What is Algorithm Stablecoin?
Algorithm stablecoin, which has other names such as Non-Collateralized Stablecoins or Seigniorage shares, is not pegged by any fiat or crypto currency. Instead of that, it totally depends on algorithms and smart contracts to control the supply of issued token. The financial power in non-collateralized stablecoins does not rely on a central entity but a formula derived from demand-supply. Functionally, its monetary policy shares some similarities to the mechanism of how Central Banks control their national currencies.
Basically, an algorithm stablecoin system will reduce the token supply if its price remains under the price of the fiat currency it was backed by (for example, USD). If its price exceeds the fiat one, additional tokens will be issued until price returns to be equal or under the fiat’s price. Ampleforth (AMPL) is an Ethereum-based cryptocurrency protocol with an algorithmically adjusted circulating supply.
Let’s take a look at how AMPL works!
Basically, Ampleforth adjusts its supply based on demand. When demand goes up, the total supply of AMPL increases and when demand goes down its total supply decreases. We have an example to explain as below.
Alice has 1 AMPL in her wallet worth 1$USD. However, the demand for AMPL suddenly rises, which makes the market price for AMPL jump to 2$USD per AMPL.
This is where the protocol works. The Ampleforth protocol adjusts supply, and now Alice has 2 AMPL worth 1$USD each. What is remarkable about Ampleforth is that it is non-dilutive, meaning that Alice will still have in her wallet the same percentage of Ampleforth’s total supply when it changes.
Contrary to the example of EXPANSION above, we have CONTRACTION, the state in which the supply is decreased when the demand for AMPL declines.
In conclusion, Ampleforth has 3 states: Expansion, Contraction, and Equilibrium (where no increase or decrease in supply is needed). The graph below shows the relationship among 3 states.
5% is considered the Equilibrium Threshold for the Current Price to compare with Target Price. In other words, when the Current Price passes or less 5% than Target Price, the Expansion or Contraction is automatically launched to maintain the equilibrium state.
Algorithm Stablecoins vs Asset-backed Stablecoins
Stablecoins in general and Algorithm Stablecoins in particular come with a range of different pros and cons because of their digital, programmable, and blockchain-based nature. DInSight has summarized some of the most important advantages and disadvantages of Algorithm Stablecoins for readers’ information.
Our skepticism
We doubt that algorithmic stablecoins may experience limited platform growth. In this case, when the crypto-bonds are being issued no one would buy them because their belief in the platforms has failed.
Another concern is that trading stablecoins may be trending, but they are ignoring basic economics principles, that is, in all market-based exchanges, price is determined by a meeting of the minds of a buyer and seller, not by an algorithm. This view was reported by Preston Byrne, founder of Monax, when he said that “developers of stablecoins fail to account for basic economic principles by assuming that they will always be able to incentivize users of their systems to purchase their coins at an arbitrary price.”
The potentials of algorithmic stablecoins are promising, however, there is still much skepticism around its execution. Time will tell, but it seems unlikely that these algorithmic stablecoins will be replacing national currencies any time soon.
