Algorithmic Stablecoin: All You Need to Know!

Have you ever heard of algorithmic stablecoins? These are a new type of cryptocurrency that aims to solve the volatility problem of traditional cryptocurrencies like Bitcoin and Ethereum. Algorithmic stablecoins are designed to maintain a stable value by using smart contracts and algorithms. In this guide, we will cover everything you need to know about algorithmic stablecoins, including how they work, their benefits, risks, and popular examples.

What are Algorithmic Stablecoins?

An ‘Algorithm’ is a set of instructions that a computer program follows to perform a task when certain conditions are met.

A ‘Stablecoin’ is a type of digital currency that is designed to keep its value steady, usually by being tied to the value of something else like a traditional currency or asset.

So, an ‘Algorithmic Stablecoin’ is a type of digital currency that uses a computer program to automatically adjust its supply in order to keep its value stable. This is usually done by creating or destroying tokens in response to changes in demand for the stablecoin. Most Algorithmic Stablecoins do not have any real-world financial backing or reserves.

Why Algorithmic Stablecoins are Needed

There are several reasons why algorithmic stablecoins are needed.

Traditional stablecoins are often backed by physical assets such as USD or gold, which require a high degree of trust in the custodian or issuer of the asset. Algorithmic stablecoins, on the other hand, rely on mathematical formulas and smart contracts to ensure stability, reducing the need for trust in a centralized entity.

Algorithmic stablecoins can offer greater flexibility in terms of scalability and accessibility. As they are not dependent on physical assets, they can be easily traded on decentralized exchanges and used for various applications in the DeFi ecosystem.

It is true that an algorithmic stablecoin project could potentially avoid legal regulations if it remains decentralized and not backed by any fiat-based reserves or collateralization. This concept appeals to those who support a truly decentralized global financial system. Trustless transactions are indeed a fundamental aspect of cryptocurrency, as they allow for peer-to-peer transactions without the need for intermediaries or third-party trust. However, it is important to note that the absence of legal regulations can also create risks for users, such as market volatility or fraud. Therefore, while the idea of a trustless and decentralized financial system is appealing, it is also crucial to consider the potential risks and benefits of such a system.

Algorithmic stablecoins can potentially offer a more stable value compared to traditional stablecoins, which may experience fluctuations due to changes in the underlying asset’s value or fluctuations in supply and demand.

Overall, algorithmic stablecoins offer a promising solution for maintaining price stability in the cryptocurrency market, and their development and adoption could have a significant impact on the growth and evolution of decentralized finance.

Types of Algorithmic Stablecoins

Rebasing Algorithmic Stablecoin model in simple terms.

This is a model for a decentralized algorithmic stablecoin that stabilizes the token price by a process called ‘rebasing’. Rebasing means adjusting the total supply of the token either upward or downward every day in proportion to the percentage increase or decrease in price from the peg price. This adjustment happens automatically in all wallets that hold the token.

For example, if you bought 100 tokens today for $1 each and the price increases to $1.10 (a 10% increase) tomorrow, the protocol will increase the total supply of tokens by 10% the next day. This means that after the rebasing, the number of tokens in your wallet would have increased by 10% to 110 tokens. This process is non-dilutive, meaning that the percentage stake of your tokens in the total supply remains constant.

However, in reality, most rebasing stablecoins have a tolerance band above and below the peg price within which the rebasing mechanism doesn’t activate. The industry standard is a 5% tolerance band.

You might wonder how this mechanism stabilizes the token price. Well, market participants like us make use of arbitrage opportunities. In liquidity pools of decentralized exchanges (DEXs), the supply of the rebased tokens automatically adjusts, bringing the price down instantly. However, in centralized marketplaces, the sudden increase in token supply could create additional selling pressure from existing holders looking to book profits from the rebasing. The greater the volatility in price from the pegged value, the longer it takes for the rebasing mechanism to bring the price back to the peg.

Advantage of rebasing stablecoins is that they are often non-dilutive, meaning that holders can potentially profit from owning the stablecoin, especially if they buy in at an early stage with a smaller market cap. As adoption and usage increase, the market cap also increases, giving early buyers a larger percentage stake in the total supply and the opportunity for greater profits.

Disadvantages of holding rebasing algorithmic stablecoins is that their value can fluctuate based on changes in market cap. While the rebasing mechanism ensures that the token price stays around the pegged price, the value of an individual’s holdings may decrease if the market cap falls. This means that rebasing tokens are not necessarily more stable than other types of cryptocurrencies. For a more detailed discussion of the debate around the viability of rebasing tokens, you may want to watch this informative video by Boxmining.

Seigniorage Algorithmic Stablecoins in simple terms.

Seigniorage Algorithmic Stablecoins are a type of decentralized stablecoin that uses an algorithmic approach to maintain price stability. Similar to rebasing algorithmic stablecoins, the supply of the stablecoin is adjusted to maintain a target price. However, unlike rebasing stablecoins, Seigniorage stablecoins do not change the total supply of tokens in circulation. Instead, they adjust the price of the token by creating or burning tokens through smart contracts, based on the market demand for the stablecoin.

Let me explain this in simpler terms. If the price of the Seigniorage stablecoin is above the target price, the smart contract will create new tokens, increasing the total supply in circulation. This new supply is then sold on the market to bring the price back down to the target price. On the other hand, if the price of the stablecoin is below the target price, the smart contract will burn existing tokens, reducing the total supply in circulation. This reduction in supply increases the price of the stablecoin, bringing it back up to the target price.

The key difference between Seigniorage stablecoins and other stablecoins is that they do not rely on any external asset or collateral to maintain price stability. Instead, they use the market demand for the stablecoin to determine the supply of tokens in circulation. This makes Seigniorage stablecoins fully decentralized and independent of any central authority or external asset.

