Algorithmic Stablecoins Explained in Simple Terms

Algorithmic stablecoins are a type of cryptocurrency designed to maintain a stable value, often pegged to a fiat currency like the US dollar.

They work by using complex algorithms to adjust the supply of the stablecoin in response to changes in its value, preventing it from fluctuating wildly.

These algorithms can be based on various factors, such as the price of the stablecoin in relation to a reference asset.

The goal is to create a stable and reliable store of value, similar to traditional fiat currencies.

Consider reading: Fiat Backed Stablecoin List

A stablecoin is a cryptocurrency that's designed to maintain a stable value, typically pegged to a reserve asset like the US dollar. This is different from other cryptocurrencies like Bitcoin and Ethereum, which can be quite volatile.

Algorithmic stablecoins are a type of stablecoin that uses an algorithm to achieve price stability. They're designed to issue more coins when their price increases and buy them off the market when the price falls.

A fresh viewpoint: Stablecoin Price

These coins grant traders the comfort of receiving many of the benefits of crypto assets without the risk of too much price volatility. They're a representation of true decentralization, without any regulatory bodies to maintain or watch over the proceedings.

Algorithmic stablecoins use a two-coin system, where one coin is used to "absorb" market volatility, and the other strives to keep the peg. This former token is commonly referred to as a balancer or share token.

The Terra blockchain system, for example, contains two tokens: TerraUSD, a stablecoin, and Luna, a governance token. The interaction between the two is intended to keep TerraUSD's dollar value steady.

Algorithmic stablecoins require a level of demand support for the entire ecosystem to function. However, the entire system will fail if demand falls below a certain level.

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Stablecoins are a type of cryptocurrency that maintains a stable value, usually pegged to a fiat currency like the US dollar. They're designed to reduce the volatility of cryptocurrencies like Bitcoin.

There are several types of stablecoins, including fiat-collateralized stablecoins, which are backed by a reserve of traditional currency. For example, USDT is backed by a reserve of US dollars.

Commodity-backed stablecoins are another type, which are backed by a physical asset like gold or oil. However, this type of stablecoin is less common.

Algorithmic stablecoins, on the other hand, use complex algorithms to maintain their value. They don't require a reserve of traditional currency or a physical asset.

Some stablecoins, like USDC, are fully collateralized, meaning they're backed by a 100% reserve of traditional currency. This provides an added layer of security for users.

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Algorithmic stablecoins work by leveraging a dynamic mechanism to adjust their token supply based on market forces. This is done through a process called burning, where excess tokens are removed from circulation to increase scarcity and drive up the price.

The algorithm can also increase the supply by minting more tokens to reduce the value. For example, if the stablecoin's value drops below the target value, the algorithm reduces its supply via burning, token buybacks, and locked staking.

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There are different types of non-collateralized stablecoins, such as rebasing, seigniorage, and fractional algorithmic stablecoins. Rebase mechanisms use an oracle contract to retrieve pricing information and a rebasing contract to determine whether to mint or burn tokens. Seigniorage algorithms work with two or more assets, including a stablecoin and a second token representing seigniorage ownership.

Here's a breakdown of the different types of algorithmic stablecoins:

Algorithmic stablecoins are a type of stablecoin that uses a dynamic mechanism to adjust its token supply based on market forces. They don't tie their value to external assets like collateralized stablecoins do.

One way algorithmic stablecoins work is through a process called burning, where the algorithm reduces the token's circulating supply if the stablecoin's price drops below its target value. This increases scarcity and drives up the price.

Rebase mechanisms are a type of non-collateralized stablecoin that employs an oracle contract to retrieve pricing information from other exchanges. The rebasing contract then determines whether to mint or burn tokens based on the obtained information.

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Seigniorage is another type of algorithmic stablecoin that involves issuing and redeeming two or more types of tokens. If the value of the stablecoin deviates from its intended peg, shares are used to increase or decrease the token supply.

There are three main types of algorithmic stablecoins: rebasing, seigniorage, and fractional. Rebase-style stablecoins handle price-elastic ERC-20 tokens, where the total supply is not fixed and is modified adaptively regularly.

