A Dive Into Algorithmic Stablecoins
Stablecoins are cryptocurrencies either backed by an asset or designed as algorithmic stablecoins set to combine the best of both fiat and cryptocurrency worlds.
Unlike fiat currencies, cryptocurrencies by nature are highly volatile, making them unsuitable for regular use. In a financial market, currencies are supposed to serve as mediums of exchange and storage modes for monetary value. This is the reason many users avoid taking payments in cryptocurrencies as it is hard to rely on their purchasing power. Stablecoins are cryptocurrencies either backed by an asset or designed as algorithmic stablecoins set to combine the best of both fiat and cryptocurrency worlds.
For instance, during the 2017 crypto bull run, Bitcoin rose from $5600 to $20000 before falling drastically back to slightly above the $6000 mark. The same trend cuts across the cryptocurrency market. This creates the ground for stablecoins, which are labeled to the prices of fiat currencies like the US dollar, and aren’t volatile like other cryptocurrencies.
Known for their price stability in a rather shaky market, stablecoins have proven to be worthwhile. By the end of 2020, the overall value of stablecoin assets had surpassed the $20 billion mark. Currently, the stablecoin market is estimated to be worth $100 billion.
The role of stablecoins
Since their inception, stablecoins have been seen as the middle ground between traditional currencies and cryptocurrencies. They provide the best of both worlds by providing the price stability available in traditional markets while also providing convenience and privacy seen in cryptocurrencies.
Independent custodians constantly regulate and maintain these underlying assets to control prices when required. Traditionally, custodians only move into a market to manage the supply and demand during drastic market movements. The result causes stablecoins valuations to remain free from wild fluctuations caused by inflation.
Notably, the first Stablecoin to enter the cryptocurrency space was Tether (USDT), launched on July 28, 2014. Currently, there are over 200 stablecoins available in the market, including Dai, USDC, True USD, Digix Gold, Havens Nomin, Binance USD, Gemini Dollar, and many more.
The rise of stablecoins has helped the growth of the Decentralized Finance (DeFi) space. Whether it be lending or borrowing, liquidity pools, yield farming, or staking pools, the stablecoins have been at the heart of DeFi.
Type of stablecoins
Usually, stablecoins are pegged to fiat currencies like the US dollar and the euro and commodities like oil, gold, or silver. Others are pegged to trading assets like forex reserves, while others are algorithmic.
Stablecoins can be further divided into four groups:
As the name suggests, these are stablecoins with underlying fiat currency reserves. In addition, these stablecoins are regularly audited to ensure they comply with the set financial regulations.
These currencies use hard assets such as gold, real estate, silver, oil, and many more. Many projects in the market prefer using gold as their collateralized asset. However, a few projects in the Middle East region use oil reserves to peg their stablecoin.
These stablecoins have other cryptocurrencies in their reserves to serve as collateral. Notably, these types of stablecoins are usually over-collateralized. Therefore, before issuing any crypto-backed Stablecoin, project managers have to maintain a higher number of pegged assets in their reserves. This is done to overcome the high volatility of the reserved asset. For example, the Synthetix project demands about 600% over-collateralization for every USD Stablecoin issued.
Algorithmic stablecoins are among recent developments within the Stablecoin market. These assets serve the same purpose as other stablecoins in the market. However, unlike their predecessors, they are not collateralized.
A dive into algorithmic stablecoins
Algorithmic stablecoins are pegged cryptocurrencies that automatically adjust their demand, supply, and other essential details to reduce their volatility. The asset to which the algorithmic asset is tied could be a fiat currency or a commodity like gold.
As mentioned above, algorithmic stablecoins do not use any reserve. Instead, they use an algorithm (smart contracts) or codes to mint and burn coins in response to the prevailing market conditions.
Currently, the longest-running algorithmic Stablecoin is Ampleforth (AMPL). Other Algorithmic stablecoins include DefiDollar (USDC), Terra Money, Basic Cash, Reserve, Debasonomics, Frax (FRAX), and Empty Set Dollar (ESD).
