Stablecoins have become one of the most prominent interventions in the crypto world to address volatility concerns. Anyone who closely follows the crypto space will know that crypto coins and tokens are considered volatile. The value of cryptocurrency fluctuates dramatically in response to market conditions, supply, and demand changes. It is important to note that high volatility in the crypto domain may pose a significant risk to investors.
Therefore, stablecoins were created as a long-term solution for dealing with the cryptocurrency’s high volatility. Among the many different types of stablecoins, algorithmic stablecoins have been praised as the “purely stable” decentralised crypto tokens. Are they truly stable? What value do algorithmic stablecoins bring to the table? The following discussion provides a comprehensive overview of algorithm-based stablecoins, including their mechanism, functions, and notable names in the algorithmic stablecoins list.
Different Variants of Stablecoins
From $5.9 billion at the beginning of 2020 to over $35 billion at the beginning of 2021, stablecoins have been quite successful in establishing a massive market presence. Their total supply increased by 493% in only one year.
Most importantly, the continuous push for the DeFi market has accelerated the impressive growth of stablecoins. Stablecoins are divided into three categories:
- Off-chain collateralised stablecoins
- On-chain collateralised stablecoins
- Algorithmic stablecoins
Off-chain collateralised stablecoins are generally associated with the support of bank deposits as well as regular auditing. Off-chain collateralised stablecoins are minted and maintained by a centralised entity.
On-chain collateralised stablecoins, on the other hand, are associated with cryptocurrency collaterals. DeFi protocols mint such stablecoins without requiring permission while embedding high-quality collateral.
What are Algorithmic Stablecoins?
Algorithm-based stablecoins do not have any associated collateral. Hence, they’re also known as non-collateralised stablecoins. Algorithm-based stablecoins are new cryptocurrency variants designed to improve price stability. Furthermore, it can assist in balancing the supply and demand for the asset in circulation. Most importantly, algorithm-based stablecoins outperform collateralised stablecoins in terms of capital efficiency.
The algorithm or protocol that underpins these stablecoins functions as the ‘central bank.’ It aids in increasing supply if a token is deflating or decreasing supply if the stablecoin’s purchasing power declines.
How Algorithmic Stablecoin Works
As you can see, the working of an algorithm-based stablecoin is heavily reliant on an algorithm. The algorithm establishes the rules for balancing the stablecoin’s supply and demand. You should get familiar with ERC-20 smart contracts and their functionalities. They make sure that the number of tokens related to a specific address is updated each time a token is transferred from one to another.
In the case of algorithm-based, non-collateralised stablecoins, ERC-20 smart contracts have additional functions like minting and burning. These functions facilitate efficient management of processes for updating the tokens related to the wallet. However, the working of algorithm-based stablecoins is more complicated than just the ERC-20 smart contracts.
Algorithmic stablecoins also include oracle contracts. The oracle contract enables the smart contract to communicate outside of the blockchain. Oracle contracts can obtain the price of an algorithmic stablecoin from multiple exchanges.
Chainlink is one of the most prominent examples of an oracle contract. The working of algorithmic stablecoins also includes a rebase contract. After finding out the price of the concerned stablecoin, the oracle contract sends the value to the rebase contract every 24 hours. The rebase contract is primarily concerned with determining the ideal option between contracting and expanding supply.
The rebase contract then sends the available information to the stabiliser contract. The stabiliser contract calculates the number of tokens that must be burned and minted from all user wallets associated with the contract and initiates the procedure.
Overall, the primary logic underlying the functions of algorithm-based stablecoins is based on burning tokens when the price of the stablecoin exceeds a predefined stable value and minting new tokens if the price of the tokens falls below a predetermined stable value.
Types of Algorithmic Stablecoin
Now that you understand how algorithmic stablecoins work, you can look forward to learning about the best algorithmic stablecoins. The first algorithm-based stablecoin variants included ‘rebase’ coins like the Ampleforth or AMPL token. The rebase coins aided in adjusting the supply to match the current market rate for AMPL.
When AMPL trades above $1.05 and below $0.95, the protocol either issues new tokens to holders or destroys them. As a result, it can provide more efficient transmission of price volatility to the market cap. As a result, the market capitalisation changes in response to changes in demand for rebasing tokens, with no price changes.
AMPL is an example of one of the first algorithmic stablecoins to use a single-token model. Token holders in this model could benefit from increased supply following increased demand. However, the risks of algorithmic stablecoins become evident in the single-token model. How? In this model, token holders are responsible for financing a re-peg in the event of declining demand or trading of the token below a specified threshold due to supply contraction.