Advantages of Seigniorage Algorithmic Stablecoins include their decentralization, transparency, and independence from external assets. They also do not require any collateral or reserves, which reduces the risk of a black swan event or a sudden price collapse. However, Seigniorage stablecoins can still be subject to market volatility and liquidity issues, which can affect their price stability.

Disadvantage of Seigniorage algorithmic stablecoins is the potential for price volatility. Since the token price is primarily determined by the supply and demand dynamics of the market, sudden changes in either factor can lead to significant price fluctuations. Additionally, unlike traditional stablecoins, Seigniorage stablecoins do not have a direct peg to an external asset, which can make it difficult to determine their true underlying value.

Furthermore, the seigniorage mechanism relies on the willingness of users to buy and sell the token in order to maintain price stability. This means that if user demand drops, it can lead to a decrease in the token price, which in turn can lead to a decrease in the overall supply of tokens as users try to sell off their holdings. This can create a negative feedback loop, resulting in further price declines and supply reductions.

Another potential disadvantage of Seigniorage algorithmic stablecoins is the complexity of their economic models. These tokens often require sophisticated algorithms to manage supply and demand dynamics, and may require significant computing power to operate effectively. As a result, they can be more difficult to understand and use compared to traditional stablecoins, which are often backed by fiat currency or other tangible assets.

Overall, Seigniorage Algorithmic Stablecoins are an interesting approach to maintaining price stability in decentralized finance. However, like any other financial instrument, they come with their own set of risks and limitations that investors should be aware of.

Over-collateralized algorithmic stablecoins in simple terms.

Over-collateralized algorithmic stablecoins are a type of stablecoin that uses a collateralization model to maintain its price stability. In this model, the stablecoin is backed by a pool of assets, usually cryptocurrencies such as Ethereum, Bitcoin, or stablecoins like USDT or USDC. These assets are held in a smart contract, which acts as collateral and is used to issue and redeem the stablecoin.

The main advantage of this model is that it ensures price stability by maintaining a fixed ratio between the value of the collateral and the value of the stablecoin. For example, if the stablecoin is pegged to the US dollar, the smart contract will require a certain amount of collateral to be deposited for each stablecoin issued. This collateralization ensures that the stablecoin is fully backed by the value of the collateral, and therefore, should maintain its peg to the US dollar.

However, the main disadvantage of over-collateralized algorithmic stablecoins is the high collateralization ratio required to maintain price stability. Typically, the collateralization ratio is set at 150% or higher, meaning that for every $1 worth of stablecoins issued, there needs to be at least $1.5 worth of collateral held in the smart contract. This high collateralization ratio results in a low supply of stablecoins, which can limit their usefulness as a means of exchange or store of value.

Furthermore, the over-collateralization model does not provide any mechanism to increase or decrease the supply of stablecoins. This means that if there is a high demand for stablecoins, there may not be enough collateral to issue more stablecoins, which can lead to a shortage and a rise in the stablecoin’s price above its peg. On the other hand, if there is a low demand for stablecoins, there may be an excess of collateral, which can lead to a surplus of stablecoins and a drop in price below its peg.

Overall, over-collateralized algorithmic stablecoins are a relatively simple and transparent way to achieve price stability. However, the high collateralization ratio and lack of supply adjustment mechanisms can limit their usefulness and adoption as a stablecoin.

Fractional algorithmic stablecoins in simple terms.

Fractional algorithmic stablecoins are a newer type of stablecoin that aims to maintain a stable value by using a fractional reserve model. Instead of being backed by collateral or relying on rebasing or seigniorage, they are backed by a reserve of other cryptocurrencies or assets. The reserve is then used to buy and sell the stablecoin in order to maintain its pegged value.

One of the advantages of fractional algorithmic stablecoins is that they can be more efficient than over-collateralized stablecoins, as they don’t require as much collateral to maintain their stability. This can make them more attractive for users who don’t want to lock up a large amount of collateral in order to use a stablecoin.

However, one of the potential disadvantages of fractional algorithmic stablecoins is that they are more reliant on the reserve assets to maintain their stability. If the reserve assets experience volatility or lose value, it could affect the stability of the stablecoin. Additionally, the fractional reserve model has historically been associated with traditional banking systems and can carry some of the same risks associated with traditional fractional reserve banking, such as bank runs or liquidity crises.

Conclusion

Algorithmic stablecoins are a relatively new concept in the world of decentralized finance. They aim to provide price stability to cryptocurrencies by relying on algorithms instead of traditional collateralization methods. While the idea is promising, the success of these stablecoins depends on their ability to offer more than just stability.

Rebasing algorithmic stablecoins achieve stability by adjusting the supply of tokens in response to changes in demand. However, achieving equilibrium in the market cap of the token is essential for the stability of the token in terms of price and purchasing power.

Seigniorage algorithmic stablecoins, on the other hand, rely on a multi-token system that has independent value apart from maintaining the price of the primary stablecoin. Additionally, partnering with other projects can generate adoption and increase the utility of the stablecoin.

Over-collateralized algorithmic stablecoins offer a functioning model for maintaining a relatively stable price peg. However, it is not a pure algorithmic stablecoin model.

Fractional algorithmic stablecoins limit the risk of falling into a death spiral by locking a fully-collateralized fiat stablecoin as a reserve. However, this model still faces the risk of unforeseen events and regulatory issues.

In conclusion, the algorithmic stablecoin ecosystem is still evolving, and new models will continue to emerge through experimentation and failure. Ultimately, the success of these stablecoins will depend on their ability to offer utility beyond just stability. Algorithmic stablecoins have the potential to revolutionize decentralized finance, but only if they can provide a reliable and useful product for users.