How do the Algorithmic Stablecoins Work?
Algorithmic stablecoins have a two-coin structure. The first coin absorbs market volatility. While the other coin actually a governance token keeps the peg. Terra earlier relied on the two-coin system and later included Bitcoin reserves. The interaction between the first and the second coin is required to keep the algorithmic stablecoin dollar value steady.
For instance, when the price of an algorithmic stablecoin valued at $1 increases above the pegged price, the algorithm mints new tokens, hoping that the new tokens will be sold off and drive down the price. On the other hand, if the price falls below the $1 value price, the algorithm burns some tokens hoping that the remaining tokens are valued higher than the previous price.
Types of Algorithmic Stablecoins
The algorithmic stablecoins are further divided into three categories:
- Rebasing Algorithmic Stablecoins: The rebase algorithmic stablecoins work on the price-elasticity by ERC-20 tokens. In these coins, the price is modified regularly by adopting a rebase process.
- Seigniorage Algorithmic Stablecoins: The seigniorage coins is further comprised of two types of crypto — stablecoin and seigniorage ownership. Shares are here to increase the supply of coins. A redeemable bond as an incentive is also issued by the coins when the prices fall.
- Fractional Algorithmic Stablecoins: These algorithmic stablecoins are the combination of fully collateralized and fully algorithmic stablecoins. It has fewer custodial risks and shows a higher level of stability. Frax is the fractional algorithmic stablecoins that use partial-collateral protocol & has two-token architecture.
Pros of Algorithmic Stablecoins
Algorithmic stablecoins aim to increase capital efficiency by using codes to maintain prices near the pegged asset. These assets rely on smart contracts to supply tokens to the market if the value increases above the peg or sell tokens if the price falls below the peg.
Notably, algorithmic stablecoins provide true decentralization within the stablecoin market since they remove third-party interference, a popular commonality among traditional stablecoins. These stablecoins also eliminate the struggles that come with raising enough capital needed to serve as the reserve.
Another advantage of algorithmic stablecoins is that they allow more trust between the users and developers since the peg is closely tied to an algorithm and not collateral.
Cons of Algorithmic Stablecoins
The algorithmic stablecoins have a weak architecture and are vulnerable to de-pegging risk. The coins are largely affected by the demands thus no demand for coins can cause a price decrease.
The coins depend on investors who must be concerned about profiting from them. Sometimes, the herd mentality and decisions are taken from an emotional point of view resulting in selling the algorithmic stablecoins, causing a price drop.
Challenges faced by algorithmic stablecoins
While these assets provide a range of benefits, there are a few challenges as well. For example, creating an algorithmic stablecoin that maintains its peg is more complicated than it looks on paper. Generally, the process creates a few risks that could lead to the destruction of the entire project.
- First, algorithmic stablecoins face the risk of increased and decreased supply each time the market shifts. If the asset price goes above the valued price, more tokens are minted by the algorithm. In this case, increased supply raises the question of who gets the new tokens. However, if the price goes below the value price, the algorithm is forced to burn the tokens. In some cases, it reduces the supply by offering bonds to buyers, who only get paid when the price rises above the valued price. Buyers can only hope the system will eventually even out and pay them for their purchases.
- Another challenge is the reliance on oracle technologies since blockchains cannot access information outside their protocol. Algorithms use oracles to get prices from exchanges, compare the prices and adjust their system to maintain the balance. In this case, the data needs to be accurate in relation to the current price. Notably, it is always a challenge for developers or project managers to get the oracles right.
- The last challenge is the risk of pegs separation (peg break). This occurs when a chain breaks away from the parent chain. A peg break is reportedly the worst-case scenario for any stablecoin. They have the strength to destabilize the algorithmic stablecoins causing price fluctuations that eventually could kill the entire project.
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