Here are the three main types of algorithmic stablecoins:

Algorithmic stablecoins rely on independent individuals to undertake price-stabilizing arbitrage to earn market incentives. However, this can be risky, as it depends on separate, market-driven actors to execute price-stabilizing discretionary arbitrage without legal obligations.

Fractional stablecoins are a type of stablecoin that combines the best of both worlds - they're neither fully collateralized nor fully algorithmic.

Frax is a notable example of a fractional algorithmic stablecoin, which previously used a fractional algorithm that allowed for arbitrage and reduced the stablecoin supply.

The algorithmic reserve in Frax was not asset-based, but rather utilized a balancing mechanism with mint and burn. This mechanism allowed users to mint the stablecoin by depositing 92% USDC and 8% Frax's FXS token, earning a profit on the arbitrage and increasing the stablecoin supply.

In February 2023, Frax governance voted to stop using the algorithm due to the risks following Terra's collapse. This move marked a significant shift in the stablecoin's design.

Frax's two-token architecture, which includes FRAX as a $1-pegged stablecoin and FXS as a governance token, is a key feature of its fractional algorithmic design.

Peg stability is crucial for maintaining investor confidence and liquidity in algorithmic stablecoins. The collapse of Terra's UST in 2022 is a prime example of an algorithmic stablecoin failing to live up to its promise.

Algorithmic stablecoins can fail to maintain a stable peg due to weak architecture and vulnerability to depegging risk. They require a certain level of demand to function correctly and can collapse if demand falls below a specific level.

The Terra stablecoin (UST) used a two-token seigniorage scheme to stabilize the prices of Terra and Luna. However, the collapse of TerraUSD became a significant algorithmic stablecoins controversy when UST lost its dollar peg.

In times of crisis, traders acting on ambiguous information and uncertainty may cause an algorithmic stablecoin to lose value, triggering a herd mentality and massive price drop. The Terra ecosystem meltdown led lawmakers and officials to call for algorithmic stablecoins regulation to protect the crypto market from another crash in the future.

Rebasing is a mechanism used by some stablecoins to maintain price stability. It involves adjusting the supply of stablecoins based on demand.

If the demand for a stablecoin is high and its value exceeds $1, the supply will increase to bring the price back to $1. Conversely, if demand is low, the supply will decrease to raise the price to $1.

This adjustment is called "rebasing." The Ampleforth protocol, for example, has a feature called rebasing that changes the token supply. This means that the number of AMPL tokens in your wallet will vary based on the weighted average of the token price over that time every 24 hours.

A rebase-style stablecoin's total supply is not fixed and is modified adaptively regularly. The correction is made automatically using the rebase process, which gradually stabilizes the price of a target stablecoin towards a fixed peg, such as $1.

Algorithmic stablecoins first emerged in 2014 with the now-defunct Nucoins project. They aim to address the shortcomings of other types of stablecoins.

Algorithmic stablecoins are decentralized and are also more capital efficient than crypto-backed stablecoins that require overcollateralization. This is because they don't need a tangible asset backing.

Most algorithmic stablecoins are managed by decentralized autonomous organizations (DAOs), allowing changes to be made through governance votes open to all coin holders. This level of participation is unique in the crypto world.

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Fractional algorithms are a type of stablecoin mechanism that combines collateral assets with an algorithmic reserve. This unique approach allows for more stability and fewer custodial risks compared to fully algorithmic designs.

Prior to a change in February 2023, Frax, a well-known stablecoin, used a fractional algorithm that allowed users to mint or burn the stablecoin by depositing or burning a combination of USDC and FXS tokens.

Frax's algorithmic reserve was initially set at 8% of the total supply, leaving 92% collateralized by USDC. This setup enabled users to earn a profit on arbitrage, increasing the stablecoin supply when the price of FRAX went above $1.

Related reading: Usdc Stablecoin

The mechanism also allowed users to buy FRAX and burn it to receive $1 in FXS when the price fell below $1. This helped reduce the supply of stablecoins and maintained a somewhat tight peg with the US dollar.

