Comprehending Algorithmic Stablecoins

Not all stablecoins are backed by local currency or commodities. There is a separate category of digital assets called algorithmic which quotes are regulated by special mechanisms and their emission occurs due to the algorithm.  Guaranteeing the backing of a stablecoin with another cryptocurrency is a risky business because the rate of even the mainstream cryptocurrencies can swing. In this case, projects resort to the use of special smart contracts that would regulate the vital processes of the stablecoin. Consequently, the price of such cryptocurrencies does not depend on security, but on special price regulation mechanisms. How do algorithmic stablecoins work? 

How does an algorithmic stablecoin work? 

The algorithmic stablecoin protocol increases the supply if there is a deflationary trend, or decreases it if there is an inflation. The rules, according to which the issuance is adjusted, are embedded in the smart contract. They can only be changed if a consensus is reached by the users or by a decentralized vote between the holders of the project’s control token.

The functionality of smart contracts allows tokenization and recording, for example, the ERC-20 standard handles this. These features help manage token updating processes.

However, the operation of algorithmic stablecoins requires more. Oracle contracts also play an important role. An oracle helps a smart contract interact with data outside of the underlying blockchain. Oracles derive the price of a stablecoin by gathering information from multiple crypto exchanges.

Decentralized Chainlink oracles are often used. When the oracle determines the price of the desired stablecoin, it passes it on to a special “rebasing contract”. The “rebasing contract” sends information to the “stabilizer contract”. It determines the number of tokens to be burned or minted and begins the procedure.

The outcome lies in a scalable solution that is so far only present in this type of asset in the market. The lack of requirements for real assets eliminates the possibility of errors on the part of a user.

Pros and Cons of Algorithmic Stablecoins

Pros

• Algorithmic stablecoins aim to increase capital efficiency by using codes to keep prices near the pegged asset. These assets rely on smart contracts that deliver tokens to the market if the price rises above the peg or sell tokens if the value falls below the peg.

• Notably, algorithmic stablecoins provide a true decentralization of the stablecoin market because they eliminate the third-party interference often found in traditional stablecoins. These stablecoins also eliminate the difficulty of raising sufficient capital to perform the reserve function.
• Another advantage of algorithmic stablecoins is that they allow for increased trust between users and developers, as the peg is closely connected with the algorithm rather than to the collateral.

Cons 

• Algorithmic stablecoins have a weak architecture and are vulnerable to the risk of peg cancellation. Coins are highly demand-driven, so a lack of demand for coins can cause the price to drop. 
• Coins depend on investors to be interested in making a profit. Sometimes a herd mentality and decisions are made from an emotional point of view, leading to the sale of algorithmic stablecoins, causing the price to fall.

Types of algorithmic stablecoins

Developers are still looking for the best way to consistently match the price of an asset. Each algorithm has its disadvantages, but also its advantages. 

Rebasing

It is one of the first models of decentralized stabilization. By constantly “recalculating” the tokens on their balances, their amount in the wallet will change accordingly to the change in the market price of the asset to which they are pegged.

This opens up the possibility of arbitrage. Someone will make money on the difference that arises, and thus bring the price back to stable. 

In practice, the rebasing model does not allow to achieve ideal proximity to the real price of an asset. There is always at least a 5% deviation. In stressful market situations, it grows the risk of intensified imbalance. Balance updates are not instantaneous, first, the difference needs to reach a certain boundary.

Known protocols (by capitalization size) are below:

• Olympus;
• Wonderland;
• Ampleforth;
• Redacted Cartel.

Seigniorage

The Senorage model allows you to liquidate surpluses (when the price goes up) and get funding (when the cost goes down).

Seigniorage (which means that network members are directly incentivized to support the price of a coin through coin minting and token burning mechanisms). The bottom line is the difference between the face value of the coin and the cost of producing it. Typically, the system includes one token tied to a certain value and one or more tokens that act as incentives to maintain the peg.

The disadvantage of the seignorage algorithm is that there is no real value to the reserve token. Many protocols have failed for this reason (deprecation).

Known protocols:

• Terra (Lost parity);
• Basic Cash (Lost parity);
• Empty Set Dollar (Lost parity).

Fractional

This particular model can be described as a mixture of Seigniorage-stablecoins and fully collateralized ones. Fractional algorithmic stablecoins are also equipped with a multiple-token system. Secondary assets are used for coinage, and stablecoins backed by fiat are used as partial collateral. If necessary, there is partial burning of the secondary token using DeFi tools in the system. The goal is to achieve maximum capital efficiency.

Known protocols:

• Fei;
• Iron Finance (Lost parity).

All projects strive to create a sustainable and efficient mechanism to ensure that the peg is maintained. Developers have tried other systems, but they have not stood the test of time. It is likely that in the future there will be other options, allowing us to achieve the goal most simply and logically.

