Stablecoins have emerged as a revolutionary concept within the crypto space. In the highly volatile crypto industry, stablecoins emerge as a stable option, helping investors park their funds safely for a longer period. This is the reason that the demand for stablecoins has shot up quite significantly over the years. From less than $6 billion in 2020 to $35 billion in 2021, the market cap of stablecoins has skyrocketed. In fact, the market cap of stablecoins breached the $100 billion mark in 2021. Hence, it is important to understand the reason behind this growth to decode the rise of algorithmic stablecoins.
The increasing adoption of decentralized finance (DeFi) is a major reason behind the exponential growth of stablecoins.
What Are Algorithmic Stablecoins?
Essentially, there are three categories of stablecoins:
- Off-chain collateralized stablecoins
- On-chain collateralized stablecoins
- Algorithmic stablecoins
Algorithmic Stablecoins-
As the name suggests, Algorithmic stablecoins are backed by algorithms. Unlike off-chain collateralized stablecoins and on-chain collateralized stablecoins, algorithmic stablecoins do not have any associated collateral. The key goal behind the creation of algorithmic stablecoins is to offer improved price stability. Algorithmic stablecoins have an edge over collateralized stablecoins as they offer better capital efficiency.
The algorithm backing algorithmic stablecoins works as a central bank for these coins. The algorithm increases or decreases the coin supply depending on the market condition or the shift in the coin’s purchasing power. Smart contracts contain the rules regarding the governing power of these stablecoins and any change in these rules requires governance votes.
What Makes Algorithmic Stablecoins So Successful?
There are several technical aspects that we can look at to understand the rise of algorithmic stablecoins. From token design to market design, there are several factors that fuel the growth of algorithmic stablecoins. Here are some of those factors:
- Governance: Most of the algorithm-based stablecoins follow a DAO structure. Smart contracts hold the decision-making authority and any changes with respect to the structure can be only made through governance votes. From fair token distribution to offering adequate governance privileges to stakeholders, the authority is responsible for ensuring the proper functioning of all the critical factors. However, some algorithm-based stablecoins also follow a centralized governance approach.
- Token Adoption: The rise of algorithmic stablecoins has a lot to do with their adoption by DeFi protocols. Increasing adoption is a major factor behind the growth of algorithm-based coins. However, limited adoption does pose a challenge to continuous growth.
- Accuracy: Stablecoins are pegged to FIATs and that’s a major reason behind the high adoption rate. Stablecoins like USDT and USDC are examples of successful stablecoins. However, algorithm-based stablecoins have a long way to go when it comes to maintaining a peg.
The Significance of Algorithmic Stablecoins
Algorithmic stablecoins stand true to the core principle of cryptocurrencies, which is decentralization. The absence of a centralized authority differentiates algorithmic stablecoins from other stablecoins. Meaning, that, unlike other stablecoins, an algorithmic stablecoin is not pegged to a fiat. The price is decided by the code itself.
Also, since there is an absence of tangible asset requirement behind Algorithmic Stablecoin, the possibility of error at the end of users is reduced substantially. Algorithmic stablecoins add a significant value to the DeFi space as they bring back seignorage. Ampleforth (AMPL), DeFiDollar (USDC), Empty Set Dollar (ESD), and Frax (FRAX) are some of the most popular algorithmic stablecoins.
How Does An Algorithmic Stablecoin Work?
While an algorithmic stablecoin is not pegged to any FIAT, it is always backed by one. In case the price of the algorithmic stablecoin remains under that of the FIAT supporting it, the token supply is reduced. Similarly, if the price of the algorithmic stablecoin exceeds that of the FIAT backing it, additional tokens are issued to bring the price to the level of the FIAT.
Risks Involved With Algorithmic Stablecoins
Despite being fully decentralized, algorithm-based stablecoins may face several challenges. Skeptics fear limited growth potential. Algorithm-based stablecoins tend to sideline basic economic principles in their pursuit to be governed by codes. Instead of the activities by buyers and sellers, the code has the authority with respect to deciding the price. Here are some of the risks associated with algorithm-based stablecoins:
- Broken Pegs: While algorithmic stablecoins are not pegged to any FIAT, they must maintain a price level similar to that of the FIAT backing them. The basic principle of stablecoins is to bring stability. However, algorithm-based stablecoins tend to stray away from this principle. Peg breaks are one of the worst things to happen in the crypto market. Something which we are currently seeing with Terra Luna.
- Selection Of Oracles: Oracles, or Oracle contracts, are responsible for offering price data for a stablecoin. With the algorithm deciding on the price changes, selecting an Oracle could be a daunting task. There can be serious concerns regarding price accuracy, going forward.
- The Role Of Bonds: Bonds are issued when the need arises to reduce the supply. However, the issuance of bonds tends to jeopardize the movie behind reducing the supply. How? Well, the issued bonds are available in an open market sale for prices much lower than the predecided stable price. This is bound to have a negative impact on the price stability of the coin. The payment for these bonds is done in stablecoins. But with high chances of price instability, it is difficult to build trust among the investors.
Terra, an open-source blockchain platform for algorithmic stablecoins, shot to popularity, cashing in on the popularity of the concept. But we can see how it struggles to maintain price stability in a red market.
Understanding Terra’s Algorithmic Market Module
When the price of UST rises above the $1 peg, users holding $LUNA can swap it for one UST and later sell it for more than $1. This method helps in increasing the supply of UST, resulting in the return of the peg to $1. Similarly, when UST falls below the $1 peg, the protocol incentivizes users to burn UST in exchange for LUNA. Here, the value of UST is brought back to $1 by reducing supply. The ‘market swap’ feature on the Terra Station wallet can be used for such processes.