FXS, the governance token of Frax, plays a crucial role in the collateralization of the FRAX stable asset, conferring governance rights and helping to maintain the stability of the peg.

Peg stability is crucial for maintaining investor confidence and liquidity in an asset. A stablecoin's ability to maintain its peg, or value, is its most critical feature.

The collapse of UST in 2022 was a high-profile example of an algorithmic stablecoin failing to live up to its promise. This event showed the importance of a stable peg in the cryptocurrency market.

Rebasing algorithms aim to maintain price stability by adjusting the supply of stablecoins according to demand. This adjustment is called "rebasing" and is a key feature of elastic, non-dilutive cryptocurrencies like Ampleforth (AMPL).

A user holding AMPL tokens may find the amount of tokens changes based on the weighted average of the token price over the last 24 hours. This means that users retain the same proportion of the overall supply, even as the supply changes.

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Algorithmic stablecoins are inherently weak in design, making them vulnerable to depegging risk. This is because they rely on market incentives and financial engineering to maintain a stable price, rather than actual collateral.

The demand for these stablecoins is crucial for their functioning, and if demand falls below a certain level, the system collapses. I've seen this happen in the past, where a lack of demand led to a significant depeg in the price of a stablecoin.

Stablecoins like TerraUSD are also vulnerable to traders acting on ambiguous information and uncertainty, which can cause a massive price drop. This can trigger a herd mentality, leading to a massive sell-off of the underlying stablecoin.

The Terra stablecoin (UST) is a prime example of this, where the price fell below $1 due to a massive depeg. The collapse of UST was a significant controversy in the crypto market, with many calling for regulation to protect investors.

The two-token seigniorage scheme used by Terra to stabilize the prices of Terra and Luna is also a risk factor. This scheme can create a snowball effect, where a massive sell-off of UST can lead to more Luna in circulation, causing the price of Luna to drop further.

The Terra ecosystem meltdown was a perfect storm of events that led to the depeg of UST and the subsequent collapse of the Terra ecosystem. It's a cautionary tale of the risks involved with algorithmic stablecoins and the importance of regulation to protect investors.

UST Depeg in May 2022 was a pivotal event in the history of algorithmic stablecoins. The collapse of Terra's UST stablecoin began on May 7, 2022, as large-volume withdrawals from Terra's largest DeFi protocol Anchor started in earnest.

These withdrawals had a domino effect on the UST pool on Ethereum's Curve Protocol, the main hub for stablecoin liquidity in DeFi. The stablecoin's price began to fall, eventually dropping as low as $0.29 on May 11.

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The events surrounding UST's depegging are still debated, with some attributing it to a coordinated attack and others to a series of spontaneous panic-ridden withdrawals due to the souring wider market conditions. The Luna Foundation Guard, the entity that defends UST's peg, deployed over 80,000 BTC (around $3 billion at the time) to help maintain the peg, but ultimately failed.

The UST incident highlights the risks associated with a stablecoin losing peg stability and the importance of the role of reserves. In the case of UST, the collapse of the peg led to a "death spiral" where investors lost faith and began attempting to exit positions in UST and LUNA.

As a result of the Terra ecosystem meltdown, lawmakers and officials across the world have called for algorithmic stablecoins regulation to protect the crypto market from another crash in the future. The incident underscores the importance of robust architecture and effective risk management in the development of algorithmic stablecoins.

Algorithmic stablecoins are not inherently stable, as evidenced by the collapse of TerraUSD, which nearly led to a meltdown in the crypto world. This event highlights the risks associated with these innovative currencies.

One of the main pros of algorithmic stablecoins is that they allow for financial product innovation, which can lead to new and creative solutions. However, this innovation can also be engineered to be intrinsically unstable.

The global financial system nearly crashed in 2008 due to a bewildering array of sophisticated securitization-driven derivatives, which shows that even traditional financial systems can be fragile. This fragility is also present in the crypto world.

The stability of algorithmic stablecoins is a major concern, as their collapse can have far-reaching consequences. This is evident in the case of TerraUSD, which collapsed and nearly led to a meltdown in the crypto world.

