Cryptocurrency prices move up and down due to their volatility. This price fluctuation and instability may be a turnoff for traders and investors. However, to avoid this uncertainty in the market and prevent price volatility, stablecoin emerged.
Stablecoins are digital currencies backed by fiat currency, other cryptocurrencies, or physical assets like gold. The values of these coins do not change significantly because secure investments support them. As a result, investors and traders frequently utilize stablecoins to stay in crypto markets while shielding themselves from market price volatility because they are pegged to an expected and stable value.
Stablecoins are typically pegged to an underlying asset, usually in a 1:1 ratio, which means that one stable coin equals one unit of other fiat currency. They come in various types, and each uses a unique method to keep its peg with the currency or asset it follows.
Consequently, a stablecoin pegged to a physical asset or another digital asset is classified as collateralized asset, and they rely on a central issuer or a third-party certifier. Thus, having a central authority defiles the decentralized nature of cryptocurrency.
On the other hand, to address the issue of stablecoin's reliance on central authorities and third-party certifiers, Algorithmic stablecoin was developed.
What is Algorithmic Stablecoin?
Algorithmic stablecoins are stablecoins that maintain their parity using a self-contained and decentralized economic protocol. They are built on an economic mechanism that allows them to maintain equivalence by increasing or decreasing the quantity of cryptocurrency by burning or mining tokens. Algorithmic stablecoins have no central issuer. Instead, they are managed by algorithms and smart contracts. Hence, they are called algorithmic because they are supported by an on-chain algorithm that enables a swing in supply and demand between them and the underlying cryptocurrency.
Since the smart contract code controls the supply, demand, and target price, algorithmic stablecoin portrays decentralization in actual practice without requiring any regulatory organizations or central authority to uphold or monitor the processes. Users can engage with a smart contract to exchange the algorithmic stablecoins, and an algorithm controls the overall supply of the stablecoins. The overall supply is determined and regulated by trading algorithmic stablecoin to the system.
Essentially, an algorithmic stablecoin system cuts the token supply of the fiat currency in which it is priced when the token's market price falls below the cost of the fiat currency it follows. Similarly, if the token price exceeds the price of the fiat currency, fresh tokens will enter the circulation to lower the stablecoin's price.
How Does it Work?
Algorithmic stablecoins typically use a two-token structure, with one stablecoin and a different cryptocurrency ss the stablecoins' underlying stability. The algorithm controls how these two interact.
For example, the market volatility is absorbed by one token while the other keeps the peg.
Let's look at Terra's blockchain to understand how the algorithmic stablecoin works using the two-token system. The Terra network has two tokens in its ecosystem; UST and LUNA, a stablecoin and a governance token. The tokenomic process of the algorithmic stablecoin UST is intended to mint 1 UST by burning the $1 equivalent of LUNA.
This indicates that if 1 UST is to be minted and LUNA costs $50, then 1/50 (0.02) of LUNA will be burned. As more LUNA is burned and the market's demand remains the same, there will be less LUNA available for sale, causing LUNA's price to increase. Because there is less LUNA supply than there is demand in a high-performance market, LUNA will continue to rise. As a result, LUNA can increase in value up to $100, and one UST will require 1/100 (0.01) LUNA to mint.
Owing to the algorithmic connection between the two-token system, the LUNA must take the volatility of the UST into account. The price of LUNA can fall dramatically in the face of an increasing token supply since new tokens can be continuously created whenever UST is less than $1.
Therefore, different mechanisms are used by algorithmic stablecoin developers to support the coin's stability. In contrast to most stablecoins, algorithmic stablecoins include these mechanisms in the protocol and make them accessible to everyone on the blockchain.
Types of Algorithmic Stablecoin
Rebasing Algorithmic Stablecoin
One of the earliest designs for a decentralized algorithmic stablecoin is the Rebasing Algorithmic Stablecoin. Stablecoins that use algorithms to base their value are controlled by supply. As a result, a rebase mechanism's algorithm automatically reduces the number of coins when their price falls below a predetermined level and increases it when it climbs above a certain value. The percentage of price increases or decreases from the peg price is inversely correlated with this change in the token supply. Ampleforth (AMPL) is a stablecoin that adopts the rebasing algorithmic stablecoin model.
Seigniorage Algorithmic Stablecoin
The "Seigniorage Algorithmic Stablecoin" methodology uses a multi-token structure to keep its price peg. The two cryptocurrency types that comprise this model are typically stablecoin and investment shares in the network. One or more tokens that serve as incentives to preserve the primary token's stable price peg are paired with one or more tokens pegged to a stable value. Shares are used to increase the number of coins when the price of a currency exceeds the desired peg. However, when demand for the token falls, the share owner also bears the debt burden. Hence, seigniorage describes the discrepancy between a coin's face value and production cost. TerraUSD (UST) is an example of a seigniorage stablecoin. It maintains its value of the USD by using its native currency, LUNA.
Fractional Algorithmic Stablecoin
Stablecoins that use fractional algorithms combine the advantages of completely algorithmic and fully collateralized coins. They are supported by asset collateralization and cryptographic algorithms and partially collateralized. Fractional algorithmic stablecoins aim to strike a balance between fully algorithmic and fully collateralized stablecoins. With less fiat cash needed as security, this approach increases capital efficiency. In other words, fractional stablecoins are worth more as circulating currency than as security.
Frax is the first stablecoin to employ the partial-collateral protocol, supported by mathematical techniques and asset collateralization. As a result, the project's coin will be trustless, scalable, and stable on-chain currency. The Frax cryptosystem employs two asset classes: Frax (FRAX) and Frax Shares (FXS), with FRAX serving as a $1-pegged stablecoin and FXS serving as a governance token.
Risk Associated With Algorithmic Stablecoin
The risks involved with algorithmic stablecoins are one of the most significant aspects to consider when understanding them. Here are some significant entries among the risks associated with algorithmic stablecoins:
No real-world asset
Algorithmic stablecoins are extremely risky because they aren't truly backed by any real-world assets and aren't tied to an underlying stable asset. They lack collateral; therefore, their price stability is less secure. In addition, algorithmic stablecoins, like many other cryptocurrencies, are subject to fluctuations in demand and supply. Since the system needs a certain amount of demand to operate properly, the system can collapse if demand declines below a certain point.
Depegging
When a stablecoin strays away from its intended peg, it is referred to as "depegging." For example, a stablecoin tied to the US dollar is said to be depegged if its value falls below $1. Hence, a pair of algorithmic stablecoins can have a domino effect if the value of one coin crashes. Depegging can destabilize the algorithmic stablecoins and generate price volatility, eventually killing the parent project. The Terra LUNA market crash is a scenario.
The Takeaway
An algorithmic stablecoin demonstrates total decentralization, with no regulatory bodies to manage or monitor the procedures, as a smart contract code is responsible for supply and demand. However, there are still several factors that can quickly influence their value and cause significant financial loss. Furthermore, the algorithmic stablecoin ecosystem is still in its infancy. As a result, more working models for algorithmic stablecoins will be developed and explored.
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