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What are Algorithmic Stablecoins?

What are Algorithmic Stablecoins?

Main

  • Algorithmic Stablecoins are cryptocurrencies whose price stability is provided by algorithms, smart contracts, or the actions of the users who interact with them.
  • As a consequence, the value of such cryptocurrencies depends not on collateral, but on the specific price-holding mechanisms, actions and behavior of the holders. As a result, the price of algorithmic stackcoins is more volatile than their centralized counterparts or coins with excess collateral.
  • Algorithmic stablcoins are actively used as a highly liquid trading instrument, as well as in DeFi applications for secured crypto-asset lending, income farming, cryptocurrency derivatives transactions, and other transactions.

How do algorithmic stablecoins work?

Centralized steblecoins, such as USDT, USDC, and BUSD, are typically issued by a single issuer, which ensures their price stability through its own reserves and controls their issuance.

Algorithmic steblecoins are not fully backed by reserves. In other words, if there are $1 billion of these coins in circulation, they can only be backed by $0.5 billion in reserves from cryptocurrencies or other assets.

The price is supported by special mechanisms used by the developer of stabelcoin, such as senorage, rebalancing, or provisioning with native coin. The active element of these mechanisms is the users themselves, who are incentivized to take certain market actions.

What are the advantages of algorithmic stabelcoins?

The issuance, circulation and burning of algorithmic stablcoins are decentralized, i.e. available to everyone through the interaction with smart contracts. Partial provisioning increases the efficiency of investing in such steblecoins and allows the ecosystem to scale much faster as the number of holders grows.

The consequence of decentralization is that algorithmic stablcoins cannot be locked into users’ wallets. At the same time, centralized stackablecoins stored in users’ wallets can be blocked by the issuing company, which has been practiced many times.

What are algorithmic stackablecoins and how do they differ?

As of mid-May, there are about 20 algorithmic stabelcoins on the cryptocurrency market, with more than 90% of their total capitalization coming from five projects.

There are several basic mechanisms for stabilizing the price of this type of stabelcoin.

Rebalancing

This mechanism is used by the Ampleforth Project (AMPL), one of the pioneers of the algorithmic stablcoin segment, launched back in 2019 on the Ethereum blockchain. The price of the AMPL token is regulated by daily rebalancing. If the exchange rate of the token is above the target, AMPL wallet balances increase, and if the rate is below $1, it decreases. This mechanism generally works, but does not solve the problem of price volatility.

Senorage

This mechanism is implemented, for example, in Empty Set Dollar (ESD) and Basis Share (BAS) projects. It involves a system of rewards for token holders.

If the price is above the target price, new tokens are credited to the holders, which increases the supply of coins, encouraging them to sell the surplus. When the price decreases, token issuance stops, and users in the project’s DeFi-application can buy special debt “coupons” by burning stabelcoins. The coupons can only be redeemed and profit when the price of the stabelcoin returns to the target.

Securing a native token

The most successful until recently have been algorithmic stablecoins, whose rate stability is provided by the native coin ecosystem.

The most famous example of this approach was TerraUSD (UST) on the Terra blockchain. Users themselves can issue USTs while burning the native LUNA token through a special service called Terra Station, and vice versa. When the value of a UST deviates from $1, an opportunity for arbitrage arises. User exchanges should stabilize the price.

Also, to increase UST stability, the Luna Foundation Guard (LFG) reserve fund was created in January 2022, effectively creating a “hybrid” TerraUSD price stabilization mechanism.

The native token security mechanism is used by other stable coins: Neutrino USD (USDN) on the Waves blockchain, USN (NEAR network) and USDD (TRON).

Partial Security

This method is used in the Frax Finance (FRAX) project. Stablecoin is partially secured by another stable coin – USDC, partially by the native cryptocurrency Frax Shares (FXS). The collateral increases when FRAX is below $1 and decreases when it is above $1. This arrangement makes FRAX one of the most stable algorithmic stablecoins.

What are the disadvantages of algorithmic stablecoins?

