What Is An Algorithmic Stablecoin, And How Does It Work?

Did you know that 63% of Americans say they have little to no confidence that current ways to invest in, trade, or use cryptocurrencies are reliable and safe? Isn't that alarming? 

Now, think of a world where digital currencies remain stable without relying on traditional assets like cash or gold. That's the promise of stablecoins, where cryptocurrencies are designed to maintain a steady value. While reserves back some stablecoins, algorithmic stablecoins take a different approach, using smart contracts and supply mechanisms to keep their price in check.

But how do they work, and can they indeed maintain stability? Let's explore what algorithmic stablecoins are, how they function, and why they're shaping the future of decentralized finance (DeFi).

What Are Algorithmic Stablecoins?

Algorithmic stablecoins are a type of digital asset designed to maintain a stable value. They are typically pegged to the US dollar. While some projects experiment with alternative pegs, most rely on algorithmic mechanisms to regulate supply and demand rather than direct asset backing. Unlike stablecoins backed by regular money, which depend on having reserves, these stablecoins use smart contracts and algorithms to adjust their supply based on what people want in the market.

They do this through pre-programmed rules that respond dynamically to price fluctuations. If demand increases, new tokens are issued to prevent price surges. Conversely, tokens are removed from circulation when demand drops to counteract price declines.

Unlike algorithmic stablecoins, which rely on smart contracts and supply adjustments to maintain their value, the most widely used stablecoins, such as USDT and USDC, are backed by reserves, including cash and cash-equivalent assets. They have actual fiat currency reserves, which translate to a one-to-one correspondence between each issued stablecoin and a unit of fiat currency (such as the US dollar) that is kept in reserve.

Examples of reserve-backed stablecoins include USDT (Tether) and USDC (USD Coin), which aim to maintain a one-to-one peg with the US dollar. However, the nature of their reserves can vary, including a mix of cash, government securities, and other assets.

How Do Algorithmic Stablecoins Maintain Their Peg?

Algorithmic stablecoins are designed to keep a stable value, usually pegged to the US dollar or a bunch of different assets. They do this through a clever system that automatically changes how many coins are in circulation based on how much people want them. If the stablecoin price goes too high, the algorithm makes more coins to decrease the price. If it goes too low, the system takes some coins out of circulation to bump the price back up. This constant tweaking helps keep the price steady.

But there's more to it. Algorithmic stablecoins use pre-programmed mechanisms to adjust supply dynamically. While these systems respond to market fluctuations, they do not 'learn' as artificial intelligence does, and their stability can be challenged in volatile conditions. But still, algorithmic stablecoins can sometimes struggle to stay at their target price when the market is rough.

Now that we've explored how algorithmic stablecoins work and their stabilization mechanisms, we must consider their risks and real-world performance. Let's move on to understand the different types of algorithmic stablecoins available in the market.

What Are The Types Of Algorithmic Stablecoins, And How Do They Work?

Algorithmic stablecoins come in different models, each using unique mechanisms to maintain price stability. While they all rely on smart contracts and algorithmic adjustments, their approach to managing supply and demand can vary. Below are the main types of algorithmic stablecoins:

1. Rebase Stablecoins

Rebase stablecoins adjust their total supply at regular intervals to maintain a target price. When the price rises above the peg, new tokens are automatically minted and distributed among holders. Some tokens are removed from circulation if the price drops below the peg. Rebase stablecoins adjust supply proportionally, meaning that while users' token holdings change, their percentage of the total circulating supply remains relatively stable. However, factors like liquidity pools and trading dynamics can affect the practical value of these holdings.

Example: Ampleforth (AMPL) is a decentralized algorithmic stablecoin that uses an elastic supply mechanism to target a stable purchasing power over time. While it references the Consumer Price Index (CPI) as a guideline, AMPL is not directly pegged to CPI in real-time and can experience short-term volatility. This index, provided by the Bureau of Economic Analysis, reflects the inflation-adjusted worth of a 2019 U.S. dollar. Essentially, AMPL's price target is linked to the purchasing power of one 2019 U.S. dollar, as determined by CPI data.

The protocol automatically adjusts the token supply through rebasing to maintain this target. If AMPL's price rises above the index, the protocol increases the number of tokens in users' wallets. Conversely, the supply is reduced if the price falls below the index. This dynamic adjustment influences market prices by modifying the circulating supply of AMPL.

