What are algorithmic stablecoins? What will their future look like in DeFi
Decentralized finance (DeFi) is a complex but fast-growing industry. Algorithmic stablecoins exhibit these characteristics. There are still many questions surrounding DeFi and this stablecoin.
Let’s learn about Algorithmic Stablecoins and their future implications for decentralized finance.
What are algorithmic stablecoins? How are they different from regular stablecoins?
A stablecoin is a cryptocurrency designed to hold a particular value, typically against a fiat currency such as the US Dollar. Because stablecoins are fixed at an expected and stable value, investors or traders often use them to stay in the cryptocurrency market while protecting themselves against market price fluctuations.
The majority of stablecoins aim to achieve their rates using some kind of escrow mechanism. The stablecoins in circulation are backed by valuable assets that guarantee the value of the stablecoin.
Most major stablecoins, such as USDC and Tether (USDT), are collateralized with off-chain collateral like USD held with a centralized institution like a bank. However, stablecoins can also be collateralized on-chain using decentralized mechanisms, as with DAI.
Algorithmic stablecoins are different. Algorithmic stablecoins, in their purest form, are not centralized at all, and their value is not backed by any external assets. Instead, they use algorithms – specific instructions or rules that must be followed (usually by a computer) to produce some result.
These algorithms are optimized to incentivize market participant behavior and to manipulate the circulating supply so that the price of any given coin is – in theory – stable around the peg.
The most popular algorithmic stablecoins on the market include UST, USDD, AMPL, BAC, and UXD.
How do algorithmic stablecoins work?
These stablecoin designers use different mechanisms to help the coin maintain its rate. Unlike most stablecoins, with algorithmic stablecoins, these mechanisms are written into the protocol, which is publicly available on the blockchain for all to see. There are two popular models of decentralized algorithmic stablecoins, illustrated with a $1 peg assumption.
The first is stablecoins that follow the Rebase algorithm that manipulates the base supply to maintain the peg. The protocol for mining (adding) or burning (removing) pool from circulation corresponds to the coin’s price deviation from the $1 peg. If the coin price is > $1, the protocol will charge. If coin price < $1, protocol burns coins. Coins are minted or burned from the coin owner’s wallet.
The second is Seigniorage algorithmic stablecoins that use a multi-coin system. The price of one coin is designed to be stable, and at least another coin is designed to facilitate stability. Seignorage models typically implement a combination of protocol-based burn and burn and free-market mechanisms that incentivize market participants to buy or sell volatile coins to push up the price of stable coins towards its latch.
There is also a third model, fractional stablecoins, which is becoming increasingly popular. Part seigniorage, part collateral, and part fractional stablecoins aim to maintain their rates by combining the best mechanisms from decentralized “pure” stablecoins and rivals their mortgage. Frax Finance pioneered this model.
What the Future of Algorithmic Stablecoins Look Like in DeFi
So far, stablecoins built on algorithms are evolving. However, after the collapse of UST, the community was bewildered and lacked confidence in its great theory. Moreover, after that accident, more regulations are gradually being put in place to control the risk of this stablecoin.
Regardless of the type of stablecoins, they threaten government fiat-based money systems with their anti-regulatory nature.
As of now, no algorithmic stablecoin has achieved a consistent, stable peg. As such, their use cases tend towards speculative arbitrage traders.
DISCLAIMER: The Information on this website is provided as general market commentary and does not constitute investment advice. We encourage you to do your own research before investing.
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