What Are Algorithmic Stablecoins?

The advent of centralized stablecoins has caused a major shift in the world of cryptocurrency trading. There was a need for a medium of exchange that was not volatile in price like Bitcoin, to allow traders to protect their earnings from selling cryptocurrencies. Subsequently, due to the growing need for more decentralization in the crypto industry, so-called algorithmic stablecoins became more and more common. Thus, stablecoins like USDT and USDC have become one of the major means of exchange.

What Are Algorithmic Stablecoins?

Algorithmic stablecoins are coins that are not backed by any reserves, but their supply and circulation are regulated solely by an algorithm. This code regulates the supply and demand of the currency, with the aim of keeping the price pegged to the reference currency, often the US dollar. Usually, in order to obtain this peg, the algorithm makes more coins to be issued when the price increases and similarly, more coins to be bought back from the market when the price falls. This mechanism is similar to seigniorage, i.e. the practice of central banks to create or destroy money to regulate its supply or value. The functioning of some of these stablecoins can be modified according to the proposals of the community. Such modifications are put in action through decentralized governance, placing seigniorage in the hands of those who use the currency and not the banks.
In a nutshell, algorithmic stablecoins differ from more common stablecoins (such as USDT and USDC) in decentralization and because of the fact that they do not require reserves and are independent of other currencies. Since algorithmic stablecoins are currencies based on the intrinsic relationship between mathematics, monetary economics, and technology, they represent a potentially more advanced stablecoin model than their centralized counterparts.

How Do Algorithmic Stablecoins Work?

Non-collateralized algorithmic stablecoins are typically divided into two categories based on how they work and how they are meant to keep the 1-to-1 peg with the dollar:

1. Rebase: These algorithmic stablecoins manipulate the base supply to maintain the peg. If the market price starts to fall below the dollar value, the algorithms will remove coins from circulation; on the contrary, if the price exceeds that of the fiat, the system will introduce more coins into the market. In a nutshell, the protocol adds or removes supply from circulation in proportion to the coin’s price deviation from the $1 peg;

2. Seigniorage: These algorithmic stablecoins use a multi-coin system, wherein the price of one coin is designed to be stable, and at least one other coin is designed to facilitate that stability. This process is similar to that of the Rebase, with the difference that multiple coins are involved providing incentives for the holders to keep the main coin pegged to the value of 1 dollar.

Over time, one more algorithmic stablecoin model has been developed introducing the concept of collateralization into the mechanism.
Stablecoins based on this model are called ‘fractional-algorithmic’. These coins are partly seigniorage, and partly collateralized meaning that they have multi-token systems similar to seigniorage stablecoins, but are also backed by a secondary currency that guarantees a good part of the value. Stablecoins using fractional algorithmic technology aim to bridge the gap between purely algorithmic currencies and purely collateralized currencies such as USDT and USDC.
It is difficult to say which one of these models is the most efficient. The idea of elastic supply makes sense when taking into consideration the general behavior of cryptocurrencies. However, this model could potentially face major problems if the incentive mechanism does not satisfy the holders or if the secondary token has few use cases (and therefore, little demand). So ideally, partial collateralisation could provide a higher level of protection.

Examples of Algorithmic Stablecoins & Use-Cases

Although the market is still dominated by the usual centralized stablecoins, investors’ interest in decentralized algorithmic stablecoins have been growing lately. The most relevant projects of the algorithmic section are listed below.

TerraUSD (UST)

TerraUSD (UST) has long been the most discussed algorithmic stablecoin. UST was the decentralized and algorithmic stablecoin of the Terra blockchain, fueled by Terraform Labs. It was created with an aim of offering a scalable solution for DeFi amid severe scalability problems faced by other stablecoins. Its mechanism of balancing the peg with the dollar moved around the secondary token, LUNA, and various incentives that had to be able to keep the UST price stable, in line with seigniorage.
Ultimately, the project failed miserably, due to a lethal spiral of events: as UST started losing its dollar peg, people started selling it for other stablecoins. At the same time, LUNA’s short sales drove the price of LUNA, the collateral for UST, down. This downward pressure on prices forced Terra to mint even more LUNAs as an attempt to stop the downward spiral of UST. This diluted the price of LUNA, but did nothing to restore the peg. Now the native blockchain has suffered a hard fork, so the initial project is practically dead.

DAI

DAI is one of the two coins of MakerDAO, a project based on the Ethereum blockchain. Currently, it is collateralized by a combination of Ethereum, USDC, BTC, and other cryptocurrencies (multi-collateral system). The DAI stablecoin uses smart contracts that respond to varying market dynamics in order to keep its peg, and uses its secondary token, MKR, as a last-resort collateral in case of crashes in Ethereum price. This particular type of stablecoin differs from the others already mentioned, because it is over-collateralized, which means that it is fully backed by other currencies.
Nowadays, DAI can be used in all major DeFi lending protocols. It is a good store of value and a decentralized alternative to the more popular stablecoins such as Tether and USD Coin. In addition, it is also taking space in the gaming industry; you can use DAI in Decentraland or win it on the CelerX mobile app.

Ampleforth (AMPL)

Ampleforth (AMPL) is an Ethereum-based algorithmic stablecoin. It belongs to the Rebase category and has an elastic supply, which means that it expands when the price rises above the dollar price, and contracts when the price falls. What distinguishes Ampleforth from the others, is its ability to manage the consequences of this supply variation.
Usually, an increase in supply leads to the dilution of the percentage of the coins that each wallet holds, compared to the total supply. This implies that our balance will decrease. To remedy this when its supply increases, Ampleforth automatically adjusts all the balances of the wallets in the network, so that the number of coins of each owner remains proportional to the circulating supply.
The AMPL token is an efficient form of collateral in decentralized finance (DeFi) protocols. To accelerate adoption, the Ampleforth crypto protocol incentivizes on-chain liquidity through its Geyser program. Geyser takes advantage of the liquidity pools of decentralized exchanges, such as Uniswap, Balancer, and Sushiswap, allowing AMPL owners to stake and receive rewards.

Conclusion

Algorithmic stablecoins have provided the best prospects for securing decentralization without government regulation. Stablecoins have the fundamental advantage of being scalable compared to other solutions. Algorithm-based coins use transparent and verifiable code, which makes them attractive to build trust.
However, they are not completely free from risks, but are linked to strong instability during bear market periods mainly, with consequent definitive de-peg from the dollar. There is a lot to learn from what happened with TerraUSD (UST) meaning that these types of stablecoins have not yet found the perfect formula to gain absolute investor confidence. So far, over-collateralized projects have shown more resilience. With increased adoption of crypto and numerous stablecoin use-cases, there is plenty of room to fill for projects aiming to compete.