2. Seigniorage-Based Stablecoins

Seigniorage stablecoins use a dual-token model to regulate supply and stabilize value. Instead of adjusting a single coin's supply, they rely on an ecosystem of assets to absorb price fluctuations. These systems often involve a primary stablecoin, a governance token, and sometimes a bond mechanism that incentivizes users to stabilize the system. These systems rely on market incentives to maintain the peg.

Example: TerraUSD (UST) was an algorithmic stablecoin that attempted to maintain its peg to the US dollar using a mint-and-burn mechanism with its sister token, LUNA. However, due to its design flaws and market vulnerabilities, UST lost its peg in May 2022, leading to the collapse of both UST and LUNA. When UST demand increased, new UST was minted by burning an equivalent value of LUNA, reducing LUNA's supply and helping stabilize the peg.

Similarly, when UST's price fell below $1, users could swap it for LUNA at a discounted rate, reducing its supply and increasing demand to restore the peg. This algorithmic balancing relied on market incentives rather than collateral reserves. However, UST ran into serious problems, and once it stopped being pegged to the dollar, it, LUNA, and the entire Terra blockchain came crashing down.

Also Read: Idea Paper: Yield Optimization on Stablecoins on Arbitrum Chain

3. Fractional Algorithmic Stablecoins

Fractional algorithmic stablecoins combine collateral-backed and algorithmic mechanisms to maintain stability. This approach attempts to balance efficiency and decentralization. Breaking from conventional designs, this stablecoin pioneer in adopting a fractional-algorithmic framework. This implies that a portion of its value is secured by assets like USDC, with the remainder stabilized algorithmically.

Example: Frax (FRAX) used to employ a fractional-algorithmic model, where a portion of its value was backed by collateral while the rest was stabilized algorithmically. The exact collateralization ratio can vary over time and is subject to governance adjustments within the Frax protocol. The collateralization ratio adjusts dynamically based on on-chain data and governance parameters, responding to market demand and liquidity conditions. This blended strategy aimed to harness the advantages of both collateral-backed and algorithmic stablecoins.

However, the current status is that FRAX is becoming fully collateralized, as decided by the community vote in February 2023. The Frax Finance community chose to increase the collateral ratio to 100%. The vote was primarily driven by the desire to improve the perceived safety of FRAX, especially after the collapse of other algorithmic stablecoins like TerraUSD (UST).

Note: Fractional algorithmic stablecoins remain experimental and are subject to risks, as seen in past failures like Iron Finance's TITAN.

4. Collateral-Backed Stablecoins

Collateral-backed stablecoins are digital assets pegged to a stable value and supported by reserves like fiat currency, crypto, or commodities. The value of the collateral is intended to be equal to or greater than the circulating supply of the stablecoin. Collateral-backed stablecoins aim to maintain stability by holding reserves equal to or greater than the circulating supply.

Example: USD Coin (USDC) is a notable example of a collateral-backed stablecoin. Unlike algorithmic stablecoins, USDC is backed by fiat currency, meaning each USDC in circulation is supported by an equivalent US dollar held in reserve at regulated financial institutions. This 1:1 backing is designed to provide enhanced price stability, making it a preferred choice for traders, institutions, and individuals seeking a reliable medium for transactions within the crypto space. Additionally, USDC reserves undergo regular audits to maintain transparency and build user trust.

While algorithmic stablecoins use different mechanisms to maintain stability, they all face risks such as liquidity crises, loss of market confidence, and potential de-pegging events. Trust in these systems often hinges on transparent governance, robust collateralization, and well-audited algorithms. Projects like TerraUSD, which faced a dramatic loss of confidence, contrast with others like DAI, which have maintained stability through over-collateralization, illustrating how market trust can be gained or lost. If demand drops sharply or the algorithm fails to adjust effectively, the stablecoin may struggle to maintain its intended value. If market demand takes a nosedive, the algorithm might have difficulty keeping the price steady, which could cause real issues.

Risks And Challenges When Algorithmic Stablecoins Lose Their Peg?

