What Are Algorithmic Stablecoins and How Do They Work?

Join the Trading Community: Learn & Earn with BingX.

New trends and emerging technologies in the crypto space are gaining and some have already gained much traction and attention like DeFi, NFTs, or now metaverse. Such technological developments, improvements and enhancements may attract less attention at first but are essential for shaping the future of the whole sector. One of the examples of such an improvement is the invention of algorithmic stablecoins, which will be briefly introduced in today’s article.

What are algorithmic stablecoins?

Stablecoins

Before we look at algorithmic stablecoins, it is vital to make sure that everyone understands “stablecoins” the same way. Stablecoins have been around the cryptocurrency world for quite some time now and have one main goal. To take out the volatility that the non-stablecoin cryptocurrencies have on a daily basis and thus bring a stable cryptocurrency that has the same purchasing power over time.

Most stablecoins are currently backed by fiat currencies such as the dollar, pound, Korean won, or euro. The dollar has been by far the most used fiat currency for the cryptocurrency pegs. The best-known stablecoins are Tether (USDT), which is also the fourth-largest cryptocurrency, followed by USD Coin (USDC), Binance USD (BUSD), TerraUSD (UST), or Dai (DAI).

The overall capitalization of the stablecoins is around 160 billion dollars, which is up from the 25 billion dollars that were seen at the beginning of the year 2021. The rise of mainly Tether and USD Coin market capitalizations shows that stablecoins are now an essential subsector in the cryptosphere. That, however, does not mean that it cannot be improved.

The total market capitalization of stablecoins, source: coingecko.com

Algorithmic stablecoins

And that is what algorithmic stablecoins are trying to do. The most significant difference between algorithmic stablecoins and other types of stablecoins is that algorithmic stablecoins do not have any associated collateral to back them, which is also a reason why they are often regarded as non-collateralized stablecoins. However, they still track a fiat currency, for instance, the dollar, to express the value that they should represent.

Instead of using any collateral, whether fiat or cryptocurrency, algorithmic stablecoins rely on specialized algorithms or smart contracts that manage the overall supply of tokens, thus resulting in price stability. For instance, the system will automatically reduce the number of tokens in circulation if the market price of the stablecoin falls below the price of the fiat currency it is tracking. On the other hand, in a situation where the token price exceeds the price of the tracking fiat currency, the system will emit new tokens into circulation so that the value of the stablecoin adjusts downwards.

Thus, the peg or tracking of the fiat currency is solely made of a set of rules that are followed automatically by the system. This is also one of the reasons why many believe that this type of stablecoins is truly decentralized since there is no governing body or centralized institution that makes decisions.

“To create USDC, you need USD in the bank, which works well if you are starting. What comes after, is the right kind of monetary policy that allows stability and low volatility to allow people to trade. If we can do that with math and we can do that with monetary policy, it will be more efficient.”

That is one of the statements regarding algorithmic stablecoins by Lisa Jy Tan, founder of Economics Design. Lisa Tan has been studying algorithmic stablecoins for some time. She has highlighted how they should evolve and how they can be helpful in the future. For instance, Tan believes that it is way too early for these stablecoins to work, but that is fine for now.

Best algorithmic stablecoins to watch?

Even though it might be early now, there are already a few projects attracting analysts’ and technologists’ attention in this sector. Here we will only briefly introduce a few projects that are showing potential, and might have a bright future.

Ampleforth (AMPL)

One of the best-known and also oldest projects in the algorithmic stablecoins category is Ampleforth (AMPL). Ampleforth was one of the first cryptocurrencies, particularly stablecoins; which brought trading price volatility for the supply volatility so that the tokens have a stable value. The only thing that changes is the market capitalization of the project.

FRAX (FRAX)

FRAX (FRAX) is another algorithmic stablecoin that is becoming more famous. That is mainly because it has introduced a new ideology that blends two different concepts. Frax is partially backed by collateral and also partially stabilized by the algorithm. This combines the two most common approaches to stablecoins, which are either complete collateralization or an entirely algorithmic approach without backing.

Empty Set Dollar (ESD)

Empty Set Dollar (ESD) is another representative of this category. This algorithmic stablecoin prides itself by being stable, composable, and decentralized, all of which are properties that are necessary for a successful algorithmic stablecoin. 

ESD is trying to maintain the price around USD Coin stablecoin with a target of 1 USDC to make it stable. It adheres to an ERC-20 token standard, which makes it composable through the dynamic system supply. And the decentralization was achieved thanks to completely decentralized on-chain governance from day one of the projects. However, it is essential to note that Empty Set Dollar, like many other algorithmic stablecoins, is now at a price tag of around 0.01 dollars and not 1 dollar.

There are other notable projects in this sphere as well. These are, for instance, DefiDollar (DUSD), Dynamic Set Dollar (DSD), Reserve (RSV), and last but not least, Dai (DAI). Even though these projects show real potential, this sector is so new that it has numerous risks that need to be mentioned.

Risks

The cryptocurrency proponents will know that each sector in this sphere has its own risks. The same applies to algorithmic stablecoins, where there are several risks that everyone needs to take into account before using these platforms or their products and services.

Too much too soon

One of the risks was already mentioned earlier by the citation of Lisa Tan. It is believed that algorithmic stablecoins are so new and complex that they need much more time before they will be useful to the cryptocurrency market. Moreover, Lisa Tan thinks that they do have a place in the future. For instance, she has said the following:

“Failures now do not really prove that the algorithmic approach cannot work, only that the world is not ready for it.”

Even if she is correct, the fact remains that the very young age of these projects coupled with their complex nature possesses a risk.

Too fragile and unsustainable

Moreover, some critics of the whole idea of algorithmic stablecoins state that these projects are incredibly fragile and that they only exist in a state of “perpetual vulnerability.” They simply believe that algorithmic stablecoins are only here to fail. Even if it looks like they are working now, the future will show that the idea of decentralized, uncollateralized systems based on smart contracts is not sustainable.

The risk of a dead zone or a death loop

Algorithmic stablecoins also suffer from one peculiar anomaly that makes usage of these assets pretty risky. And that is the death loop or the dead zone. In this scenario, the algorithmic stablecoin loses its peg and falls so far off that the automatic mechanism cannot save it. As mentioned above, this happened to an Empty Set Dollar, Basic Cash, Dynamic Set Dollar, or more recently to Iron Finance. The death loop is one of the most significant risks connected to algorithmic stablecoins.

The likelihood of algorithmic stablecoins being trapped in a death spiral, source: hashkey.com

Yet, not all hope is lost with the algorithmic stablecoins. As of now, they definitely have some problems and risks, but time can help not only improve the drawbacks of this sector but can also change the perception of how people look at value and trust. This was, for instance, shown by Kory Hoang, CEO of Stably, which is an asset tokenization startup. Kory stated the following about the future of algorithmic stablecoins:

“The way that we view money is: Money is just a medium of trust that people have. Trust is something that is very hard for us to measure or predict. If over time more and more people come to trust the system and more and more people come to use it, it could potentially work out.”

Conclusion

Algorithmic stablecoins are one of the most intriguing categories of cryptocurrencies. However, they are currently a relatively small and unknown category that can play a significant part in the future of the cryptocurrency world, which is one of the reasons why it can be wise to pay attention to developments in this area. 

 

Disclaimer: BingX does not endorse and is not responsible for or liable for any content, accuracy, quality, advertising, products, or other materials on this page. Readers should do their own research before taking any actions related to the company. BingX is not responsible, directly or indirectly, for any damage or loss caused or alleged to be caused by or in connection with the use of or reliance on any content, goods, or services mentioned in the article.