Crypto tokens and coins are highly volatile depending on market conditions and cryptocurrency supply and demand. The risk involved can be off-putting to some, making them consider stablecoins – a crypto asset class that has become an integral part of the ecosystem in recent years. Specifically, a subtype of stablecoins – algorithmic stablecoins use technology to automate the trading process.
Algorithmic stablecoins embody these characteristics: part monetary economics, part financial markets, part math, and part technology. Located at the intersection of currency and blockchain technology, they are new and complex, with many challenges and unresolved issues
In this article, we will be discussing what algorithmic stablecoins are and the best algorithmic stablecoins for crypto.
What are Algorithmic Stablecoins
Algorithmic stablecoins don’t have any collateral attached to them. As such, they’re referred to as “non-collateralized” stablecoins. They’re decentralised and are tailored to improve market price stability without involving a central authority — which is often done by “pre-programming” the supply to match the demand of the asset. This is done using predetermined stabilisation measures hardcoded into smart contracts on Ethereum.
The algorithm underlying these stablecoins is programmed to increase the supply of currency in the event of a “deflationary trend” in the token and decrease the supply of the currency in the event of a “decline in purchasing power.” These algorithmic stablecoins respond to market events with automated stabilisation measures and increases their decentralised nature, giving rise to a smart, responsive currency that’s not controlled by a single institution — which is similar to a central bank’s working model.
These purely algorithmic stablecoins reveal the internal logic of the tokens and any collateral used for maintaining token value, thereby maintaining transparency on the network.
How Do Algorithmic Stablecoins Work?
The litmus test to determine if a stablecoin (algorithmic or otherwise) works is simple: how well does it maintain its peg?
Algorithmic stablecoin designers use various mechanisms to help the coin maintain its peg. Unlike most stablecoins, with algorithmic stablecoins, these mechanisms are written into the protocol and publicly available on the blockchain for anyone to view. Below are three common uncollateralised algorithmic stablecoin models, illustrated assuming a peg for $1.
Release: Rebase algorithmic stablecoins manipulate the base supply to maintain the peg. The protocol mints (adds) or burns (removes) supply from circulation in proportion to the coin’s price deviation from the $1 peg. If the coin price is> $1, the protocol mints coins. If the coin price < $1, the protocol burns coins. Coins are minted into or burned from coin holders’ wallets.
Seigniorage: Seigniorage algorithmic stablecoins use a multi-coin system, wherein one coin’s price is designed to be stable, and at least one other coin is designed to facilitate that stability. Seigniorage models typically implement a combination of protocol-based mint-and-burn mechanisms and free market mechanisms that incentive market participants to buy or sell the non-stablecoin to push the stablecoin’s price toward its peg.
Fractional-algorithmic stablecoins: Fractional-algorithmic stablecoins are becoming increasingly popular. Part seigniorage, partly collateralised, fractional algorithmic stablecoins aim to maintain their peg by combining the best mechanisms from “pure” uncollateralised stablecoins and their collateralised counterparts. Frax Finance pioneered this model.
Best Algorithmic Stablecoins for Crypto
1. DefiDollar (DUSD)
DefiDollar aims to be an index of stablecoins that uses decentralised finance (DeFi) primitives to stay near the dollar mark while subsidising the collateralisation ratio to protect users from counterparty risk, holdings seizure risk and bank run risk, etc. DefiDollar allows investors to index varying stablecoins with a single token (DUSD) that protects users from the underlying risks attached to such tokens.
2. Empty Set Dollar (ESD)
Empty Set Dollar (ESD) offers a combination of decentralisation, novel protocol mechanisms and composability that makes it a central part of the DeFi space. ESD is a decentralised, oracle-driven stablecoin that uses novel protocol mechanics to overcome the downfalls of other rebasing tokens. Token holders who do not want to maintain the price peg actively can use ESD in DApps, or hold it as a stablecoin without needing a counterparty or committing funds to a CDP — and without needing to worry about amounts changing in their wallet.
3. Frax (FRAX)
Frax is looking to serve as a DeFi money market, including services like minting and redeeming the FRAX stablecoin, as well as staking by providing liquidity provider (LP) tokens to various trading pairs on Uniswap. The Frax crypto protocol uses two distinct stable assets: Frax stablecoin (FRAX), pegged 1:1 to the U.S. dollar, and the Frax Shares (FXS) governance and utility token.
4. Ampleforth (AMPL)
Ampleforth is a decentralised stablecoin that maintains price stability with a flexible supply. Rebasing is used by the underlying protocol to adjust the supply of AMPL daily. This provides better price stability as compared to fixed-supply cryptocurrencies. Ampleforth’s stablecoin, AMPL, is elastic and non-dilutive.
Stablecoins have thus far been regarded as a new and safer form of crypto investment. Algorithmic stablecoins, however, are somewhat of an exception as they rely on complex financial engineering to hold their value steady.
In light of the recent TerraUSD (UST) crash, please do your own research and proceed with the utmost caution if you’re looking to invest in any algorithmic stablecoin.