In today’s article, we’ll take a deep dive into algorithmic stablecoins, a special kind of stablecoins.
It was the collapse of Terra LUNA and UST that brought algorithmic stablecoins to the news.
In May 2022, Terra’s stablecoin UST lost its 1:1 dollar peg and its algorithm was to blame.
And more recently, in July 2022, NIRV, another algorithmic stablecoin based on Solana, lost its dollar peg.
Hmmm…what exactly are algorithmic stablecoins? And why do they keep losing their 1:1 dollar peg?
Keep reading this article and you’ll find out.
- What Are Algorithmic Stablecoins?
- Types Of Algorithmic Stablecoins
- Examples Of Algorithmic Stablecoins
- Why Algorithmic Stablecoins Lose Their Dollar Peg
Click on any item above and read its details immediately.
Let’s get to it.
1. What Are Algorithmic Stablecoins?
Algorithmic stablecoins are cryptocurrencies governed by algorithms and pegged to the US Dollar.
Don’t let the word, “Algorithm” scare you, it is simply a set of codes that determine a process. And these codes are written in a smart contract.
Also, Algorithmic stablecoins rely on two tokens – one stablecoin and another cryptocurrency that backs the stablecoin.
This is unlike the conventional stablecoins e.g. USDT that are backed by a physical reserve of fiat (US Dollars).
However, this does not mean that algorithmic stablecoins do not have a 1:1 dollar peg.
They do have a 1:1 dollar peg and so, a unit of an algorithmic stablecoin should be equal to $1 all the time.
The major difference is they depend on algorithms to maintain their peg.
Hence the reason why conventional stablecoins are generally viewed as collateralized while algorithmic stablecoins are labeled uncollateralized.
Basically, this is how algorithmic stablecoins work:
Say stablecoin A is backed by cryptocurrency B.
Although A is a stablecoin, it is still a cryptocurrency, therefore, it is subject to crypto market conditions.
To prevent the price of A from de-pegging i.e. moving away from $1, algorithms regulate the supply and demand of B.
Thus, when the demand for B is high but with little supply, its price goes up and vice versa.
So long as the supply of B is in check, A will stay pegged to $1, at least theoretically.
Next, I’ll show you the different types of algorithmic stablecoins.
2. Types Of Algorithmic Stablecoins
An algorithmic stablecoin can take any of these three forms:
a. Rebase algorithmic stablecoins
This type of stablecoins manipulate their base supply to maintain the peg.
In other words, new coins are minted or circulating coins burned with respect to how the coin deviates from its $1 peg.
That is, if the coin’s price is more than $1, the protocol mints new coins.
On the other hand, if the coin price is less $1, the protocol burns coins.
Note also that coins are minted into or burned from coin holders’ wallets.
b. Seigniorage algorithmic stablecoins
What we have here is a multi-coin system, wherein market participants are incentivized to buy or sell a cryptocurrency to maintain the peg of its twin stablecoin.
So, when the stablecoin is below $1, holders are encouraged to sell it to get rewarded in the other cryptocurrency
Then when it is above $1, they are to sell the other crypto and get rewarded in the stablecoin.
c. Fractional algorithmic stablecoins
Here, we have a combination of the seigniorage model and the collateralized stablecoin model.
That is to say, fractional stablecoins are partially backed by collateral and partially stabilized algorithmically.
So, if the price rises above $1, the protocol mints new stablecoins until the price returns to $1.
Otherwise, some stablecoins are burned to maintain the peg.
In the next section, we’ll see some examples of algorithmic stablecoins.
3. Examples Of Algorithmic Stablecoins
Listed below are some of the algorithmic stablecoins that I found and a brief description of how they maintain their peg.
Check them out:
UST is the stablecoin of the Terra blockchain. It is backed by the network’s native token – LUNA.
According to its algorithm, any time the price of UST rises above 1$, LUNA holders can burn $1 worth of LUNA to mint UST.
And if the price of UST falls below $1, holders can burn UST to mint $1 worth of LUNA.
That way, both coins will enjoy a stable market and holders will remain in profit.