The stablecoin market is unregulated, which means investing in stablecoins includes a risk of devaluation and may be prone to speculative attacks in case of under-collateralization.

To protect stablecoins like TerraUSD, they should be fully backed by stable collateral, ideally liquid US dollar reserves, or its blockchain counterpart in stablecoins. This is crucial for maintaining stability and preventing a huge attempt to redeem stablecoins.

A lack of trust in the initiative, as well as any consequences on the underlying collateral, might harm the economy. This is because a decrease in the value of the collateral lowers the mandatory value of the stablecoin.

The stability of any stablecoin is defined by its collateralization, making it essential to understand the interdependencies between the components. Single component flaws can reinforce one another, especially if the obligations and responsibilities are unclear.

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Algorithmic stablecoins are unlikely to pass institutional compliance checks due to the lack of reserves and uncertain regulatory status of the asset.

The collapse of UST led to several cryptocurrency operators going under, including major operators like Celsius and Three Arrows Capital. This has resulted in regulatory scrutiny of the stablecoin sector.

The EU Markets in Crypto Assets regulation will require stablecoins to be backed 1:1 by reserves, making algorithmic stablecoins that only rely on an algorithm to maintain peg stability without the presence of reserves unlawful.

LFG Reserves dwindled to just 313 Bitcoins from 80K after the UST crash, highlighting the risks associated with algorithmic stablecoins.

The regulatory environment is becoming increasingly strict, making it unlikely for algorithmic stablecoins to remain viable in the long term.

The stablecoin market is unregulated, which means investing in stablecoins comes with a risk of devaluation and potential speculative attacks.

Investing in stablecoins includes the risk of devaluation and may be prone to speculative attacks in case of under-collateralization.

To protect stablecoins, they should be fully backed by stable collateral, ideally liquid US dollar reserves, or its blockchain counterpart in stablecoins.

Smart contracts can be used to preserve over-collateralization, enforcing stablecoin liquidation to maintain complete peg stability and collateralization in case of a low collateral to stablecoin ratio.

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A lack of trust in the initiative, as well as any consequences on the underlying collateral, might harm the economy.

A decrease in the value of the collateral lowers the mandatory value of the stablecoin, potentially leading to a huge attempt to redeem stablecoins.

In the event of a crash, users risk losing their investments if there's no collateral to liquidate the stablecoin back.

Cryptocurrencies and stablecoins have distinct differences in terms of their design and functionality.

Stablecoins, like the USDT, are pegged to the value of a fiat currency, such as the US dollar, to minimize price volatility.

Algorithmic stablecoins, on the other hand, use complex algorithms to maintain their value.

These algorithms often involve a combination of factors, including supply and demand, to keep the stablecoin's price stable.

Stablecoins are designed to provide a more stable store of value compared to traditional cryptocurrencies like Bitcoin.

Algorithmic stablecoins have gained popularity due to their potential to provide a more decentralized and transparent alternative to traditional stablecoins.

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However, they also come with their own set of challenges, such as maintaining the stability of the stablecoin's price.

The algorithmic stablecoin, DAI, uses a unique system to maintain its value, known as the "Collateralized Debt Position" (CDP) system.

This system involves locking up collateral, such as Ethereum, to borrow DAI, and then using the borrowed DAI to stabilize the stablecoin's price.

The CDP system is designed to maintain the stability of the stablecoin's price by adjusting the amount of collateral required to borrow DAI.

This system has been successful in maintaining the stability of the DAI stablecoin, but it also comes with its own set of challenges and risks.

Stablecoins like USDT are widely used in the cryptocurrency market for various purposes, including trading and settlement.

Their stability and low volatility make them an attractive option for traders and investors.

Algorithmic stablecoins, on the other hand, are still in the early stages of development and are not yet widely adopted.

However, they have the potential to provide a more decentralized and transparent alternative to traditional stablecoins.

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Their use of complex algorithms to maintain stability could also provide more flexibility and adaptability to changing market conditions.

The success of algorithmic stablecoins will depend on their ability to maintain stability and adapt to changing market conditions.

Only time will tell if they will become a widely accepted and trusted alternative to traditional stablecoins.