Top Algorithmic Stablecoins

The top algorithmic stablecoins list includes the following assets:

Terra UST

Terra UST was the most successful algorithmic stablecoin. At its peak, it was one of the top three in terms of market capitalization. In May 2022 the stablecoin fell into a “death spiral”,  lost its peg to the U.S. dollar, and eventually ceased to exist. This caused the fall of the entire cryptocurrency market. As a result, many other stablecoins were temporarily unpegged. The Terra blockchain has been restarted. The asset in question is now USTC (UST Classic).

Ampleforth

This project is an algorithmic stablecoin running on the Ethereum blockchain and one of the most popular “rebasing” stablecoins. The Oracle service is Chainlink. The protocol adjusts the AMPL emission every 24 hours to maintain a solid price. Any AMPL holder will see the wallet balance adjusted every day at 2:00 UTC. However, it is worth noting that the technology behind Amplefort is not perfect.  Its price can fluctuate at the level of 1.18 – 1.26 U.S. dollars, the minimum level was 30 cents, and the maximum was 4 U.S. dollars. However, the asset is quite popular, partly due to its spirit of decentralization.

DAI

MakerDAO (DAI) is considered to be the first and one of the best algorithmic stablecoins. DAI is a multi-cryptocurrency stablecoin built on the Ethereum blockchain. The coin is managed by a smart contract that enforces the rules for MakerDAO. Until March 2023 it was “softly” pegged to the U.S. dollar and backed by deposits of several cryptocurrencies in a virtual vault controlled by MakerDAO. However, the American banking system has recently come under serious pressure. The big shock for the market caused the bankruptcy of Silicon Valley Bank. About 8% of the reserves, which ensured the USDC stablecoin peg to the U.S. dollar, were stored in this bank. As for the DAI stablecoin, it is directly related to USDC, since its reserves are almost 50% provided by this particular token. As part of the reaction to all that happened, the market rates of both of these assets went down sharply. The situation with the “decoupling” from USDC and DAI has become a serious negative factor for other stablecoins. In addition to these two tokens, the FRAX algorithmic stablecoin also lost its U.S. dollar peg, which was also heavily backed by USDC.

Are algorithmic stablecoins safe?

After the failure of TerraUSD, the cryptocurrency market lost confidence in algorithmic stablecoins.

However, Charles Hoskinson, the creator of the Cardano network, argues that in the long term, algorithmic stablecoins are important to the full realization of Satoshi Nakamoto’s original intent for Bitcoin. According to Hoskinson, algorithmic stablecoins such as the recently launched Djed may be the only way to overcome the current pegging problem plaguing stablecoins like USDC. Hoskinson also provided an explanation of how the Cardano-based Djed stablecoin can maintain a peg to the U.S. dollar, stating that the Djed platform provides a 400-800% collateralization ratio for Djed and Shen tokens.

The recent fiasco around TerraUSD has increased attention not only to the stablecoin ecosystem but to the cryptocurrency landscape as a whole, prompting lawmakers to step up regulatory oversight of the industry. Good news for those who believe that regulation will increase the security and trust in stablecoins, and thus benefit the entire ecosystem. The alternative view is that this will open the door to tighter regulatory controls, which will inevitably lead to less competition and more centralization in the industry.

FAQ

Are Algorithmic Stablecoins fully decentralized?

Algorithmic types of stablecoins are decentralized. The lack of a single asset management center allows you to bypass counterparty risk and users do not need to trust the group of individuals who control the token.

The research division of Bloomberg believes that the market for algorithmic stable cryptocurrencies is growing faster than traditional stablecoins.

In the Bloomberg Intelligence Crypto Outlook, 2022 the analysts argue for the benefits of decentralization. According to experts, this is due to the fact that the algorithmic stablecoin, which does not have a centralized issuer, is very resistant to regulation.

Are Algorithmic Stablecoins safe to use?

The security of algorithmic stablecoins has not been proven. In the history of the crypto market, there are known cases of the loss of the peg of the token exchange rate to the main asset. At the same time, the security of centralized stablecoins also raises a lot of questions. Algorithmic stablecoins are inherently fragile. These uncollateralized digital assets that attempt to anchor the price of a benchmark asset through financial engineering, algorithms, and market incentives are not stable at all but are in a state of perpetual vulnerability.

Without user trust, an asset can simply sink into oblivion, as has already happened with many tokens. In the case of stablecoins, this scenario is called broken pegs. Experts believe that it is still too early for the ideal solution to appear, but the fact that developers are looking for and trying different options will certainly lead to results.

What is the future outlook for Algorithmic Stablecoins?

The list of algorithmic stablecoins is not as wide as one of their “classic” fellows. They do not have any fiat or crypto collateral being called “unsecured” stablecoins. Currently, the crypto industry is dominated by collateralized stablecoins. The mechanisms of their work are more clear to people, as they are close to the already familiar electronic money. In the event of market shocks, they are better able to withstand the U.S. dollar peg. Peg of algorithmic stablecoins during periods of crisis works worse, and in addition, they are more volatile. 

In the crypto universe, algorithmic stablecoins have become a unique and innovative solution and are undoubtedly an exciting and dynamic part of the landscape. They are widely used within the DeFi industry, but cannot yet go beyond it. They just have to find applications in real economic transactions.

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