Despite the mechanisms to maintain a peg, algorithmic stablecoins can lose their peg under certain conditions. A stablecoin is said to be "de-pegged" when its price moves away from the asset it's tied to. This can happen due to a variety of factors:

1. Volatility

Algorithmic stablecoins are designed to maintain price stability, but their effectiveness depends on the strength of their underlying mechanisms. Some have demonstrated relative stability, while others have experienced severe volatility, especially during periods of market stress. These ups and downs usually happen because of quick shifts in what people want or substantial changes in the overall crypto world, which messes with how well the algorithms behind them work.

If an algorithmic stablecoin experiences a significant increase in sell orders, its peg might face pressure. The system's ability to restore balance efficiently depends on its specific stabilizing mechanisms, which vary. While some rely on arbitrage incentives or collateral adjustments, others may use alternative methods tailored to their design. This unevenness makes people worry about using them for regular purchases or putting money into them for a long time.

2. Regulatory Uncertainty

Another big obstacle is regulation. Financial regulators around the globe are still figuring out how to categorize and monitor algorithmic stablecoins. Many countries have tight rules for financial assets and the unique characteristics of algorithmic stablecoins. They might not have direct backing from assets and depend on automatic changes, which makes it tricky to use the current legal structures.

This lack of clear rules can make businesses and investors hesitant to adopt them fully. While USDC, a fiat-backed stablecoin, briefly lost its peg to the US dollar in March 2023 due to concerns over its reserves at Silicon Valley Bank, it quickly regained stability following regulatory intervention and liquidity support. In contrast, algorithmic stablecoins face different risks. Their stability relies on algorithm-driven mechanisms rather than direct fiat backing, making them more vulnerable to market fluctuations and loss of confidence.

3. Trust

Trust is paramount for any currency to succeed, and earning and keeping that trust is challenging for algorithmic stablecoins. Their intricate inner workings and brief history cause a lot of users to feel uneasy, pushing them towards more traditional stablecoins that are backed by actual currency holdings.

Unlike fiat-backed stablecoins, which are often issued by centralized entities with institutional backing, algorithmic stablecoins rely on decentralized governance and automated mechanisms to maintain stability. While decentralization offers benefits like reduced counterparty risk, the lack of traditional financial support can make some investors hesitant.

4. Adoption Barriers

Another issue is getting a broader audience to embrace them within the financial world. To achieve widespread adoption, algorithmic stablecoins must gain trust within the financial ecosystem. While their primary use case is currently within DeFi, broader acceptance by merchants, payment platforms, and financial institutions would require greater regulatory clarity and proven stability.

However, their tendency to fluctuate in value and the unclear regulatory landscape surrounding them make many businesses wary of incorporating them into their payment methods. Fears about potential legal shifts and the complexities of the technology itself also contribute to the slow pace of adoption.

These challenges, including governance risks, market liquidity issues, and technical flaws in algorithmic models, highlight the need for continuous improvements. Real-world incidents, like the collapse of TerraUSD, emphasize the importance of regulatory clarity and more substantial trust-building efforts to enhance the resilience of such systems.

Also Read: Stablecoins in Argentina: A Rising Financial Solution Amid Soaring Inflation

Now that we have learned about the types of algorithmic stablecoins, let's understand their benefits and uses:

Benefits Of Algorithmic Stablecoins

Algorithmic stablecoins aim to achieve price stability through automated supply adjustments, sometimes relying on a combination of smart contracts and collateral mechanisms rather than traditional full-reserve backing. The benefits are as follows:

• Algorithmic stablecoins are designed to boost capital efficiency. Smart contracts and algorithmic mechanisms attempt to maintain the stablecoin's peg to its target asset, though real-world performance can vary based on market conditions and demand. These digital currencies use smart contracts to either release more tokens into the market when their price exceeds the target value or buy them back when the price dips below it.

  
  

• One key feature of algorithmic stablecoins is that they are thought to be more decentralized. Algorithmic stablecoins are generally designed to function without a central authority managing reserves. However, some projects incorporate decentralized governance models to make decisions, while others may retain mechanisms for centralized oversight or external interventions during periods of market stress.

  
  

• Rather than requiring full collateral reserves like traditional stablecoins, algorithmic models use dynamic monetary policies and economic incentives to regulate supply and demand, even though this can introduce additional risks.

  
  

• The design and functionality of algorithmic stablecoins may continue to evolve, marking a new chapter in stablecoin technology.