Sadly, UST plummeted in May 2022 costing investors over $40 billion.
[Suggested Read: LUNA Update: The Rescue Plan For The Terra Ecosystem]
DAI is an Ethereum-based stablecoin that is issued and developed by MakerDAO.
The price of DAI is pegged to the US dollar.
Also, it is backed by a mix of several cryptocurrencies that are deposited into smart contract vaults.
Interestingly, this stablecoin does not comply with the general view of algorithmic stablecoins as uncollateralized.
DAI in the real sense is over-collateralized. The collateralization of DAI is roughly 1.5 times the average amount of DAI in circulation. Cool!
You can read our complete review of DAI to learn more.
This is a Solana-based stablecoin issued by Nirvana Finance together with ANA, the native token.
ANA tokens back NIRV. For instance, if the spot price of ANA is $12, the protocol accepts 12 NIRV to purchase an ANA token.
But an ANA token can be sold for any other stablecoin in the reserves.
Thus, opening up an arbitrage opportunity should NIRV wander from its peg.
Unfortunately, Nirvana Finance lost $3.5 million to hackers on July 29, 2022, which caused NIRV to drop in value by 85%.
AMPL is an Ethereum-based stablecoin issued by Ampleforth.
It is a typical example of a rebase algorithmic stablecoin.
AMPL adjusts its supply daily to achieve price stability.
According to its algorithm, a rebase occurs if the AMPL price goes above $1.06 or below $0.96.
Also, token holders own a fixed fraction of the total AMPL circulating supply, rather than a fixed number of tokens. Cool!
USDD is a stablecoin created by the TRON DAO. It is issued on the Tron, Ethereum, and BNB Chain.
Here, the mechanism involves alternatively creating and destroying units of USDD and TRX (the native token of Tron).
Additionally, the Tron DAO operates a 30% interest rate reserve to manage USDD.
USDD lost its 1:1 dollar peg in June 2022. OMG!
Read our review of USDD to learn more.
Other algorithmic stablecoins are:
Among all the algorithmic stablecoins I researched, there is no one that has not lost its dollar peg for a significant period. Ouch!
Moving on, we’ll talk about why algorithmic stablecoins often lose their dollar peg.
4. Why Algorithmic Stablecoins Lose Their Dollar Peg
Before we look at the downsides, let’s see the pros of this kind of stablecoins.
The first one is that they help to achieve decentralization because the algorithm defines the rules, and not regulatory agencies.
Secondly, they remove the risk of user error because the trading of these coins relies on smart contracts.
Also, algorithmic stablecoins bring about seigniorage in the crypto ecosystem.
This makes it easy to assess the profit or loss made on the production of a currency.
Now to the downsides…
It is difficult to achieve stability from a volatile asset.
That’s one reason why I believe algorithmic stablecoins keep failing because the crypto backing them can drop in value at any time.
Besides, algorithms and market incentives are not enough to maintain the stability of a coin’s value.
Once demand falls below a particular level, the system will fail.
Moreover, these coins thrive at the mercy of independent investors who wish to profit from the algorithm.
This makes algorithmic stablecoins vulnerable to de-pegging risk.
Whenever there is bad news, investors may be forced to sell off the stablecoin, leading to a massive price drop.
Just like the case of Terra: UST sell-off = more LUNA in circulation = lower LUNA price = Terra ecosystem meltdown.
Looking ahead, lawmakers across the world have called for the regulation of algorithmic stablecoins to protect the crypto market from another crash in the future.
If I find any more information about how algorithmic stablecoins can preserve their pegs, rest assured that I’ll be back here to let you know.
Crypto Trading Made Easy!
We have now come to the end of our discussion on algorithmic stablecoins. I hope it was worth your time.
The original idea behind stablecoins is to protect traders from the volatility of cryptocurrencies
But most algorithmic stablecoins are not meeting this need because of their weak architecture.
Hopefully, the light bulbs in the crypto space will come up with a solution to this problem soon.
It’s your turn! What do you think the future holds for algorithmic stablecoins?
Tell me in the comments section right away. Ask any questions you may have as well.
Before you go, please share this article with your friends too. Thank you!
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