36. Algorithmic stablecoins – everything you should know about them.

You understand, cryptocurrencies are assets, characterized by high volatility of value in the market. Stablecoins, unlike cryptocurrencies, are backed by a stable asset or designed to combine some characteristics of fiat currencies and some cryptocurrencies.

Known for their stability, stablecoins are assets worthy of attention. Today we are taking on algorithmic stablecoins. However, before you get to the main topic, recall the basic issues about stablecoins [LINK – WHAT ARE STABLECOINS – BASIC LEVEL].

The role of stablecoin in the world of cryptocurrencies

Since their inception, stablecoins have been seen as something between traditional currency and cryptocurrencies. Their advantage is that they provide the best of both worlds: price stability, convenience, and privacy. What more could you want?

An important feature of stablecoin is that it is free from price fluctuations. The first stablecoin to enter the world of cryptocurrencies, was Tether (USDT). It was launched exactly on July 28, 2014. Currently, on the market of digital assets, we have a multitude of stablecoins available. We are talking, for example, about DAI, which we wrote about here [LINK – WHAT A DAO AND DAI MAKER IS – INTERMEDIATE LEVEL].

This would also include USDC, Digix Gold, Gemini Dollar and many, many others. The stablecoins themselves had a positive impact on the development of DeFi (Decentralized Finance). Whether it was lending, borrowing, liquidity pools, yeld farming – stablecoins were an indispensable part of DeFi.

Types of stablecoin

We can divide stablecoins into four main groups.

1. Fiat Collateralized (secured with fiat currency).

As the name suggests, these are stablecoins, whose underlying asset is fiat currencies. What’s more, this type of stablecoin is regularly audited, further confirming its compliance with current financial regulations.

2. Stablecoins backed by commodities.

That is, those that are backed by assets like gold, oil, silver, real estate and the like.

3. Secured with cryptocurrencies.

That is, stablecoins, whose reserve asset is cryptocurrencies. Interestingly, this type of stablecoin is usually all the way over-secured. Therefore, before any cryptocurrency backed by stablecoin is released, the project must keep more pledged assets in its reserves. This is done to prevent high volatility of the reserved asset.

4. Algorithmic stablecoins.

Algorithmic stablecoins have the same purpose in the market as others. However – they are not secured. So much by way of introduction. We will devote several paragraphs to this type of stablecoins.

Algorithmic stablecoins – definition

This type of stablecoin is pledged to cryptocurrencies. But with the difference that it automatically adjusts its demand, supply and other relevant details to reduce its volatility. Algorithmic stablecoins may be pledged with fiat currency, commodities, or even gold.

However, what sets them apart from other stablecoins, is that they have no reserve. Instead, they use intelligent contracts or codes for minting and firing new coins, which is their response to current market conditions.

The ranks of algorithmic stablecoins include Ampleforth (AMPL), DefiDollar (USDC), Basic Cash, Reserve, Debasconomics, Frax (FRAX), Empty Set Dollar (ESD).

How do algorithmic stablecoins work?

Algorithmic stablecoins consist of two coins. The first is responsible for market volatility, and the second holds the peg. Coin number two is the management token. This interaction between the first and second coins is required to maintain the stable value of an algorithmic stablecoin.

Let’s use an example. When the price of an algorithmic stablecoin, which is priced at $1, rises above the pledged price, then the algorithm mints new tokens. Why? The algorithm hopes that the new tokens will be sold and cause the current price to fall.

On the other hand, when the price falls below $1, then the algorithm will burn part of the tokens, hoping that the remaining ones will be priced higher than the previous price.

Stablecoins will not cease to amaze us. Algorithmic stablecoins can also be divided into three basic types:

1. Rebasing Algorithmic Stablecoins. They operate based on the price elasticity of ERC-20 tokens. For these stablecoins, the rebase process regularly modifies the price.
2. Seigniorage Algorithmic Stablecoins. This type of stablecoin consists of two coins – a cryptocurrency/stablecoin and a seigniorage property. This division was used to increase the supply of coins.
3. Fractional Algorithmic Stablecoins. This type of stablecoin is a combination of fully algorithmic and secured stablecoins. They have a significantly lower deposit risk and exhibit the highest level of stability. They use a partial-collateral protocol and a two-token architecture in their operation.

Advantages and disadvantages of algorithmic stablecoins

The main task of algorithmic stablecoin is to increase capital efficiency. All thanks to intelligent contracts which are used to keep prices near pagged levels.

Moreover, algorithmic stablecoins maintain full decentralization in the stablecoin market. How? No third party is involved in their operation. At the same time, they eliminate the problems of raising sufficient capital, which is needed for reserve assets.

A big advantage of algorithmic stablecoin is also the high trust between users and developers. All thanks to peg, which is closely related to the algorithm of a given stablecoin, rather than security.

However, on the other hand, algorithmic stablecoins have a weak architecture. And despite their peg advantages, they are prone to de-pegging risk. Algorithmic stablecoins are also heavily influenced by demand, so thinking logically – a lack of demand for a particular coin, can cause its price to fall.

Another disadvantage of algorithmic stablecoins is that they depend on investors. Sometimes, as it happens in psychology, there is a herd mentality in the market for digital assets. We then have to deal with emotional decision-making and, for example, selling off algorithmic stablecoins. This causes their price to fall.

Can we trust algorithmic stablecoins?

Here are four main reasons why the answer will be yes.

1. Compared to other top cryptocurrencies, they have higher stability.

They provide a far higher level of stability than traditional cryptocurrencies.

2. Transparent code that we can check.

Algorithmic stablecoins are based on intelligent contracts and codes that are used to maintain the price. Any such code is open-source, so there’s nothing stopping you from taking a look at it to see if a particular stablecoin is safe and trustworthy.

3. They have a decentralized structure.

The nature of algorithmic stablecoins is decentralized. No external entity has power over them. The data on algorithmic stablecoins is distributed across nodes, allowing them to be distributed evenly and fairly.

4. Network management capability.

Algorithmic stablecoins are treated as native tokens in some protocols. Thus, the more of a given coin you have, the more influence you have over decisions in a given ecosystem.

Summary

You already understand the definition and what algorithmic stablecoins are all about. The topic is not as complicated as you might think.