- An algorithmic stablecoin is a kind of cryptocurrency that uses smart contracts and algorithms to regulate and lessen price swings of a certain asset, such as the US dollar.
- This indicates that the algorithm used by this type of stablecoin can produce more coins in the event that the price rises and buy coins back from the market in the event that the price falls.
- Because of this, traders can profit from holding cryptocurrency assets like ETH and BTC without being concerned about large fluctuations in price.
Important lessons learned
A cryptocurrency known as a stablecoin is one that is based on the value of a real asset, such as gold or fiat money.
Because such tokens are decentralized and use smart contracts to maintain the stablecoin’s value in line with its underlying asset, they are incredibly secure.
How Are Algorithmic Coins Operational?
An understanding of “two-coin” systems is necessary to comprehend algorithmic stablecoins. In this category, one stablecoin serves as a buffer against market volatility, while the other seeks to keep its value tied to a tangible item.
The first is called a balancer or share token and is usually traded on DEXs. Initially, Terra just had this two-coin arrangement; however, it later incorporated Bitcoin (BTC) reserves as a backup.
To learn more about how a two-coin system functions, let’s take a closer look at the Terra network. Two tokens are available on the Terra blockchain: Luna, a governance token, and TerraUSD, a stablecoin.
The two tokens’ interaction was intended to keep the value of TerraUSD at $1. In the event that demand drives the price of TerraUSD above $1, a holder of Luna can convert $1 worth of Luna into TerraUSD and profit from the higher price.
On the other hand, traders can exchange the currency for $1 worth of Luna if its value declines, which lowers the supply and drives up the price. But for the system to work, algorithmic stablecoins need a certain amount of demand support.
The system as a whole may collapse if demand drops below a predetermined point. Fei’s USD-pegged token proved this when, in April 2021, its buying price fell by 80% due to a large decline below its targeted value. The Terra Classic legendary collapse also triggered massive losses for many retail users.
Furthermore, in order for algorithmic stablecoins to benefit from market incentives, independent parties must engage in price-stabilizing arbitrage. It is as dangerous, though, to depend on independent, market-driven parties to carry out discretionary arbitrage in the absence of regulatory requirements.
Important Elements
The goal of algorithmic stablecoins is to improve trading accessibility and comfort for both novice and seasoned traders. Algorithmic stablecoins include the following essential characteristics:
Minimal Volatility Increases Value
Because they are convenient and have fixed pricing, stablecoins are dependable coins for transactions but are devoid of any basic value unless backed.
Because of this characteristic, stablecoins can be used for cross-border transactions and offer collateral diversity to fend against market volatility and hyperinflation.
Agile Responses to the Industry
An automated response to market data is ensured without the need for human interaction by the smart contracts that encode the algorithm into the stablecoin properties.
These factors are intended to stabilize market supply and demand for these tokens after a thorough analysis of the underlying market dynamics.
Safety
To maintain security, stablecoins can be kept in virtual wallets, to which only the funds linked with the stablecoins are accessible to the private holder.
To boost security, network owners might also employ cutting-edge encryption technologies.
What Kind of Algorithmic Stablecoins Are There?
A few instances that can help you better grasp the Stablecoin supply are provided below when it comes to investigating these digital assets.
Base Cash (BAC)
In addition to the recent fiasco of LUNA, Do Kwon, the founder of Terra, has made numerous unsuccessful attempts at creating stablecoins. One of these initiatives was the creation of the first algorithmic stablecoin, Basis Cash (BAC).
When BAC first started off, its goal was to keep prices at a constant 1:1 dollar value. The BAC protocol was created to modify the token supply in order to maintain purchasing power, much like central banks do when they exchange government debt without collateral.
The three exchangeable tokens that make up BAC are Basis Share, Basis Bond, and Basis Cash.
Because Basis Cash was not tethered to the US dollar, it was not a stablecoin. Investors lost faith in the coin as a result, and it currently trades for less than $0.01.
