What are Algorithmic Stablecoins? | Transak

Transak Team

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12 May 2022

 

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Stablecoins are supposed to be, as the name suggests, stable. But is it possible for an algorithm to help reduce crypto’s volatility?

By definition, stablecoins are a type of cryptocurrency for which the value is linked, or “pegged,” to a fiat (government) currency – like the euro (EUR), Australian dollars (AUD), and others – or alternative assets, such as gold.

There are four main types of stablecoins: Fiat-backed stablecoins, cryptocurrency-backed stablecoins, commodity-backed stablecoins, and algorithmic stablecoins.

Today, we’ll touch on the last type — algorithmic stablecoins — since their unique design makes them a much-debated topic among federal regulators and news outlets. Many people wonder, can an algorithmic stablecoin lose its peg? We’ll go over this answer, plus the pros and cons of algorithmic stablecoins, in the article below.

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What are stablecoins?

Stablecoins are a type of cryptocurrency that’s designed to maintain a stable value. 

Most stablecoins are collateralized by reserves of some kind, usually made from external assets such as fiat currency (aka U.S. dollars and euros). One of the original stablecoins, Tether (USDT), for instance, has a market capitalization (market cap) of $83 billion at the time of writing this article. Therefore, a reserve exists within Tether’s treasury that holds the same value of $83 billion USD in some combination of fiat and liquid assets. This reserve collateralizes the value of the stablecoins so that they always remain pegged to the U.S. dollar (USD). When you buy a stablecoin, you can usually expect that the price will always be the same value of the currency or asset to which it’s pegged.

Algorithmic stablecoins, on the other hand, are a type of stablecoin for which there’s no reserve collateral (or at least less than a 1:1 ratio). These are known as algorithmic stablecoins because a computer-generated code helps control the supply in order to make sure the value of the coin remains pegged to its respective asset. 

Let’s take a look at how algorithmic stablecoins work and what the pros and cons of them are.

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How do algorithmic stablecoins work?

To put it simply, each type of algorithm stablecoin works differently. What they have in common, however, is that they are controlled by code. 

One CoinDesk article describes algorithmic stablecoins as like a bucket of water left outside with a water level line marked inside of it:

To keep the water inside the bucket at exactly the same level, you set up a mechanism that adds or removes water depending on how far the water level has deviated from the mark, reads the article. This is controlled by a computer algorithm such that if it rains and the bucket begins to fill up, the algorithm instructs the mechanism to release water out of the bottom of the bucket until it reaches the water level mark. Conversely, if it’s a hot day and water evaporates out of the bucket, the computer algorithm would instruct the mechanism to add more water to the bucket until the correct level is regained.

In theory, algorithmic stablecoins are set up to respond to supply and demand. As more people buy them, the demand increases. When people sell them, the supply increases, and the demand goes down. The computer notices the change in market volume and adjusts.

 

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Examples of algorithmic stablecoins

According to the crypto tracking website CoinMarketCap, Ampleforth (AMPL) is the longest-running algorithmic stablecoin.

Here are some examples of other non-collateralized (aka algorithmic) stablecoins:

  • Rai Reflex Index (RAI): While other stablecoins are pegged to USD and other fiat currencies, RAI is a non-pegged stable asset. RAI is used as collateral in decentralized finance (DeFi) protocols and is considered a truly decentralized stablecoin, as it maintains its stable price without being tied to a particular asset. It’s not tied to the price of USD, for instance. It’s simply its own price. This algorithmic stablecoin is a less volatile form of collateral compared to BTC or ETH, making it a top choice for DeFi traders and investors. RAI uses interest rates to stabilize its price, and it has two prices, a redemption price and a market price.

  • Fei USD (FEI): This stablecoin was designed to maintain a 1:1 USD peg and be used in the Fei DeFi protocol.

  • Terra (UST): Terra (UST) is known as the world’s largest algorithmic stablecoin. It is the 11th largest crypto by market cap. Through an algorithm that controls the supply of both UST and another Terra cryptocurrency called LUNA, Terra was designed to maintain a 1:1 USD peg. In theory, $1 of LUNA is minted each time a UST token gets minted, and vice versa. When UST drops below $1, traders get LUNA in exchange for burning (destroying or trading in) their UST.
     
  • Frax (FRAX): This is a type of hybrid stablecoin, as it’s collateralized by USDC in addition to having an algorithmic component. According to the Frax Protocol whitepaper, the purpose for having both collateralized stablecoin assets and a reserve was to scale and stabilize the value of FRAX quickly, while providing a pathway to create a purely decentralized, algorithmic coin as more users onramp to crypto. Here’s how Frax describes it: As FRAX adoption increases, users will be more comfortable with a higher percentage of FRAX supply being stabilized algorithmically rather than with collateral.

 

Pros and cons of algorithmic stablecoins

Algorithmic stablecoins have been called both a “money god” and a risky bet. Truthfully, they can be both. Risk is inherent in DeFi, and crypto as a technology is still new. In order to better understand the potential risks, as well as the benefits, of algorithmic stablecoins, you need to consider how they work and how volatile market conditions may impact the price of whatever stablecoin you’re holding.

Let’s look at the pros and cons:

Pros of algorithmic stablecoins

  • Popular for DeFi positions such as staking, lending, borrowing, and derivatives
  • Fully decentralized (at least in theory)
  • Less volatile than BTC and other altcoins

Cons of algorithmic stablecoins

  • Algorithm doesn’t always work (the currency could lose its peg)
  • High volatility can influence the market and disrupt the algorithmic balance

 

Bottom line

Algorithmic stablecoins provide the hope and even possibility for a totally decentralized currency that bypasses crypto’s trademark volatility. However, they aren’t backed by any assets, and therefore they work only when there is widespread buy-in from investors. The above stablecoins on our list of best algorithmic stablecoins is exemplary of the investment in stablecoins both conceptually and practically speaking. Investors at the institutional level and individual level rely on algorithmic stablecoins when taking advanced DeFi positions, and some speculate that a 1:1 USD-pegged stablecoin will be necessary in order for crypto to ever become a day-to-day method for exchanging money. 

 

Institutionally, it’s a little tricky to determine whether buy-in from major banks and accredited investors is sustainable on a long-term basis, since massive sudden activity from major market players can disrupt the algorithm and make stablecoins lose their peg. 


Only time will tell whether algorithmic stablecoins are here to stay — after all, the longest-running one, AMP, has only been around since roughly 2019. But the value of algorithmic stablecoins is clear, and their use cases are constantly evolving in the ever-experimenting world of crypto and DeFi.

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