A Deep Dive into Algorithmic Stablecoins
How trustless code and economic incentives try to keep the value of a token pegged to a dollar.
At the time of writing, the total value of stablecoins issued on public blockchains is over $184B. At a $1.77T total market capitalization of crypto, stablecoins represent more than 10% of the value on it. In just one year this value has more than quadrupled since at the start of 2021 the market cap of these stablecoins was less than $40B. This growth portrays the importance that stablecoins serve as the option to avoid the intrinsic volatility that distinguishes crypto.
Besides its incredible growth, the stablecoin market is vastly different among its different coins. Although most of these stablecoins try to maintain a value of $1, each of them carry a different set of risks. The biggest difference between them depends on if they are controlled by an entity. Centralized stablecoins (e.g. USDT, USDC, BUSD) are collateralized by fiat and require trust in an entity to issue new coins and redeem the collateral. This fact carries a counterparty risk that many users of crypto refuse to take.
The solution for this was conceived years ago as decentralized stablecoins collateralized by crypto (e.g. UST, DAI, MIM). In this case its solvency is not determined by any trusted entity; it depends on autonomous smart contracts that react to a variety of market conditions.
Nowadays over the total market capitalization of stablecoins, 15.43% is represented by these decentralized stablecoins with more than $27bn. This figure showcases how much trust is deposited by crypto investors over the smart contracts that hold these stablecoins.
The Inner Workings
Decentralized stablecoins can be either overcollateralized (DAI, MIM, LUSD), or partially collateralized (FRAX, UST). Both of them have algorithmic mechanisms where the expansion and reduction of its supply is determined mathematically in smart contracts: an automatic stability mechanism that adjusts its supply algorithmically to peg to a price target.
Increased demand for a stablecoin means an expansion phase where the system issues new coins in order to keep the price peg back to $1. On the opposite hand, when demand decreases and contraction phases occur, the system buys off part of the supply in order to maintain the price peg at $1.
Commonly many algorithmic stablecoin protocols (UST, FRAX) use a two token model system, where one token is used to maintain the peg and another to absorb the market volatility (shares). Partial collateralization does not mean that they necessarily are undercollateralized. Only means that part of the collateral could be a volatile crypto asset which might suffer price variations and thus affect the stablecoin collateral value.
Printing Revenue
Many stablecoin protocols have integrated modules that interact with other DeFi protocols like loan markets or AMMs to issue and redeem automatically part of its supply. Maker D3M does exactly that by targeting a certain DAI borrow rate on Aave. This allows DAI borrowers to have an attractive borrow rate while allowing DAI supply to expand. Similarly, FRAX’s algorithmic market operations (AMOs) deposit into Curve, Uniswap, Compound and others to keep a tight peg of FRAX. These mechanisms have the advantage of being able to accrue protocol fees (trading fees or borrow rates) and redirect those as revenue for the holders of the governance tokens of these protocols.
Benefits and Drawbacks
The biggest benefit of algorithmic stablecoins resides in its main utility: a trustless refuge of crypto markets inherent volatility. Its decentralization makes them regulatory immune: no central authority as an issuer means inability to shut down the protocol. Furthermore, some of them are not overcollateralized, which is a massively capital efficient property (that is one of the main reasons why fiat money is created through fractional reserves in traditional banks), so their growth is not limited as much.
Decentralized stablecoins improve auditability compared to centralized options: collateral is held openly by certain smart contracts, protocol revenue, and monetary policy parameters are all fully transparent and auditable in real time thanks to the public nature of blockchains and the open source code of its smart contracts.
Among decentralized stablecoins’ drawbacks, the most notable ones are that they are not redeemable for U.S dollars since they just rely on independent actors with market incentives to perform price-stabilizing arbitrage. This arbitrage means that a support level of demand for operational stability is required, and this demand could be unstable. This instability is a vulnerability as well as the volatility of the underlying collateral that backs the protocol. A worse case scenario could induce a negative feedback loop where a sudden loss in confidence could lead to a situation where to cover a price drop in the stablecoin, more shares have to be issued to cover the redemptions of traders, leading to hyperinflation and permanent price peg loss (as happened before with IRON).
The future ahead
Exceptional market conditions such as those that happened in March 2020 are helping to test the resilience of these algorithmic stablecoins under severe situations. Overtime we will be able to monitor how well they keep their price stability and how they continue relating with their centralized counterparts. Nevertheless they aspire to be the holy grail of DeFi: trustless, stable in price, safely collateralized and capital efficient. Will any of these algorithmic stablecoins be able to achieve it in the future? Time (and the market) will tell.
