Be Straight With Me: What Is an Algorithmic Stablecoin?

Be Straight With Me: What Is an Algorithmic Stablecoin?

The most popular stablecoin in the world, Tether (USDT), is worth over $80 billion. If you believe that no one company should have all that power, then you may want to hold algorithmic stablecoins instead.

Be Straight With Me: What Is an Algorithmic Stablecoin?
Darry Port

Published Mar 12, 2022Updated Mar 17, 2022

Crypto

Crypto

Technology

Technology

Global Markets

Global Markets

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Cryptocurrencies were created as an alternative to fiat money that’s controlled by central banks. 

And while there are enough cryptos listed on CoinMarketCap (18,000+) to boggle the mind, you can broadly split them all into two groups: pegged cryptocurrencies and non-pegged cryptocurrencies.

Non-pegged cryptocurrencies like Bitcoin and Ethereum have the potential for major price volatility. A stablecoin, on the other hand, is pegged to a reserve asset—like the U.S. dollar or gold—to provide it with price stability. The combination of the relative stability of fiat currency and the security and efficiency of cryptocurrency has led some to posit that stablecoins are the future of money.

 

True to the spirit of cryptocurrencies, algorithmic stablecoins are more decentralized and trustless.

Some stablecoins use an algorithm, rather than a physical reserve asset, to stabilize their price. These are called algorithmic stablecoins. Here's everything you need to know about algorithmic stablecoins, from what they are to whether or not you should invest in them.

What are algorithmic stablecoins?

Algorithmic stablecoins are pegged to a stable asset, just like regular old stablecoins. But instead of being backed by a reserve, they rely on smart contracts and user incentives to maintain a stable price.  

There are four main types of stablecoins, based on the mechanisms they use to maintain price stability.

Fiat-collateralized stablecoins: These are stablecoins that are backed by fiat currency, like the U.S. dollar or the euro. Examples include Tether (USDT) and USD Coin (USDC).

Commodity-collateralized stablecoins: These are stablecoins that are backed by a commodity, such as reserves of gold or precious metals. Examples include Digix Gold (DGX) and Tether Gold (XAUT).

Crypto-collateralized stablecoins: Crypto-collateralized stablecoins are backed by cryptocurrencies rather than fiat money. This does away with much of the centralization in fiat-collateralized stablecoins, but since cryptocurrencies are highly volatile (up to 50% swings), these stablecoins have to be over-collateralized. Examples include Wrapped Bitcoin (WBTC), a stablecoin that's pegged to the value of Bitcoin.

Algorithmic stablecoins: Non-collateralized (or algorithmic) stablecoins don't use fiat or crypto reserves at all. But how do they keep prices stable then? Let’s dive into how these magic internet dollars work.

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How algorithmic stablecoins work

Most algorithmic stablecoins use the same underlying principle of supply and demand to maintain price stability. Here’s how that works: When the stablecoin price goes above $1, the protocol issues more tokens to apply downward pressure. Conversely, when the stablecoin price goes below $1, the protocol buys/burns tokens to apply upward pressure.

True to the spirit of cryptocurrencies, algorithmic stablecoins are more decentralized and trustless. This means that no single government or company can freeze your assets. But using algorithmic stablecoins comes with its own set of risks.

Risks of algorithmic stablecoins

Compared to collateralized stablecoins, algorithmic stablecoins have a harder time staying on peg. If they don’t have the proper balance of liquidity, incentives and automation, then the coin can enter a so-called “death loop” where it becomes impossible to restore the peg. 

Examples of algorithmic stablecoins

But if algorithmic stablecoins use the same mechanism to stay pegged to $1, then why does it matter which one I choose? Well, it all comes down to risk. Every algorithmic stablecoin is different in terms of their:

  • Longevity: how long the protocol has been running and how battle-tested it is, e.g. by surviving market crashes
  • User adoption: as measured by the market cap, transaction volume and active wallets
  • Incentives: how profitable it is for users to hold the stablecoin or maintain price stability
  • Transparency: whether the smart contracts have been audited and how the token supply is distributed

A few popular algorithmic stablecoins include: TerraUSD (UST), Frax (FRAX), Ampleforth (AMPL) and Celo Dollar (CUSD).

But at a $14 billion market cap, TerraUSD (UST) is the most popular algorithmic stablecoin by far. It recently surpassed the crypto-backed stablecoin DAI, and is now on its way to overtaking fiat-backed stablecoins like BUSD, USDT and USDC. Here’s how TerraUSD works.

TerraUSD (UST)

The Terra (LUNA) blockchain was built with a focus on fiat-pegged stablecoins that are more decentralized than USDT and USDC, but also more scalable than DAI. To that end, TerraUSD (UST) is LUNA’s U.S. Dollar-pegged algorithmic stablecoin. 

Terra incentivizes its users to maintain the price stability of UST with its volatile native currency LUNA. If the price of UST goes above $1, this means that there is less supply than demand. To correct this, users can burn LUNA to mint UST. As a result of this, the supply grows larger and the price is pulled down until it restores its $1 peg.

Conversely,  if the price of UST goes below $1, this means that there is more supply than demand. Users can fix this by burning UST for LUNA. This decreases the supply of UST and pushes the price up until it restores its $1 peg.

 

But why are users even incentivized to maintain the price stability? Because they profit off the price differences (arbitrage) between UST and LUNA. Let’s look at an example where UST is worth $1.10. If a user burns $1,000 worth of LUNA for UST in this case, they’ll receive $1,100 in UST. In other words, they banked $100 off the price instability while helping to restore the peg. 

 

Outside of arbitrage opportunities, the Terra ecosystem incentivizes users by offering an impressive 20% interest on UST via the lending app Anchor. It’s easy to see why the price of LUNA has been going to the moon since 2021.

The bottom line on algorithmic stablecoins

Algorithmic stablecoins are stablecoins that use smart contracts and user incentives to maintain their peg to $1 (or other fiat currency). 

The main benefit of algorithmic stablecoins over fiat-backed stablecoins is that the former is decentralized, so no institution can seize your assets. But the tradeoff is that algorithmic stablecoins can lose their $1 peg if enough users abandon the protocol or its smart contract malfunction. In other words, algorithmic stablecoins aren’t necessarily the safest stablecoins you can buy.

Just keep these risks and rewards in mind as you choose which stablecoin to place your hard-earned money in.

Pick your poison: Wallet blacklist or death loop?

While collateralized stablecoins are more regulated by financial institutions, they can also be frozen if you’re placed on a wallet blacklist. Algorithmic stablecoins, while more decentralized, can lose their peg forever by entering a death loop. Which of these two unpleasant scenarios do you prefer?

Pick your poison: Wallet blacklist or death loop?

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