablecoin increases, its value will increase as well, and the smart contract will respond by increasing the supply of the stablecoin. If the demand decreases, the value will decrease, and the smart contract will respond by decreasing the supply of the stablecoin.
Therefore, market participants who hold algorithmic stablecoins have a direct impact on their stability. If they buy or sell large amounts of the stablecoin, it can significantly affect the market’s supply and demand, causing the stablecoin’s value to fluctuate as can be seen in the case of Luna and TerraUST.
Moreover, market participants also play a critical role in providing liquidity to the algorithmic stablecoin market. Liquidity providers ensure that there is enough liquidity to facilitate the buying and selling of the stablecoin, which contributes to its stability.
Types of Algorithmic Stablecoins
While different algorithmic decentralized stablecoins have varied features or traits, they generally follow the same protocols. Following are the different types of algorithmic stablecoins.
Rebase algorithmic stablecoins
The basic idea behind rebase algorithmic stablecoins is to use a mechanism that adjusts the supply of tokens based on the price of the underlying asset or basket of assets. This mechanism is typically triggered at regular intervals, such as every 24 hours or every week, and adjusts the supply of tokens in response to the price of the underlying asset relative to the target price.
For example, if the target price of a rebase algorithmic stablecoin is $1 and the price of the underlying asset is $1.05, the supply of tokens will be increased to reduce the price per token to $1. Conversely, if the price of the underlying asset falls below $1, the supply of tokens will be decreased to increase the price per token back to $1.
Seigniorage Algorithmic Stablecoins
Seigniorage algorithmic stablecoins utilize the multi-coins system. Here, a specific stablecoin is set to be stable and at least one other coin is designed to facilitate such stability. These stablecoins use an algorithm that automatically expands or contracts the other coin’s supply to maintain its price stability.
Let’s take for instance a stablecoin STAK and its pegged token CLIFF. When the price of the stablecoin STAK rises above $1, the algorithm burns the stablecoin and mints more of the other coins CLIFF to sell on the market to maintain the peg. When the price of the STAK is below $1 a portion of CLIFF will be burned and more STAK will be minted to balance the supply and demand. Examples of seigniorage algorithmic stablecoins include TerraUSD (UST), Basis Cash (BAC), Nubbits (USNBT), and Empty Set Dollar (ESD).
Fractional-algorithmic stablecoins
Fractional algorithmic stablecoins are a combination of the previous two types of algorithmic stablecoins. Fractional algorithmic stablecoin maintains its value by being partially backed by collateral (e.g. fiat currency) and having an algorithm that modifies the stablecoin supply as needed.
Frax Finance is the pioneer in this type of algorithmic stablecoin blockchain network with the Frax Protocol Stablecoin (FRAX).
Benefits of Algorithmic Stablecoins
Algorithmic stablecoins offer several benefits compared to traditional stablecoins. Here are some key advantages:
- Decentralization
Algorithmic stablecoins are typically built on decentralized blockchain networks, making them resistant to a central authority or control. This means that the supply and demand of the stablecoin are determined by a mathematical algorithm, rather than a central authority like a government or central bank.
- Flexibility
Algorithmic stablecoins are designed to be more flexible than traditional stablecoins, allowing for greater adaptability to market conditions. The algorithms used to determine the supply and demand of the stablecoin can be adjusted to maintain the peg, even in times of extreme market volatility.
- Transparency
Algorithmic stablecoins are transparent, with all transactions recorded on a public blockchain ledger. This transparency allows for greater trust and accountability, making it easier for investors to monitor the performance of the stablecoin.
- Lower costs
Algorithmic stablecoins can potentially offer lower transaction fees compared to traditional stablecoins, as they do not require a central authority to maintain the peg. This can make them more attractive to investors looking for lower-cost alternatives to traditional stablecoins.
- Potential for growth
Algorithmic stablecoins have the potential for growth and adoption, as they are not tied to a specific fiat currency. This allows for greater global reach and potential adoption, as investors from around the world can participate in the stablecoin ecosystem.
Overall, algorithmic stablecoins offer several benefits that make them an attractive option for investors looking for stablecoin alternatives. However, it is important to consider the potential risks and conduct proper due diligence before investing.
Risks associated with Algorithmic Stablecoins
Algorithmic stablecoins come with potential risks that should be considered before investing. One such risk is the possibility of instability during periods of financial crisis or extreme market volatility. Here are three key risks associated with algorithmic stablecoins:
- Market Risk
Algorithmic stablecoins face the risk of supply fluctuations when the market fluctuates. When the digital asset’s price exceeds the valued price, the algorithm generates more tokens that are circulated on the network for potential traders to purchase. Conversely, when the price drops below the valued price, the algorithm burns tokens to reduce the supply. To compensate for the reduction in supply, bonds are offered to buyers, who only get paid if the price rises above the valued price.
- Oracle Smart Contract
Reliance on oracle technologies creates an information bottleneck since blockchains cannot access data outside their protocol. Oracles are used to obtain prices from exchanges, compare them, and adjust the system to maintain balance. However, the data obtained must be accurate with respect to the current price. It can be a challenge for developers or project managers to maintain the oracles’ accuracy, making it a potential risk.
- Peg Separation
Algorithmic stablecoins are at risk of peg separation, which 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 eventually lead to the failure of the entire project.
It is essential to consider these risks before investing in algorithmic stablecoins. Proper analysis and understanding of the potential risks can help investors make informed decisions and minimize their exposure to market volatility.
Future Outlook for Algorithmic Stablecoins
While algorithmic stablecoins sound great in theory, they have a ways to go before they are trusted as stable stores of value. Algorithmic stablecoins exemplify a unique trait of being partly monetary economics, partly financial markets, mathematics, and technology. Sitting at the intersection of money and blockchain technology, they are new and complex — and pose many challenges and unanswered questions over how the future of DeFi will unfold.
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