Financial markets, which are built on speculation, are a natural breeding ground for volatility. The cryptocurrency market, in particular, is infamous for its extreme volatility due to a multitude of factors including the relative lack of liquidity, regulatory concerns, adoption-related developments, and media hype.
Having said that, what are your options as a participant in this market? It is a good decision for most people to convert a portion of their holdings into a reserve currency during periods of extreme volatility. Stablecoins are pegged to fiat currencies like the dollar and some favour more volatile assets such as Bitcoin. In recent years, more and more people have taken up the use of algorithmic stablecoins due to concerns about safety and regulations within the ecosystem of stablecoins.
Here we explain what exactly algorithmic stablecoins are, why they are vital to the crypto ecosystem, and if they are actually safer than centralized stablecoins like BUSD, Tether, etc.
The Different Variants of Stablecoins
It is important to understand how different types of stablecoins work in order to better grasp algorithm-based stablecoins. As a result of their massive market presence, stablecoins have enjoyed great success. Over the course of one year, stablecoin supply has grown by 493%.
At the beginning of 2020, stablecoins were worth $5.9 billion, but by 2021, they became worth more than $35 billion. A huge plus is the continued push for the DeFi market, which has contributed immensely to the impressive growth of stablecoins. There are three basic categories of stablecoins, including:
- Off-chain collateralized stablecoins
- On-chain collateralized stablecoins
What are Algorithmic Stablecoins?
Let's examine the phrase in more detail: In computer programming, an algorithm is a series of instructions that a program or application executes automatically when certain conditions are met.
Crypto assets and tokens known as stablecoins are based on particular currencies or assets, which are expected to remain consistent regardless of market conditions.
By definition, an algorithmic stablecoin is one that is pegged to a decentralized, self-sustaining economic system or protocol. In terms of how they accomplish this stability, supply manipulation is the most common method.
For algorithmic stablecoins, the supply is increased and decreased automatically through functions of minting or burning tokens to maintain the peg through the automatic mechanism of economics and protocol. According to the current market, the majority of algorithmic stablecoins are non-collateralized, meaning they lack any kind of economic backing or real-world reserves.
Why do we need Algorithmic Stablecoins?
You may remember the Tether incident from last year. The worry is that centralized stablecoin issuers may not be adhering to their advertised claims of fully collateralized treasury or reserve structures.
Furthermore, centralized stablecoin issuers are also vulnerable to all sorts of interference via 'regulation' by government agencies of the jurisdictions where they are incorporated. If a government freezes the bank accounts of a stablecoin issuer in any such country, the stablecoin becomes worthless and its redeemability becomes zero, as a result. Although it may seem more likely than not, it is a very real possibility.
On the other hand, an algorithmic stablecoin project should not be subject to any legal regulation as long as it is decentralized and independent of any fiat-based reserves. A truly decentralized and independent international financial system will resonate strongly with those who are committed to that concept. Don't trustless transactions form the basis of cryptocurrency?
Types of Algorithmic Stablecoins
Various algorithmic stablecoin projects have launched over the years, but this article highlights just a few of the many and diverse ways these projects have used algorithmic mechanisms to maintain their price pegs. They can be broadly divided into four categories:
- Rebasing Algorithmic Stablecoins
- Seigniorage Algorithmic Stablecoins
- Over-collateralized Algorithmic Stablecoins
- Fractional Algorithmic Stablecoins
Rebasing Algorithmic Stablecoins
In 2004, the Rebasing Algorithmic Stablecoin was first proposed as a decentralized algorithmic stablecoin. With this model, the token price is stabilized by reducing the token supply by rebasing it. How is this done? To put it in simpler terms, all wallets that hold these tokens see their total supply either decrease or increase on a daily basis. As a result of price increase or decrease, token supply increases or decreases proportionally.
