A Beginner’s Guide On Algorithmic Stablecoins
Stablecoins are blockchain-based digital currencies that are US dollar-pegged. They are employed as vehicle currencies for trading crypto assets due to the lower intermediation costs involved with operating on the blockchain. The three goals of stablecoin designs are capital efficiency, decentralisation, and peg stability. Let’s see if the existing stablecoins fit these criteria.
The most common type of stablecoin is the centralised stablecoin, which Tether leads and has fewer liquid assets and commercial paper on its balance sheet. For instance, people can get DAI tokens by depositing crypto collateral, most commonly Ether (ETH), in over-collateralized positions. However, despite being decentralised, they are less capital-efficient than their centralised counterparts.
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How Does An Algorithmic Stablecoin Work?
A “two-coin” scheme is a standard algorithmic stablecoin structure in which one coin helps to “absorb” market volatility while the other tries to retain the peg. This former token could be a balancer or share token, which frequently goes on trade on decentralised secondary exchanges (DeXs) such as Uniswap (UNI). Terra initially relied primarily on this two-coin system but has recently included Bitcoin (BTC) reserves as a backup to its mathematical technique.
To better understand a two-coin system in the algorithmic stablecoin ecosystem, consider Terra’s network. The Terra blockchain has two tokens –TerraUSD (a stablecoin) and a governance token (LUNA). The rationale behind the interaction is the maintenance of the stability of TerraUSD dollar value.
If investor demand causes the stablecoin’s price to increase over $1, a LUNA holder can swap $1 of LUNA for that coin and profit from the higher price. On the other hand, when the coin’s value decreases, traders can profit by trading it for $1 worth of LUNA. As a result, the supply declines and the price rises.
The ecosystem needs a certain level of demand support for algorithmic stablecoins to operate. However, if demand falls below a certain point, the entire system will collapse.
Even history has proven that the base or floor levels of financial product support are not guaranteed, especially in times of crisis. For example, Fei was down 80% from its favourable buying price after the 1:1 USD pegged token fell drastically below its projected $1 value in April 2021.
Also, algorithmic stablecoins rely on different individuals to establish price stabilising arbitrage to achieve market incentives to maintain a stable ecosystem. Nonetheless, depending on separate, market-driven players to perform price-stabilizing discretionary arbitrage without regulatory duties is dangerous.
Types Of Algorithmic Stablecoins
1. Seigniorage Algorithm Stablecoins
The seigniorage algorithmic stablecoins typically consist of two types of cryptocurrencies: we have the coins (stablecoin) and shares (seigniorage ownership). When the price of a currency surpasses the desired peg, shares help increase the quantity of cash.
Along with these two cryptocurrencies, seigniorage-style stablecoins generally issue a redeemable bond as an incentive for buyers when the price falls below the peg. An example of a seigniorage algorithmic stablecoin is Basis Cash.
2. Rebasing Algorithmic Stablecoins
Rebase-style stablecoins deal with price-elastic ERC-20 tokens, which means that the total supply of a stablecoin is not fixed and is adjusted regularly. The rebase process enables the accomplishment of correction, which gradually brings the stability of a stablecoin to a fixed peg at $1.
Rebasing is a feature of the Ampleforth protocol (AMPL) and alters the token supply. It means that the number of AMPL tokens in your wallet will fluctuate every 24 hours based on the weighted average of the token price.
3. Fractional Algorithmic Stablecoins
Stablecoins that use fractional algorithms combine the advantages of wholly algorithmic and fully collateralised coins. These stablecoins minimise custodial risks and prevent over-collateralization. It aims to enforce a rather tight peg with a higher level of stability in contrast to exclusively computational designs.
The partial-collateral protocol, which enables a two-token design with FRAX acting as a $1-pegged stablecoin and FXS as a governance token, is being used for the first time by Frax, the first stablecoin implementation.
Pros And Cons Of Algorithmic Stablecoins
Innovation in financial products isn’t always a good thing; some innovations, like algorithmic stablecoin projects, are deliberately designed to have inherent instability.
The global financial system, however, came dangerously close to collapsing in 2008 because of a confusing variety of complex derivatives pushed by securitisation. The fall of TerraUSD caused a similar catastrophe in the cryptocurrency market.
Pros Of Algorithmic Stablecoins
Algorithmic stablecoins are the full embodiment of decentralisation because the code establishes the rules that govern the underlying financial system, with no regulatory agency monitoring users’ transactions. Furthermore, the lack of a demand for a tangible item in algorithmic stablecoin minimises the possibility of user error.
Seigniorage came into the crypto ecosystem via algorithmic stablecoins, which means that calculating the profit or loss on the manufacture of a currency is achievable in the decentralised realm of digital assets.
Cons Of Algorithmic Stablecoins
Algorithm-based stablecoins have intrinsically flawed architecture. These uncollateralised digital assets, which aim to peg the price of a reference asset using algorithms, financial engineering, and market incentives, are unstable and always susceptible to de-pegging risk.
Furthermore, algorithmic stablecoins have three problems. Ostensibly stable cryptocurrencies require a certain level of demand to function correctly. If the market falls below a certain threshold, the system will fail.
Second, stablecoins are problematic because they rely on self-motivated, independent investors who must have a vested interest in benefitting from the algorithm that keeps TerraUSD connected to the dollar. Finally, during times of crisis, traders acting on confusing information and uncertainty may cause the value of this type of stablecoin to decline.
Are Algorithmic Stablecoins Safe?
Because the stablecoin market is unregulated, investing in stablecoins involves devaluation risk and may be vulnerable to speculative attacks in the event of under-collateralization. When the supply of stablecoins pegs the value of the blockchain’s governance token, the danger of devaluation increases.
To secure stablecoins like TerraUSD, they need to be backed by stable collateral like the US dollar or its blockchain equivalent in stablecoins. Another possibility is to employ smart contracts to preserve over-collateralization. For example, if the collateral to stablecoin ratio falls below a specific threshold, the system will compel stablecoin liquidation to maintain total peg stability and collateralisation.
Furthermore, it is critical to recognise that collateralisation defines the stability of any stablecoin. It means that a loss of trust in the initiative, as well as any ramifications for the underlying collateral, could undermine the economy. A decline in the value of the collateral lowers the obligatory value of the stablecoin, potentially leading to a massive attempt to redeem stablecoins.
Before investing in stablecoins or any other type of digital currency, you must conduct your study and grasp the fundamentals and technical indications of the token in question.