Ampleforth (AMPL)
The goal of the Ampleforth protocol, which runs on the Ethereum network, is to keep the value of its AMPL cryptocurrency asset constant with respect to the US dollar.
The project’s backers include former senior software engineer Brandon Iles and serial entrepreneur Evan Kuo. About a dozen team members are mentioned on the LinkedIn profile of the protocol’s administration and development organization, the Ampleforth Foundation.
Because AMPL is a rebase stablecoin, holders do not receive a fixed quantity of tokens; instead, they receive a fixed percentage of the total circulating base supply.
Depending on the token’s current price, the total supply either increases or decreases. The protocol distributes newly produced tokens to current holders and raises the circulating quantity if the AMPL price rises above $1. All Ampleforth wallets are impacted and the token supply is reduced if the price of AMPL falls below $1.
The proportion of AMPL tokens held by holders does not alter, even following an algorithmic stablecoin rebasing event. Rebase events occur once a day and are viewed as negative if the price drops below $0.96 and as positive if it increases above $1.06.
The main objective of the system is to provide the market forces with incentive mechanisms to maintain AMPL’s price stability at $1.
TerraUSD (UST)
The goal of TerraUSD (formerly known as Terra Classic) stablecoin is to maintain a 1:1 peg to the US dollar (UST). It is designed to provide a scalable dApp solution, which will enhance the Terra environment. Under the guidance of Do Kwon and Daniel Shin, Terraform Laboratories established the UST in 2018.
This stablecoin, which is based on a seigniorage mechanism, uses arbitrageurs to try and keep the peg to the US dollar. LUNA, Terra’s native unstable cryptocurrency, is used to keep the UST stablecoin’s price consistent in addition to acting as a network governance token.
UST works closely with LUNA, an elastic token that modifies its quantity to support arbitrage and preserve the stablecoin’s stability. They must first mint UST by swapping their money for LUNA tokens if you buy UST stablecoin. Then, these LUNA tokens undergo a procedure called “burning crypto,” which lowers the quantity of LUNA in circulation and raises its price a little.
However, UST stablecoins must be converted in order to produce LUNA, which marginally raises UST’s price. LUNA stablecoin became highly popular until it collapsed triggering a worldwide distrust in stablecoins.
USD
Justin Sun, the creator of Tron, introduced USDD, a decentralized stablecoin, to the Tron ecosystem in May 2022. It seeks to ease transactions within the Tron network and give consumers a reliable place to keep wealth.
UXD
This algorithmic stablecoin on the Solana blockchain is completely supported by a delta-neutral position.
Algorithmic Stablecoin Types
Three distinct algorithms are used by the three algorithmic stablecoins to maintain their values. Let’s examine the three most prevalent kinds: fractional, seigniorage, and rebase.
- Rebase algorithmic stablecoins employ a technique in which the stablecoin’s supply is changed to keep it pegged to the US dollar. Coins are burnt if the stablecoin’s price falls below $1 and are created again if it goes over $1.
- A multi-coin mechanism is used by seigniorage algorithmic stablecoins to fix the stablecoin price. In order to keep the stablecoin’s price pegged, this approach typically combines free market and protocol-based processes that incentivize members to buy or sell other coins.
- Fractional algorithmic stablecoins, which are partially backed by collateral and have an algorithm that modifies the stablecoin supply as necessary, combine the advantages of the first two approaches. When it comes to this kind of algorithmic stablecoin, Frax Finance is a pioneer.
Algorithmic stablecoins’ benefits
- Minimal fees: Compared to other financial goods, algorithms stablecoin initiatives have reduced charges.
- Enhanced Privacy: Algorithmic stablecoins give users greater privacy by using a decentralized mechanism.
- Global accessibility: Anyone with internet access can use stablecoins, which increases the accessibility of payments and investments to people all over the world.
- Speed and efficiency: Compared to traditional currencies, transactions are quicker and more efficient, enabling prompt investments and payments without the need to wait for a third party.
