Cryptocurrencies have come a long way in recent years, with the emergence of algorithmic stablecoins being a notable development. Unlike traditional stablecoins that rely on external assets like fiat money, algorithmic stablecoins leverage smart contracts and specialised algorithms to maintain price stability. By adjusting the coin’s supply in real-time based on market demand, these stablecoins offer a promising solution to the issue of price volatility in the crypto market.

Algorithmic Stablecoins Explained

Algorithmic stablecoins are digital currencies that use computer algorithms and smart contracts to keep their value stable. They do this by pegging their value to another asset, such as the U.S. dollar. Unlike other stablecoins, algorithmic stablecoins do not rely on physical assets or over-collateralization with cryptocurrency to maintain their value. Instead, they often operate with less collateral than they theoretically require.

Some stablecoins use a mechanism of ‘balancer’ or ‘share’ tokens to manage market fluctuations and maintain their fixed value. The Terra blockchain system, for instance, offers TerraUSD, an algorithmic stablecoin that interacts with Luna, its governance token, to keep its value stable. When TerraUSD’s value goes above $1, Luna holders can profit by exchanging their Luna for TerraUSD. On the other hand, when TerraUSD’s value falls, traders can benefit by exchanging it for Luna, which reduces the supply and increases the price.

Algorithmic stablecoins are digital currencies that rely on the market demand to maintain their stability. However, if the demand decreases below a certain level, the whole system may suffer. Investors play a crucial role in stabilizing the prices of these stablecoins, but this may also introduce significant risks. Despite these potential drawbacks, algorithmic stablecoins are appealing to users who value transparency and decentralization, as they operate based on auditable code and are not subject to regulatory oversight.

 

Different Kinds of Algorithmic Stablecoins

As cryptocurrencies continue to gain popularity, there has been a growing demand for stablecoins that can help reduce the impact of market volatility. To meet this demand, a number of algorithmic stablecoin concepts have emerged.

These innovative models aim to provide greater stability to the crypto market and offer users a more reliable investment option. Here are some examples of how algorithmic stablecoins are leading the way in creating a more secure and stable cryptocurrency ecosystem.

 

Seigniorage Stablecoins

Seigniorage-based stablecoins adjust their supply to reflect current market conditions. Basis, a prominent project in this area, was eventually shut down.

The Basis project aimed to maintain the stability of its value by using an algorithmic stablecoin model. This model involved issuing and redeeming three types of tokens, namely Basis (BAC), Basis Shares (BST), and Basis Bonds. However, Basis decided to shut down because of the unclear legal status of these tokens under securities laws and the regulatory environment.

Dual-token Stablecoin Models

Dual-token stablecoin models use two tokens: a stablecoin and a token that reduces price volatility. The second token, often a governance token, lets token holders vote or get a share in the system’s profits. Terra (LUNA) and TerraUSD (UST) are an example of this model. In this case, LUNA balances UST’s price volatility. However, people lost confidence in the system, leading to a big sell-off and collapse in May 2022.

Rebase Models

Ampleforth (AMPL) is a stablecoin that adjusts the number of tokens in circulation every day based on market conditions. This is called “rebasing.” The supply of tokens increases when the price is too high and decreases when it’s too low. The goal is not to stabilise the price, but to maintain the purchasing power of the tokens. If the price exceeds the target, more tokens are issued, and if it falls below the target, some tokens are removed from circulation.

Collateralised Models

When someone wants to create a stablecoin, they need to lock up some other cryptocurrency they own as collateral. This is how MakerDAO’s Dai works. People who want to mint DAI use their Ether or other approved cryptocurrencies as collateral. The system remains stable through certain mechanisms, like liquidation and over-collateralization.

How Algorithmic Stablecoins Work

Algorithmic stablecoins are a type of stablecoin that use smart contracts and algorithms to maintain a stable price. Unlike regular stablecoins that are backed by external assets, algorithmic stablecoins adjust their supply based on demand.

If the price of the coin goes higher than its target value, the algorithm produces more tokens, which increases the supply in circulation and helps lower the price. On the other hand, if the price goes below the target value, the algorithm reduces the supply, which increases scarcity and drives up the price.

This process helps maintain the stablecoin’s value at the peg. TeraClassicUSD and Ampleforth are examples of projects that use this method to build a self-stabilizing system. However, there is some risk involved in algorithmic stablecoins, as market volatility can sometimes affect the efficacy of the algorithm.

The Differences Between Algorithmic and Collateralised Stablecoins

There are two ways to achieve stability in the unpredictable cryptocurrency market: algorithmic stablecoins and collateralised stablecoins. 

Algorithmic stablecoins use smart contracts and algorithms to maintain stability. They adjust their token supply automatically when the price deviates from the target. These stablecoins don’t require direct collateralisation, but their value relies on the algorithm’s ability to maintain stability.

Collateralised stablecoins, on the other hand, maintain stability by pegging their value to an underlying reserve of assets. These stablecoins rely on a clear reserve backing, which provides a more straightforward pegging method. Algorithmic stablecoins strive for decentralisation and independence from traditional assets.

Stablecoins’ Future Adoption

The evolution of the cryptocurrency space promises a bright future for stablecoins. With the implementation of more well-defined regulations, these digital assets are expected to gain greater adoption, providing a solid foundation to build upon. Central bank digital currencies (CBDCs), backed by sovereign entities, have the potential to become a crucial part of the digital payments landscape.

As technology advances and new algorithms are developed, algorithmic stablecoins can become even more resilient, addressing existing flaws. Additionally, stablecoins can become a vital player in various financial activities, such as lending, borrowing, and liquidity provision, in tandem with continued DeFi innovation. With the market maturing and current challenges being addressed, stablecoins are destined to play a pivotal role in shaping the future of digital finance.