What are algorithmic stablecoins?

Algorithmic stablecoins are a distinct type of cryptocurrency compared to traditional stablecoins pegged to external assets like fiat. These stablecoins utilize smart contracts and algorithms to minimize price volatility by dynamically adjusting the money supply based on market demand. Two typical examples of algorithmic stablecoins are TerraClassicUSD (TerraUSD) and Ampleforth (AMPL).

However, algorithmic stablecoins are not without risks, as demonstrated by the collapse of the Terra ecosystem. This decentralized finance (DeFi) platform struggled when the price of the algorithmic stablecoin TerraUSD (UST) plummeted significantly.

A 'bank run' occurred on the Anchor Protocol, where most UST was staked, alongside a crisis of confidence as UST lost its peg to the US dollar. The burn-and-issue mechanism between UST and LUNA led to hyperinflation, significantly reducing the value of LUNA as UST depreciated.

In response, the founders 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, heavily impacting the cryptocurrency market.

Following this event, the Frax community voted to transition to a fully collateralized stablecoin model, taking the collapse of Terra as the main motivation. In February 2023, the Frax governance community approved the decision to increase the collateral ratio of the Frax stablecoin to 100%, eliminating the algorithmic component entirely.

Frax, previously known for its partially collateralized model using algorithmic smart contracts, has now fully transitioned to a collateralized model. This strategic shift has made the Frax stablecoin, pegged to the US dollar, a reliable stablecoin with high scalability, fully operational on-chain in the cryptocurrency space.

Models of algorithmic stablecoins

The concept of algorithmic stablecoins has emerged within the diverse landscape of the cryptocurrency market to meet the demand for stability amid strong market volatility. Below are some typical models of algorithmic stablecoins:

Seigniorage-style stablecoins

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

To maintain stable value, Basis uses an algorithmic stablecoin model that issues and redeems three different types of 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 two-token stablecoin models, one token acts as the stablecoin, while the other helps mitigate price volatility. The second token is often used as a governance token, allowing holders voting rights or sharing profits from the system.

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

Supply adjustment mechanisms (Rebase mechanisms)

In this mechanism, the supply of the stablecoin is adjusted periodically, also known as 'rebase,' based on market price. When the price is too high, the supply will increase. Conversely, if the price is too low, the supply will decrease.

Ampleforth (AMPL) is an example that operates on this principle. Daily, the token supply is adjusted based on market conditions. Rather than stabilizing the price of AMPL, this mechanism aims to maintain the purchasing power of the token. When the price exceeds the target, more tokens will be issued; conversely, some tokens will be removed from circulation when the price drops below the target.

Collateralized debt position (CDP) model

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

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

How algorithmic stablecoins work

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

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

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

These principles are applied by projects like TerraClassicUSD and Ampleforth, aiming to build a self-balancing system without the need for direct collateral. Although groundbreaking, algorithmic stablecoins still carry risks, especially during volatile market phases when the effectiveness of the algorithms is called into question.

What are collateralized stablecoins and how do they work

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

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

Crypto-collateralized stablecoins are another type, exemplified by DAI from MakerDAO. In this model, the stablecoin is supported by a basket of different cryptocurrencies through the decentralized collateralized debt position (CDP) mechanism. CDP allows using digital assets as collateral to issue stablecoins or borrow within the decentralized finance (DeFi) system.

Thanks to collateralized assets, these stablecoins provide a decentralized alternative to fiat-backed stablecoins, offering stability and flexibility in adjustment. 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 will automatically increase or decrease the token supply to restore stability, often without the need for direct collateral.

In contrast, collateralized stablecoins maintain stability by pegging their value to a base reserve asset. These stablecoins provide a direct, clear peg with support from asset reserves, while algorithmic stablecoins aim for decentralization and independence from traditional assets.

Criteria Algorithmic Stablecoin Collateralized Stablecoin Stability Mechanism Dynamic supply adjustment Directly pegged to collateral Dependence Less reliance on external assets Directly dependent on asset reserves Type of collateral No or minimal collateral Fiat or cryptocurrency reserves Decentralization Higher potential for decentralization May have some level of centralization Flexibility Daily volatility, adapts to changing market conditions Fixed peg with collateral

Advantages and disadvantages of algorithmic stablecoins

Algorithmic stablecoins offer an innovative method to maintain price stability in the volatile cryptocurrency world. A clear advantage is the ability to operate independently of traditional collateral assets, providing a more decentralized and international alternative. In theory, algorithmic stabilization mechanisms can dynamically adjust token supply according to market demand, achieving stability without 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. The collapse of Terra serves as a warning, indicating that algorithmic stabilization methods may not withstand extremely volatile market conditions.

Additionally, algorithmic stablecoins can exhibit complex behaviors, making it difficult for users to predict and understand how they will react to market changes. Despite possessing novel features, algorithmic stablecoins need to be carefully considered, with risks evaluated thoroughly and continuously improved to address weaknesses while enhancing resilience against market volatility events.

Advantages and disadvantages of collateralized stablecoins

Collateralized stablecoins, whether backed by fiat or cryptocurrencies like DAI or USDT, each have their own advantages and disadvantages. On the positive side, they provide a straightforward mechanism for maintaining price stability, thanks to the value being linked to reserves from traditional fiat or cryptocurrency. This direct pegging allows users to easily verify the supporting assets of the stablecoin, thereby creating transparency and enhancing trust.

However, collateralized stablecoins are not without challenges. For fiat-backed collateralized stablecoins, reserves must be managed by trusted custodial institutions and may face scrutiny from regulatory authorities. Although more decentralized, cryptocurrency-backed stablecoins expose users to the inherent volatility of the cryptocurrency market.

Moreover, maintaining a 1:1 peg can be challenging, especially during periods of significant market volatility. Additionally, collateral requirements create dependence on external resources, which may limit the ability to achieve the decentralized goals of blockchain technology. Therefore, finding the ideal balance between decentralization, stability, and risk minimization 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. Broader acceptance is expected to occur thanks to clearer regulations, creating a solid foundation for these digital assets. Central Bank Digital Currency (CBDC), backed by sovereign authorities, could become an integral part of the digital payment ecosystem.

Technological advancements and new algorithms could enhance the resilience of algorithmic stablecoins, addressing current limitations. Furthermore, stablecoins could play a significant role in various financial activities, including lending, borrowing, and providing liquidity, thanks to 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.