The history of algorithmic stablocoins has shown that they are subject to all the systemic risks inherent in the DeFi industry:

  1. Attackers’ use of bugs and vulnerabilities in the smart contracts that enable the issuance and pegging of stabelcoin to steal reserves;
  2. the possibility of price manipulation when oracles do not work correctly;
  3. the possibility of information attacks on stablcoin to provoke panic selling and price manipulation.

As a result of a crisis situation, Stablecoin may lose its peg, which, in turn, may lead to an avalanche sale or a native coin that supports its price, or to mass liquidations by holders of margin positions, and eventually to panic withdrawal of capital by investors.

Most algorithmic stablcoins periodically lose stability. Here are just a few of the episodes:

  • The FEI Stablecoin, released in April 2021, almost immediately entered a period of losing its peg to the U.S. dollar. The value of the token fell below $0.7, but recovered to $1 within a month.
  • In late March 2022, the Cashio Dollar (CASH) smart token, which runs on the Solana blockchain, was hacked and $28 million worth of funds stolen from it, after which it almost completely lost its value.
  • On April 4, 2022, the USDN token lost its peg to the U.S. dollar, momentarily dropping to $0.7, despite being oversubscribed with WAVES coins. Price manipulation and information attacks by market participants were among the reasons cited.

What happened to UST Stablecoin?

The systemic risks of algorithmic stablenecoins became fully apparent in the first half of May 2022, when TerraUSD (UST) lost its peg to the dollar, causing the project to collapse.

In 2022, UST became the most popular algorithmic stablecoin: its capitalization increased more than 50 times in just one year and by the beginning of May exceeded $18.6 billion, of which about $17 billion were blocked in the DeFi-Protocol Anchor with a return of 20% per annum.

In May, developers announced a reduction in deposit rates to increase the stability of the UST. However, it turned out exactly the opposite: users withdrew more than $2.2 billion from Anchor UST in just two days, which led to a loss of stability. After that, Terra’s native coin, LUNA, also rapidly began to lose value. The Terraform Labs team decided to raise the price of UST with a massive issue of LUNA, which only led to an even bigger drop in the price of both the coin and UST. Even the reserve fund could not reverse the trend.

As a result, the price of LUNA plummeted from $80 to $0.0001 and UST to about $0.1 in just one week.

The collapse of the largest algo-stablecoin caused numerous negative consequences throughout the entire crypto market: first of all, the volatility of other stablcoins increased, including the largest of them, USDT.

The future fate of UST and the entire Terra ecosystem is in question. The remaining funds in the LFG fund will be enough to compensate only part of the losses, and the Terra Labs team has not yet been able to find other sources of funding. They suggest a hardfork and airdrop of new coins, but not everyone agrees with this plan. Vitalik Buterin, the founder of Ethereum, insists that small investors should be the first to compensate for losses. The head of Binance, Changpen Zhao, agrees with him.

What are the prospects for algorithmic stablcoins?

Since the collapse of UST, there has been a persistent distrust of algorithmic stablcoins in the cryptocurrency market. Project teams are responding by increasing their security guarantees. For example, USDD creator Justin Sun has already stated that the issuance of stablcoin will always be lower than the amount of reserves.

At the same time, algorithmic stablcoins remain one of the cheapest and easiest ways to attract liquidity to decentralized ecosystems. In addition, they offer higher yields. Therefore, they are unlikely to disappear from the market.

At the same time, algorithmic stabelcoins have attracted increased attention from regulators and lawmakers. Most likely, legal regulations for stablecoins will tighten as soon as possible. The U.S. Treasury secretary promised that a law on stablcoin will be passed by the end of 2022, while South Korea, where Terraform Labs is headquartered, plans to discuss the UST situation at the parliamentary level.

What else to read?

What is decentralized finance (DeFi)?

What is Lido?

What are custodial and non-custodial cryptocurrencies?

What is cryptocurrency airdrop?

What is DAO (decentralized autonomous organization)?

What is coin flaring and how does it affect the price?

What is revenue farming (income farming)?

What is Tether?

What are shorts and longs?

What are ERC-20 tokens?