Seigniorage Algorithmic Stablecoins
In currency terms, seigniorage is the difference between the face value and the production costs of a coin. Simply put, it involves a system wherein network participants are incentivized to mint and burn a token so as to maintain its value. To maintain its price peg, the 'Seigniorage Algorithmic Stablecoin' model uses multiple tokens. The main token is pegged to a fixed value and one or more tokens provide incentives to keep it pegged to that value.
Over-collateralized Algorithmic Stablecoins
Let me be very clear before we explore this specific model that most people consider algorithmic stablecoins entirely derived from algorithms (i.e. anti-collateral). I acknowledged at the beginning of this article that the definition of an algorithmic stablecoin includes any model that maintains its peg without relying on trust. As a result, I find it necessary to include one of the biggest stablecoins in the decentralized ecosystem - DAI, you guessed it.
Fractional Algorithmic Stablecoins
The algorithmic stablecoins presented here are best thought of as a love child between seigniorage stablecoins and collateralized stablecoins. Stablecoins that are fractional algorithmic have similar multi-token systems to seigniorage stablecoins, which usually involves a secondary token that is added to the stablecoin to mint it.
Stablecoins using fractional algorithmic technology seek to bridge the gap between purely algorithmic currencies like UST, AMPL, BAC, etc., and purely collateralized currencies like USDC, USDT, BUSD, etc. To accomplish this, they partially collateralized themselves by burning USDC tokens that drive the DEFI ecosystem and partially collateralizing themselves with fiat-backed stablecoins like USDC. A fractional algorithmic stablecoin's ultimate goal is capital efficiency. Thus, stablecoins tend to have lower fractional reserves in the long run because this provides them with more value for their tokens compared to their reserves.
The case against Algorithmic Stablecoins
While algorithmic stablecoins are promising, they also present their own set of challenges. The biggest issue is the challenge of creating a mechanism that can sustain its peg maintenance. Different algorithms have been tried by many algorithmic stablecoins, but less than half have been successful. There are two primary factors that determine an algorithmic stablecoin's long-term viability:
- A positive incentive loop.
- The ecosystem's utility of secondary tokens.
When users remain trusting in the stability of the stablecoin, a positive incentive loop works, maintaining the price of the stablecoin. In the case of purely algorithmic stablecoins such as the seigniorage model, they are more prone to a negative feedback loop failure during times of high volatility, leaving users' trust in the token weakened because of its lack of inherent value. Additionally, fractional stablecoins are vulnerable to this particular risk, but their partial collateralization provides a greater level of protection.
Often, stablecoins with multiple tokens fail because they are unable to balance the risk-reward ratio of their secondary tokens below a certain demand level. Due to the lack of utility that secondary tokens usually offer, the primary token's price is kept stable by the secondary token.
If a certain price level is broken, the algorithmic stablecoin descends into a death spiral. A few multi-token stablecoin projects such as Terra Stablecoin have achieved a perfect balance by using LUNA tokens to pay for network gas costs, while others, such as the Terra Stablecoins, have not yet managed to achieve this. Due to the utility provided by the secondary token, the primary stablecoin token has high price confidence from investors.
Algorithmic Stablecoin regulations
Regulatory clarity regarding algorithmic stablecoins in any jurisdiction in the world has not yet been reached as of this writing. It's safe to assume, however, that algorithmic stablecoin projects, as long as they remain decentralized, will be exempt from securities classification.
It is without a doubt that algorithmic stablecoins have provided the best prospects for ensuring decentralization without government regulation. Stablecoins have the foundational advantage of being scalable compared to other solutions. Furthermore, because no tangible assets are required to back up non-collateralized stablecoins, human error is also reduced.
Stablecoins based on algorithms utilizes transparent, auditable code, making them attractive to build trust. You will be able to learn more about algorithm stablecoins, the metrics that determine their success, and the risks associated with them by understanding the different types. It is important to learn about algorithm-backed stablecoins as they emerge in the crypto ecosystem and the value they can provide. Get familiar with stablecoins today!