Algorithmic stablecoins offer significant benefits when it comes to scalability and decentralization. However, their success in the long run will hinge on how much trust they can gain from the market, how clear the regulations are, and how strong their core mechanics are. So the question is, "Are algorithmic stablecoins the same as fiat-backed stablecoins?" Let's take a quick glance at the key differences between them before heading off to the uses of algorithmic stablecoins.

Key Differences Between Algorithmic And Fiat-Backed Stablecoins

Let's now talk about the probable uses of algorithmic stablecoins.

Uses Of Algorithmic Stablecoins

Algorithmic stablecoins, despite their risks, are designed with specific use cases in mind. Here's what they're intended for and how they can be used:

Decentralized Trading And Exchanges (DEXs): Like other stablecoins, algorithmic stablecoins can provide stability within the volatile environment of DEXs. They can be used in liquidity pools, facilitating trading pairs and reducing the impact of price swings.

Building a Censorship-Resistant Financial Ecosystem: One of the goals of algorithmic stablecoins is to contribute to a more decentralized and censorship-resistant financial system. While they seek to reduce reliance on centralized entities to maintain stable value, their mechanisms often depend on governance protocols, arbitrage incentives, or collateralized assets.

Decentralized Lending And Borrowing: These stablecoins can serve as collateral or loan assets in DeFi lending platforms, offering an alternative to fiat-backed stablecoins. However, their reliability depends on maintaining a stable peg, which has proven challenging for many algorithmic models.

Yield Farming and Staking: Algorithmic stablecoins are sometimes used in yield farming strategies, where users earn rewards by staking or providing liquidity. While they can serve as assets in DeFi protocols, their stability concerns make them riskier than fiat-backed or overcollateralized stablecoins.

Decentralized Payments: In theory, algorithmic stablecoins could function as a stable medium of exchange for everyday transactions. However, due to their history of volatility and risk of de-pegging, widespread payment adoption has been limited.

Decentralized Governance: Some algorithmic stablecoin protocols incorporate governance mechanisms that allow token holders to influence decisions. For example, Frax (FRAX) uses a governance token (FXS) for protocol management. While decentralized governance aligns with DeFi ideals, its effectiveness varies, as governance power can sometimes concentrate among large stakeholders.

Key Considerations:

• The inherent volatility of algorithmic stablecoins has limited their practical adoption across these use cases.

  
  

• The collapse of TerraUSD (UST) due to its flawed mint-and-burn mechanism, which was closely tied to the LUNA token, has heightened concerns about the long-term viability of algorithmic stablecoins. This incident has led to increased scrutiny of their design and resilience.

  
  

• While these stablecoins present innovative financial models, their effectiveness depends on sustained stability and market trust.

Therefore, while these are the intended uses, real-world usage has been limited.

Final Thoughts

Algorithmic stablecoins have the potential to transform decentralized finance (DeFi) by providing a stable medium of exchange without relying on physical reserves. Their algorithm-driven approach offers scalability and flexibility, making them valuable for lending, borrowing, and trading in DeFi ecosystems.

However, regulatory scrutiny poses a challenge, with potential policies requiring greater transparency and stability measures. Market trust is equally crucial, and these stablecoins must consistently maintain their peg and prove their resilience to gain widespread adoption. While they offer exciting financial innovation, their future hinges on navigating regulations and building confidence in their stability and reliability.

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FAQ

Q. How do stablecoins maintain their price?

Stablecoins are a unique class of cryptocurrencies designed to minimize the volatility inherent in traditional digital assets. The tokens aim to maintain a stable value, typically by pegging to fiat currencies or commodities, making them an attractive tool for everyday transactions and value storage.

Q. How does the value of 1 USDC stay at $1?

Every USDC is supported by one dollar or an asset of equal fair value. These assets are kept in off-chain accounts at regulated financial institutions. Customers who have a US dollar bank account can exchange one USDC for one USD, holding the tokens at a 1:1 exchange rate with the US dollar.

Q. What is censorship resistance?

In crypto, censorship resistance is all about the ability to make transactions freely, the security of your assets from being seized, and the certainty that once a transaction is made, it can't be undone. This resistance to censorship isn't a simple on/off switch but rather a sliding scale. Bitcoin is likely the most censorship-resistant cryptocurrency or digital asset.

Q. What Is a Decentralized Money Market?

A decentralized money market is where anyone can borrow and lend digital assets with an Internet connection.