What are Algorithmic Stablecoins? The Economics of Algorithmic Stablecoins
A thing or two about stablecoins
If you are a frequent reader, you probably remember that we mentioned stablecoins a few times in the past. Stablecoins are cryptocurrencies designed to hold a certain value that is tied to something else. For example, stablecoins are typically linked to fiat currencies such as the U.S. dollar.
If you are interested in learning more about stablecoins, why not read this article: ‘Crypto Basics: What is a Stablecoin?’.
Stablecoins are used to decrease the negative effects of the volatile crypto market by being pegged to a more stable asset. Most stablecoins achieve this peg by using a collateral mechanism and being backed by stable reserve assets.
Algorithmic stablecoins started off in a bad way; Terra USD didn't manage to keep the peg and collapsed. Digital asset markets have experienced broad volatility by stablecoins. Following the Terra collapse, regulators stepped in quickly and introduced a legal toolkit on how to deal with stablecoins.
In case you are not familiar with the Terra aftermath, check out this article: ‘Stablecoins and Regulatory Developments Post Terra’.
What is an algorithmic stablecoin?
An algorithm may sound like a confusing word. However, it has a quite simple definition – an algorithm is a set of instructions written in code that deals with the execution of a determined process. In crypto terms, an algorithm refers to pieces of code on the blockchain, accommodated within a set of smart contracts.
Therefore, algorithmic stablecoins are a type of cryptocurrency with the objective to maintain a stable market value by using algorithms, smart contracts, and incentive mechanisms.
Algorithmic stablecoins generally rely on two tokens – a stablecoin and another cryptocurrency that backs the stablecoin. The algorithm encoded in a smart contract regulates their relationship.
In contrast to other stablecoins, algorithmic stablecoins are known as uncollateralized stablecoins because they don’t rely on any collateral to maintain their value. Mathematical algorithms are here to regulate the supply of tokens in circulation and stabilise their market price.
To prevent the stablecoin’s price from de-pegging or moving away from its $1 value, algorithms regulate supply and demand while subject to market conditions.
Understanding basic financial terms comes in handy when dealing with a digital asset ecosystem and decentralised finance (DeFi). You can learn more about it in our ‘When CeFi Meets DeFi: Basic Finance Terms’ article.
Types of algorithmic stablecoins
There are a few different types of algorithmic stablecoins with their unique traits. Let's examine them briefly.
a. Rebasing Algorithmic Stablecoins
When it comes to rebasing algorithmic stablecoins, the supply is automatically adjusted based on the current price of the token. For example, if the price falls below the pegged value, the supply will automatically decrease to bring the price back up and vice versa.
This sort of mechanism is achieved through a so-called rebase function that adjusts the supply on a regular basis. It handles price-elastic ERC-20 tokens since the total supply is not fixed and is modified adaptively.
b. Over-collateralized Algorithmic Stablecoins
An over-collateralized stablecoin relies on a broad reserve of other cryptocurrencies to back the stablecoin. Basically, if the value of the stablecoin falls, the reserve jumps in to buy back the stablecoin and bring the price back to stability.
c. Fractional Algorithmic Stablecoins
This type is a fusion of the rebase and over-collateralized type of algorithmic stablecoins. These stablecoins are partially backed-up by a reserve of assets, yet the rest of the value is maintained through algorithmic mechanisms.
By maintaining the value in two separate ways, the amount of needed collateral is reduced, along with increased efficiency of the stablecoin regarding market fluctuations.
d. Seigniorage Algorithmic Stablecoins
This type utilises a two-token system to maintain a stable value. While one token is used as a currency, the other one is used as a bond that can be purchased to earn rewards.
The bond token incentivises users to buy or sell the cryptocurrency token when it is needed to maintain the peg.
Main advantages of algorithmic stablecoins
There are a number of benefits when it comes to using algorithmic stablecoins in comparison with other stablecoins and cryptocurrencies. At first, it sounds a bit ambiguous to use something that is governed by math solely in the volatile crypto ecosystem, but a few upper hands were enough for these stablecoins to become a popular option.
a. Resilience to Market Fluctuations
Market participants expect a stablecoin to be resilient enough to combat market volatility. In fact, algorithmic stablecoins are designed in that manner as they rely on a network of users and mathematical algorithms to maintain their stability.
Due to this feature, algorithmic stablecoins became popular among many traders and investors looking for a stable value on crypto markets.
Unlike a majority of other stablecoins, the algorithmic ones are fully decentralised. In other words, they are not subjected to constraints as their traditional counterparts backed by governments and financial authorities such as central banks.
Being decentralised, they provide greater transparency and security, making them more attractive to users that are concerned about oversight by central authorities or censorship
c. Payment Efficiency
Algorithmic stablecoins provide a greater degree of efficiency and monetary advantages when it comes down to cross-border transactions. This is due to their speed of transaction and overall ease.
Not being tied to any particular fiat currency, they can be easily used for cross-border payments without the need to exchange a foreign currency or bear any other additional costs.
Main disadvantages of algorithmic stablecoins
When hearing about famous collapses such as in the case of Terra USD and Neutrino USD, it is logical to assume that not all that glitter is gold. Algorithmic stablecoins encompass a few drawbacks that need to be taken into account before dealing with them.
a. Algorithm dependency
Algorithm dependency is a severe drawback of this stablecoin type. If the initial algorithm is poorly designed or not updated regularly as a response to ever-changing market conditions, it encompasses the potential to lead to value instability.
b. Market manipulation vulnerability
All cryptocurrencies and other financial instruments are vulnerable to market manipulation, but algorithmic stablecoins are a bit more in jeopardy than fully collateralized stablecoins.
