INTRODUCTION
With the volatile nature of the crypto market, stablecoins are the desired alternative to protect investors from the ever-fluctuating prices of crypto assets. But Currently dominating the stablecoin markets are centralized fiat-backed stablecoins susceptible to regulatory uncertainties and censorship and we need a decentralized alternative.
What are stablecoins
Stablecoins are digital currencies designed to maintain a steady value, typically by linking their worth to a specific fiat currency, like the US dollar. They combine the advantages of cryptocurrencies, such as secure and decentralized transactions, with the stability typically associated with traditional financial assets like the USD or gold.
As earlier mentioned Cryptocurrencies can be highly volatile, making its use for everyday transactions risky for both buyers and sellers. Merchants don't want to take a hit if the value of a cryptocurrency suddenly drops after receiving payment. To solve this, stablecoins step in as a solution, and offers assurance to users that it will retain its purchasing power in the long term. This stability sets them apart and gives crypto more acceptance as a legal tender.
Classification of Stablecoins
Stable coins can be broadly classified into, Centralized stablecoins or decentralized stablecoins. Each of this categories can be either over-collaterized or under-collaterized
Centralized Stablecoins
These stablecoins rely on a centralized authority to maintain their stability and manage the reserves that back their value. The centralized entity holds real-world assets such as fiat currencies or commodities such as gold and silver to support the stablecoin's value. Examples of centralized stablecoins include Tether (USDT) and USD Coin (USDC).
Centralized stablecoins provides a sense of security and trust since they are managed by a known entity, but it also means that users have to rely on that entity's operations and transparency. Thus they are mostly fully collaterized stablecoins and fully collateralized stablecoins are highly regulated and require external audits.
Decentralized Stablecoins
Decentralized stablecoins operates without the control or involvement of a central authority or entity. They are built on decentralized blockchain platforms, like Ethereum, and their stability is achieved through algorithms or smart contracts rather than relying on a centralized entity to hold reserves.
“Ultimately, decentralized and stable cryptocurrencies pave the way for a modern financial revolution that will remove inefficiencies, reduce risk stemming from centralized parties and change the way we transact.” — Rune Christensen, Founder of MakerDAO
The lack of collateral backing makes purely algorithmic stablecoins the most permissionless form of money. Over the last few years, decentralized stablecoins have gained substantial market share. Most algorithmic stablecoins fall into this category, being either over-collateralized or relying purely on coded monetary policy.
Algorithimic Stablecoins
Introduced by Robert Sams in 2014, Algorithmic stablecoin uses a set of predefined rules in the protocol that adjust the supply level based on the deviation between the market price and the target price without human intervention, They are programmed to respond to presiding supply and demand forces to maintain a pre-defined peg and price stability. They operate on smart contracts and are fully decentralized.
Algorithimic stablecoins are important building blocks for future growth in DeFi and and crypto as they are less exposed to regulation and go hand-in-hand with the ethos of crypto, offering a permissionless and decentralized alternative to regulated assets
Advantages
Algorithmic stablecoins offer several advantages that differentiate them from other types of stablecoins. Here are five key advantages, along with examples of projects that leverage these benefits:
Decentralization and Governance: Algorithmic stablecoins are typically governed by decentralized communities, allowing participants to have a say in the decision-making process. This enables a more democratic and transparent approach to managing the stablecoin's parameters. An example is Ampleforth (AMPL), which adjusts its supply algorithmically to maintain price stability.
Scalability and Accessibility: Algorithmic stablecoins can be easily accessed and used by anyone with an internet connection, without the need for a bank account or traditional financial infrastructure. This makes them particularly beneficial in areas with limited access to banking services. Terra (LUNA) is an example of an algorithmic stablecoin that focuses on scalability and accessibility for global users.
Stability in Volatile Markets: Algorithmic stablecoins use dynamic algorithms to adjust their supply and demand mechanisms in response to market conditions. This adaptability helps maintain stability even in highly volatile cryptocurrency markets. Empty Set Dollar (ESD) is an example of an algorithmic stablecoin that aims to provide stability by dynamically adjusting its supply based on market demand.
Reduced Counterparty Risk: Algorithmic stablecoins eliminate or reduce counterparty risk by design. Unlike centralized stablecoins, which rely on a trusted custodian to hold reserves, algorithmic stablecoins derive their value from the protocol itself. This reduces the risk of custodial failure or mismanagement. Frax (FRAX) is an example of an algorithmic stablecoin that minimizes counterparty risk by relying on collateralized assets within its protocol.
Potential for Decentralized Monetary Policy: Algorithmic stablecoins enable the exploration of new monetary policy frameworks in a decentralized manner. They allow for experimentation and innovation in designing and implementing monetary systems, potentially offering greater resilience and adaptability compared to traditional monetary systems.
Algorithmic Stablecoins have come a long way since they were first introduced in 2014. While centralized and fiat-backed stablecoins are still dominating, we see how crypto-backed stablecoins are continuing their growth journey and more and more algorithmic stablecoins being launched, having learned from past projects. like terra Luna, there are also inherent risks that come with algorithmic stablecoins.