October 23, 2022

What are Algorithmic stablecoins?

Algorithmic stablecoins are decentralized and maintained by algorithms; mathematical formulas. Through these formulas, coins are linked together and the price is adjusted based on supply and demand of the pairing.

What are Algorithmic stablecoins?

Let’s dive into the world of algorithmic stablecoins. These coins are a type of cryptocurrency that aim to maintain a stable value. They are similar to traditional stablecoins, which peg their value to a fiat currency or asset, but use algorithms to automatically adjust their supply in order to maintain price stability. 

Algorithmic stablecoins are decentralized and maintained by algorithms; mathematical formulas. Through these formulas, coins are linked together and the price is adjusted based on supply and demand of the pairing. 

There are different types of algorithmic stablecoins but they all share the same goal: to provide a more stable alternative to traditional cryptocurrencies like Bitcoin. The technology is still quite new and untested, so it remains to be seen whether they will be able to withstand the volatility of the cryptocurrency market in the long term.

What types of Algorithmic Stablecoins are there?

There are different types of algorithmic stablecoin. Each type utilizes a different algorithm to maintain its value.

Rebasing Algorithmic Stablecoins - these coins have a certain characteristic, namely: the supply takes over the regulation of the value. As a result, the algorithm itself intervenes in price decreases or price increases and ensures that the stock decreases or grows;

Fractional Algorithmic Stablecoins - these are an exception to the rule as these stablecoins are collateralised. This is something special, since the coins are backed by cryptographic algorithms and asset collateralization. An example of this kind is Frax Protocol;

Seigniorage Algorithmic Stablecoins - this is a variation of the rebasing model. By using two different tokens, this algorithm responds to market developments. One token is supply-elastic (flexible) and the other token is an investment share of the respective ecosystem. Holders of the latter kind of token receive inflationary rewards, but also bear the burden if the price falls;

Over-collateralized Algorithmic Stablecoins - the latter form is a good choice if you want to have a buffer against the fluctuations in the price.

How do Algorithmic stablecoins work?

As said, the goal of an algorithmic stablecoin is stabilizing its price. They are designed to maintain a stable value, even when the market is volatile. There are a few different ways that algorithmic stablecoins can achieve this stability. 

One method is by pegging the coin’s value to another asset, such as the US dollar. This means that if the dollar goes up in value, so does the algorithmic stablecoin. Similarly, if the dollar falls in value, the algorithmic stablecoin will also fall in value.

Another way that algorithmic stablecoins can maintain their stability is by using algorithms to adjust their supply based on demand. For example, if there is more demand for an algorithmic stablecoin, then the algorithm will automatically increase the supply of the coin to meet this demand. Conversely, if there is less demand for an algorithmic stablecoin, then the algorithm will reduce the supply of the coin accordingly.

Lastly, some algorithmic stablecoins use a basket of assets to peg their value instead of just one asset. This helps to further stabilize the price of the coin as it reduces reliance on any one particular asset.

Are algorithmic stablecoins safe?

Stablecoins that are based on algorithms have a weak architecture. These uncollateralized digital assets, which use algorithms, finance engineering and market incentives to attempt to peg the price of a reference asset, are not stable at all and are vulnerable to depegging risk.

There are three major problems with algorithmic stablecoins. First, these ostensibly stable cryptocurrencies only function correctly if demand is high enough. If it falls below a certain level, the system collapses.

On the other hand, stablecoins rely on self-motivated investors who are confident in an algorithm that keeps their value tied to a fiat currency. But even with this algorithm, traders acting on ambiguous information and uncertainty can cause a stablecoin to lose value. It could also trigger a herd mentality that results in sellers dumping the underlying currency, causing prices to drop.

For instance, Terra stablecoin (UST) uses a two-token system to stabilize the prices of its stablecoin, TerraUSD. To create one UST coin, users need to burn Luna tokens (the native currency of the Terra blockchain.) Luna tokens are used for paying trading fee on peer-to-peer lending platforms and voting on network upgrades.

UST Labs, creators of both TerraUSD and Luna, made a decision to remove their dollar-pegged cryptocurrency from exchanges. It seemed like the right choice at the time, but the collapse of TerraUSD became a significant algorithmic stablecoins controversy when UST lost its dollar peg. But what really happened to UST and Luna? A major depeg occurred as UST's price fell below $1. 

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