Algorithmic stablecoins’ drawbacks
- Price volatility: Users may find it challenging to forecast the value of stablecoins due to its potential for price changes.
- Uncertainty surrounding regulations: Because stablecoins are governed by the same laws as conventional currencies, it is challenging for authorities to keep an eye on how they are used.
- Lack of liquidity: If a stablecoin is not frequently traded or accepted, it may require more liquidity, which would make it more difficult for users to exchange their holdings for cash or other assets.
The Dangers of Algorithmic Stablecoins
Risks associated with algorithmic stablecoins may be precarious during times of severe volatility or financial crises. The following are a few possible risks affecting stablecoin prices:
Market Danger
Every time the market swings, there could be a fall in supply or an increase in supply of algorithmic stablecoins. If the coin’s price is higher than its value, the algorithm produces extra tokens.
These tokens are in circulation on the network, and the algorithm destroys them if the price falls below a predetermined threshold.
In order to offset this decrease in supply, bonds are made available to purchasers, who are only paid when the price exceeds the value.
Oracle Smart Contract
A communication barrier results from reliance on Oracle technologies since blockchain technology is unable to access data outside of its protocol.
Oracles retrieve prices from exchanges; they are compared, and changes are made as needed to maintain system equilibrium.
Maintaining the accuracy of the oracles is a challenging task that falls to project managers or developers.
Peg Disconnection
A chain breaks away from its parent chain, causing a peg break or the possibility of peg separation.
This is the worst-case situation for any stablecoin since it has the ability to generate price volatility and destabilize algorithmic stablecoins, which could lead to the project’s complete failure.
Are Cryptocurrency Algorithms Secure?
Because the stablecoin market is unregulated, investments in stablecoins may be risky and susceptible to outside shocks if they are not sufficiently supported.
When stablecoin creation is dependent on the value of the blockchain’s controlling token, there is an increased chance of depreciation.
You must get knowledgeable about and understand the token you purchase before making any investments in stablecoins or other digital currency.
Algorithmic Stablecoin Applications
Because there is no need for a third party, algorithmic stablecoins provide a decentralized alternative to traditional stablecoins.
This makes it possible to transact, stake, and lend on bitcoin networks with ease and without needing substantial cash reserves.
Additionally, they can be traded on cryptocurrency exchanges, saving traders’ commissions. Investors can swap fiat currency for a stablecoin and then use that stablecoin to trade for other cryptocurrencies without having to first exchange it for fiat money like US dollars.
Best Algorithmic Coins to Take Into Account
Here are some choices to think about if you’re searching for some of the top algorithmic stablecoins that are now in demand and won’t follow TerraUSD’s trajectory:
DAI
Among the most well-liked algorithmic stablecoins on the market right now is DAI. It is an Ethereum-based stablecoin that issues and develops DAI by utilizing the Maker Protocol and the MakerDAO decentralized autonomous organization.
When it comes to algorithmic stablecoins, this decentralized and automated mechanism makes it the preferred option. Users clearly benefit from DAI’s soft peg to the US dollar, which is supported by a variety of different cryptocurrencies.
Frax
Another great example of an algorithmic stablecoin that has the potential to outperform TerraUSD is Frax.
One of the first algorithmic stablecoin systems that operate only on the Ethereum blockchain as an open-source, permissionless cryptocurrency is the Frax Protocol.
A highly decentralized, algorithmic, and scalable stablecoin to support the DeFi money market is the goal of the Frax protocol.
As it uses two stable assets—the Frax stablecoin and the Frax Shares utility and governance tokens—you can mint, redeem, and stake Frax.
Set Dollar (ESD) Empty
The decentralized, oracle-oriented stablecoin known as Empty Set Dollar, or ESD, has several benefits, including composability, decentralization, and innovative protocol methods.
