What is an algorithmic stablecoin?

Algorithmic stablecoins are a type of cryptocurrency that differs from traditional stablecoins that are pegged to an external asset such as fiat currency. These stablecoins use smart contracts and algorithms to minimize price volatility by dynamically adjusting the money supply based on market demand. Two notable examples of algorithmic stablecoins are TerraClassicUSD (TerraUSD) and Ampleforth (AMPL).

However, algorithmic stablecoins are not without risks, as the collapse of the Terra ecosystem demonstrated. The decentralized finance (DeFi) platform encountered difficulties when the price of its algorithmic stablecoin TerraUSD (UST) plummeted.

The “bank run” occurred on the Anchor Protocol, where the majority of UST was staked, along with a crisis of confidence as UST lost its peg to the US dollar. The burning and issuance mechanism between UST and LUNA led to hyperinflation, which sharply reduced the value of LUNA as UST fell in price.

In response, the founder of Terra proposed abandoning the algorithmic stablecoin model and building a new blockchain called Terra 2.0. The original blockchain was renamed Terra Classic, while UST became USTC, and LUNA was renamed LUNA Classic (LUNC). This collapse exposed the risks associated with algorithmic stablecoins, which had a heavy impact on the cryptocurrency market.

Following this event, the Frax community voted to move to a fully collateralized stablecoin model, using the Terra collapse as the main motivation. In February 2023, the Frax governance community passed a resolution to increase the collateralization ratio of the Frax stablecoin to 100%, completely removing the algorithmic element.

Frax, previously known for its partially collateralized model and smart contract algorithm, has now gone fully collateralized. This strategic shift makes the Frax stablecoin, pegged to the US dollar, a trusted, highly scalable, and fully on-chain stablecoin in the crypto space.

Algorithmic stablecoin models

The concept of algorithmic stablecoins has emerged in the diverse context of the cryptocurrency market to meet the need for stability in the face of strong market volatility. Here are some typical algorithmic stablecoin models:

Stablecoin kiểu seigniorage

These stablecoins operate on a seigniorage system, where the supply of coins is increased or decreased depending on market conditions. Basis was once a prominent project in this group, but was later discontinued.

To maintain a stable value, Basis uses an algorithmic stablecoin model that issues and buys back three different tokens: Basis (BAC), Basis Shares (BST), and Basis Bonds. However, the Basis team decided to terminate the project due to the regulatory environment and the unclear status of these tokens under securities law.

Two token system

In dual-token stablecoin models, one token acts as a stablecoin, while the other token helps mitigate price volatility. The second token is often used as a governance token, giving the holder voting rights or a share of the system's profits.

Based on this concept, Terra (LUNA) and TerraUSD (UST) worked, with LUNA being used to reduce the price volatility of UST. However, the system collapsed in May 2022 when confidence was lost, leading to a massive sell-off.

Rebase mechanisms

In this mechanism, the supply of stablecoins is periodically adjusted, or “rebased,” based on market prices. When the price is too high, the supply increases. Conversely, if the price is too low, the supply decreases.

Ampleforth (AMPL) is an example of this principle in action. The token supply is adjusted daily based on market conditions. Instead of stabilizing the price of AMPL, the mechanism aims to maintain the purchasing power of the token. When the price exceeds the target, more tokens are issued; conversely, some tokens are removed from circulation when the price falls below the target.

Collateralized debt position (CDP) model

In this model, users lock up collateral (usually other cryptocurrencies) and issue stablecoins based on that collateral. Through liquidation and overcollateralization mechanisms, the system maintains stability.

MakerDAO’s Dai is a prime example of this model. Users lock up Ether and other approved cryptocurrencies to issue DAI.

How algorithmic stablecoins work

To maintain price stability, algorithmic stablecoins adopt a special process based on smart contracts and algorithms. Unlike traditional stablecoins whose prices are pegged to external assets, algorithmic stablecoins adjust their token supply dynamically according to market demand. When the value of the coin deviates from the target level, the algorithm will trigger mechanisms to increase or decrease the token supply.

For example, if the stablecoin's price is above the anchor level, the algorithm can issue more tokens, increasing the circulating supply. This can help reduce the value of the stablecoin, bringing it closer to the anchor level.

Conversely, if the price is below the target, the algorithm can reduce supply, creating scarcity and driving up the price. The goal of this automatic adjustment mechanism is to bring the stablecoin value back to the predetermined peg.

These principles are applied by projects like TerraClassicUSD and Ampleforth, which aim to build self-balancing systems without direct collateral. While groundbreaking, algorithmic stablecoins still carry risks, especially during periods of market volatility when the effectiveness of algorithms is questioned.

What are Collateralized Stablecoins and How Do They Work?