This especially refers to stablecoins that rely on supply and demand to maintain their stable value since they are more susceptible to manipulation.
Back in 2020, a seigniorage algorithmic stablecoin Basis Cash (BAC) experienced a rapid increase in price due to a group of anonymous traders manipulating the market. Such a sharp increase led to the collapse of the value and the project was shut down.
Similar to fixed exchange rates used in traditional finance, algorithmic stablecoins are vulnerable to speculative attacks. They also face competitive threats from other forms of public and private money on the market. The same thing happened with some earlier experiments with private money throughout U.S. history.
c. Peg breaks
Among all challenges associated with this type of stablecoins, this one is often considered as a worst-case scenario. Peg breaks are bad for any sort of stablecoins, yet algorithmic stablecoins run the maximum degrees of risk.
The answer lies in the fact that algorithmic stablecoins depend on market confidence. Without that feature, any algorithmic stablecoin could be doomed to fade away. For example, if an algorithmic stablecoins breaks the peg twice, it would be really hard to recover effectively.
Explaining the economics of algorithmic stablecoins
Stablecoin economics in general
Emerging markets that suffer from high inflation rates encompass a high cryptocurrency adoption rate. There is a good reason for that – emerging markets, for example, Argentina or Turkey, go through frequent inflation periods which leads their citizens to turn savings into something stable such as U.S. dollars. Stablecoins are more accepted because they provide an option for people to access capital markets easily in the first place and obtain U.S. dollars.
Furthermore, the market capitalization of stablecoins expanded and made it possible for stablecoins to actually have an impact on currencies’ stability in general. There is not enough data on stablecoin users acquired through suitable cross-country research so it is not possible to present the socio-economic aspect of stablecoins.
Algorithmic stablecoins are praised as a promising, decentralised and efficient asset – in other words, it is a holy grail among stablecoins. There is no risk in the form of an intermediary, but this subsequently comes with another risk – the backup risk.
How does an algorithmic stablecoin work?
Let’s make a quick comparison first. Have you ever wondered why PayPal balances are always equal to $1? The platform uses a traditional technique for creating a stable representative of the dollar. In other words, each PayPal dollar is backed by substantial assets.
The thing with algorithmic stablecoins is that it lays down something that hasn’t been seen before – a stable representative of a fiat currency but with no traditional backup.
As mentioned, there are divergent algorithmic stablecoins and their solutions differ. For example, MakerDAO, a protocol that manages the DAI stablecoin uses a less fragile mechanism. It backs the $1.5 billion of circulating stablecoins by holding approximately $4.5 billion worth of cryptocurrencies such as Ethereum and Bitcoin in reserves.
Algorithmic stablecoins start off by producing a number of digital tokens. Some may say they are produced out of thin air. In case the stablecoin trades above the dollar threshold, the system automatically creates new tokens until the price falls back down.
However, if the stablecoin drops below the threshold, the system must reduce the supply. There are a few ways to do that. For example, the Empty Set Dollar (ESD), an algorithmic stablecoin system, does that by suggesting to users to exchange their stablecoins for coupons that subsequently lock up stablecoins. Shifting funds to coupons removes a substantial number of circulating stablecoins, making their price rise again.
Algorithmic stablecoins vs free banking
Similar to other stablecoins, algorithmic stablecoins mirror pegged exchange rates. In traditional finance, a central bank must always be prepared to trade the national currency at a stated price in terms of foreign currency. This has to be done to maintain a fixed exchange rate.
On the other hand, algorithmic stablecoins are said to resemble the circulation of private bank notes as money during the U.S. Free Banking Era in the 1800s. At that time, banks were able to issue private bank notes that practically circulated as money, being payable on demand at the issuing bank.
However, this historical analogue was criticised by the crypto community many times since the authors of the study that suggested such a comparison, basically noted that privately issued money (free banking or based on stablecoins) cannot function only because it wasn’t issued by a central authority.
The U.S. episode of free banking wasn’t completely free; during that period, banks had to hold risky government bonds and were restricted from branching nationwide. This deterred them from diversifying their depositor base and asset portfolio, and consequently, led to numerous bank failures.
Improved algorithmic stablecoins as a way to stability?
A currency based on maths that doesn’t make detours from its back and doesn’t require capital lockups sounds great. In practice, algorithmic stablecoins are not there yet.
The perfect algorithmic mechanism still hasn’t been created, but obtaining value stability is a long-term question of incentives and users’ adoption. Before achieving stability there must be a substantial degree of liquidity. A part of the crypto community believes that speculation is the roadmap to liquidity and then finally to stability.
It is perceived, either in traditional or decentralised finance (DeFi), that something known as reflexivity will amount to the stability of algorithmic stablecoins. In other words, market participants expect an asset to behave in a particular way, and their actions make it come to life.
Another part of the community states that perfection cannot be achieved and that markets don’t function in that manner. Perfection in terms of value stability needs the fulfilment of three requirements – adaptive supply, long-term value, and a stable peg. Notably, even pegged fiat currencies didn’t manage to reach perfection.
Despite their flaws, algorithmic stablecoins provide a solid ground for innovation. They might not be a stablecoins’ holy grail, but they symbolise opportunities to push the bounds on what is possible to achieve in DeFi.