From the list of algorithmic stablecoins for the DeFi industry, it is a viable competitor. By utilizing ESD tokens in dApps, holders can circumvent the need for active price maintenance. Additionally, ESD is a stablecoin that does not necessitate funding a centralized provider.
Enchanted Online Cash
Another worthwhile algorithmic stablecoin to test is Magic Internet Money.
Users can deposit interest-bearing assets on the platform and borrow stablecoin with them as collateral.
Factors Affecting the Efficiency of Algorithmic Stablecoins
It is crucial to take into account specific elements and performance measures that assess algorithmic stablecoins in order to ascertain their efficacy.
Let’s examine some of the variables that affect algorithmic stablecoins’ price stability and efficacy:
Authority
While the majority of algorithmic stablecoins function as Decentralized Autonomous Organizations (DAO), only a small number of them have a vibrant community that regularly carries out suggestions for enhancements.
The use of smart contract governance in algorithmic stablecoins is growing in popularity. It is essential to guarantee equitable token distribution and grant all stakeholders rights to governance.
There are now certain algorithmic stablecoins that use centralized governance.
Rewards
Rebase methods are used by several algorithmic stablecoins as a means of rewarding traders. Without altering the value of the token, this same method modifies the quantity in use.
For engaging in alternative investments, such as burning coupons or increasing supply if demand exceeds supply, other protocols provide incentives and benefits.
Mechanism of Rebasing
Based on changes in the token’s price, this method automatically modifies the quantity of tokens in circulation.
Rate of Token Adoption
When selecting an algorithmic stablecoin to invest in, the rate of token acceptance is crucial. Automated Market Makers (AMM) are not among the few decentralized finance (DeFi) solutions that have accepted most protocols.
This could make tokens with an algorithmic basis less useful. Due to slower liquidity expansion, a limited token adoption rate may introduce a short period to maintain price stability.
Study Case: TerraUSD (UST)
The TerraUSD Crash in April 2022 was one of the worst cryptocurrency market crashes ever. As of May 20, 2022, the market is still having difficulty turning around.
During this meltdown, many cryptocurrencies suffered large losses, but stablecoin TerraUSD (UST) and its sibling token, the native currency of the Terra network, LUNA, were particularly badly impacted.
In just one week, the value of the algorithmic stablecoin UST fell from $19 billion to $1 billion. The subject of algorithmic stablecoins gained traction as word of the crash circulated through various websites pertaining to the cryptocurrency space.
Prior to the Anchor Protocol, which provided a high, consistent interest rate of 20% and functioned as a cryptocurrency savings account, people had kept UST.
But in March of that year, rumors circulated that Anchor Protocol would switch from a 20% to a variable rate.
As a result, there was a simultaneous withdrawal of significant sums of UST, resulting in a mass exodus from the Anchor Protocol.
Traders began selling off their LUNA and UST tokens in a panic. On Curve Finance, a different set of investors started exchanging their UST for different stablecoins. In addition, UST was burned in order to obtain additional LUNA; as a result, LUNA’s supply increased dramatically and its price decreased.
In its most basic form, this sequence of events resulted in the widespread dumping of UST, which broke the UST-LUNA balance mechanism and caused the majority of the value of both coins to disappear.
The $3 billion attempt by the Terra ecosystem’s Luna Foundation Guard (LFG) reserve fund to keep the UST peg in place was apparently failed.
Concluding Remarks Regarding Algorithmic Stablecoins’ Future
Even though algorithmic stablecoins seem like a wonderful idea, the ecosystem still needs to perform a lot of work before they can be relied upon as a reliable source of stable value.
This is due to the fact that no algorithmic stablecoin has ever been able to consistently guarantee price stability. Because of this, they are more frequently used by speculative arbitrage traders than by long-term investors.
Disclaimer : This article was created for informational purposes only and should not be taken as investment advice. An asset’s past performance does not predict its future returns. Before making an investment, please conduct your own research, as digital assets like cryptocurrencies are highly risky and volatile financial instruments.