Collateralized stablecoins are designed to maintain a stable value by pegging their price to an underlying reserve asset. These reserve assets typically include cryptocurrencies, traditional fiat currencies, or a combination of both.

Fiat-collateralized stablecoins are a popular type of collateralized stablecoin, where the value of the stablecoin is directly pegged to a certain amount of fiat currency held in reserves. Tether (USDT), USD Coin (USDC), and TrueUSD (TUSD) are typical examples. These stablecoins hold their value pegged to the US dollar through their respective reserves.

Crypto-collateralized stablecoins are another type, exemplified by MakerDAO’s DAI. In this model, stablecoins are backed by a pool of different cryptocurrencies through a decentralized managed Collateralized Debt Position (CDP) mechanism. CDPs allow digital assets to be used as collateral to issue stablecoins or borrow funds in the decentralized finance (DeFi) system.

Thanks to collateral, these stablecoins offer a decentralized alternative to fiat-backed stablecoins, providing stability and flexibility. By using collateral reserves, collateralized stablecoins attempt to combine the advantages of cryptocurrencies with price stability.

The difference between algorithmic stablecoins and collateralized stablecoins

Algorithmic stablecoins and collateralized stablecoins represent two different approaches to achieving stability in the volatile cryptocurrency market.

Algorithmic stablecoins rely on smart contracts and algorithms to dynamically adjust the token supply. When the value deviates from the target level, the algorithm automatically increases or decreases the token supply to restore stability, often without the need for direct collateral.

In contrast, collateralized stablecoins maintain stability by pegging their value to an underlying reserve asset. These stablecoins provide a direct, transparent peg with the backing of a reserve of assets, while algorithmic stablecoins aim to be decentralized and independent of traditional assets.

Criteria Algorithmic Stablecoin Collateralized Stablecoin Stability Mechanism Dynamic adjustment of token supply Direct pegging to collateral Dependency Less reliance on external assets Direct reliance on asset reserves Collateral type No or minimal collateral Fiat or crypto reserves Decentralization Higher decentralization potential Potential for some degree of centralization Flexibility Intraday volatility, adapting to changing market conditions Fixed pegging to collateral

Advantages and disadvantages of algorithmic stablecoins

Algorithmic stablecoins offer an innovative way to maintain price stability in the volatile world of cryptocurrencies. One obvious benefit is the ability to operate independently of traditional collateral, providing a more decentralized and international alternative. In theory, algorithmic stability mechanisms can dynamically adjust the token supply according to market demand, achieving stability without the need for large reserves.

However, algorithmic stablecoins are not without risks. The effectiveness of these strategies depends on the accuracy of the underlying algorithm, and unexpected market fluctuations can pose challenges. Terra's collapse is a warning that algorithmic stabilization methods may not withstand extremely volatile market conditions.

Additionally, algorithmic stablecoins can exhibit complex behavior, making it difficult for users to predict and understand how they will react to changes in the market. Despite their novel features, algorithmic stablecoins require careful scrutiny, careful risk assessment, and continuous improvement to address weaknesses and enhance resilience to volatile market events.

Advantages and disadvantages of collateralized stablecoins

Collateralized stablecoins, whether backed by fiat or cryptocurrencies like DAI or USDT, have their own pros and cons. On the positive side, they provide a simple mechanism for maintaining price stability, as their value is tied to reserves from traditional cryptocurrencies or fiat currencies. This direct peg makes it easy for users to verify the assets backing the stablecoin, creating transparency and increasing trust.

However, collateralized stablecoins are not without challenges. For fiat-collateralized stablecoins, reserves must be managed by trusted custodians and may face oversight from regulators. While more decentralized, crypto-collateralized stablecoins expose users to the inherent volatility of the cryptocurrency market.

Furthermore, maintaining a 1:1 peg can be difficult, especially during periods of high market volatility. Additionally, the collateral requirement creates a dependency on external resources, which can limit the ability of blockchain technology to achieve its decentralization goals. Therefore, finding the ideal balance between decentralization, stability, and risk mitigation remains a key factor in the development and use of collateralized stablecoins.

The future of stablecoins

The future of stablecoins promises many positive developments as the cryptocurrency space continues to evolve. Wider adoption is expected to come as clearer regulations provide a solid foundation for these digital assets. Central bank digital currencies (CBDCs), backed by sovereign authorities, could become an integral part of the digital payments ecosystem.

New technological and algorithmic advances can enhance the resilience of algorithmic stablecoins, addressing current limitations. In addition, stablecoins can play an important role in many financial activities, including lending, borrowing, and liquidity provision, thanks to the continuous innovation in decentralized finance (DeFi).

As the market matures and overcomes current challenges, stablecoins are expected to play an essential role in shaping the future of digital finance.