Of course, we also have multi-token models. Many stablecoins that use the multi-token model rely on the separation of stablecoin functionality from other protocol features. As a result, the stablecoin function differs from other functions such as value accrual or governance.
Metrics for the Success of Algorithmic Stablecoins
The majority of discussions about algorithm-based stablecoins point to a list of the best algorithmic stablecoins. However, it is critical to understand the distinct factors that determine the effectiveness of algorithm-based stablecoins. This is where you should concentrate on the key areas for algorithm-based stablecoin analysis and the metrics used to evaluate their performance.
It is difficult to compare different protocols for algorithm-based stablecoins. An assessment of the critical aspects in market design, token design, and mechanism design, on the other hand, could aid in determining the efficiency of algorithm-based stablecoins. Here are some of the most important factors to consider when determining the effectiveness of algorithmic stablecoins.
Governance
Many algorithm-based stablecoin protocols are believed to employ a DAO structure. Only a small number of protocols have an active community responsible for consistently approving upgrade proposals. A functional governance smart contract may appear to be the optimal solution for maintaining governance in non-collateralised stablecoins. However, it is also critical to ensure fair token distribution while providing adequate governance privileges to all stakeholders. Many types of algorithmic stablecoin protocols follow a de facto centralised governance approach.
Incentives
Certain algorithm stablecoin protocols use the rebase mechanism when they need to ensure active modification of a number of tokens in a user’s wallet. Some protocols, on the other hand, aimed to offer returns on alternative investment vehicles such as coupons for removing or adding supply and matching demand.
Incentives, therefore, are one of the most difficult aspects when determining the efficiency of the best algorithmic stablecoins. Why? You have the volatility of the cryptocurrency market, as well as the shifting elements of human psychology and economics. Stability is the only visible incentive with stablecoins right now.
Token Adoption
The factor of token adoption is also important in determining the ideal choices in an algorithmic stablecoins list. The majority of protocols are only used by a small number of DeFi projects. Automated Market Makers, which do not require approval from the partner protocol, are excluded from adoption. As a result, the utility of algorithm-based tokens declines, as does their exposure to new users. This limited token adoption combined with slow liquidity growth could present challenges for stablecoins’ stability.
Accuracy
Algorithmic stablecoins struggle greatly to maintain the peg because of several complicated reasons. Certain protocols may get out of control to the point where they are likely to enter a ‘death loop.’ As a result, a major protocol would be required to assist the protocol in breaking out of the ‘death loop.’
Risks of Algorithmic Stablecoins
To better understand the various risks associated with algorithm stablecoin protocols, let us consider Basis, an uncollateralised stablecoin. Here are some of the most common risks associated with algorithm-based stablecoins.
Increase in Supply
Weren’t the best algorithmic stablecoins designed to balance stablecoin supply? How will it pose risks to token holders? When the token’s price rises above a predetermined stable value, the algorithm mints new tokens to increase supply. Regarding the case of Basis, you can find Share tokens according to which the holders of shares receive newly minted stablecoins when there is an increase in supply.
On the other hand, the shares could receive new tokens only after bondholders receive their payments. Payment of newly minted tokens infuses value into the shares, though this is highly dependent on increasing demand. If there is a slowdown in demand growth, minting new stablecoins will result in a loss of value of shares.
Reducing Supply
The decrease in supply is also a significant risk of algorithmic stablecoins. A common approach to reduce supply with algorithm-based stablecoins is the facility of ‘bonds.’ Such bonds are available for sale in an open market for a lower price than the predetermined stable value. The bonds are purchased with stablecoin, with a promise of returning one stablecoin in the future. This approach means buyers are investing their confidence in the bonds’ ability to pay out at a specific point in time.
Oracles
Oracle contracts are in charge of providing price data for the concerned stablecoin. It ensures that supply is adjusted in accordance with pricing movements. However, selecting and implementing oracles can present formidable challenges, especially when trust, honesty, and accuracy are taken into account.
Broken Pegs
Peg breaks are the worst-case scenario for any type of stablecoin, and uncollateralised stablecoins are the most vulnerable. Why? They are heavily reliant on market confidence. Without market confidence, a token or coin may fade away into oblivion. If a stablecoin experiences two significant peg breaks, it will face significant difficulties recovering effectively.
Notable Examples of Algorithm-based Stablecoins
It may be easier to understand algorithm-based stablecoins when we look into examples of some of the best algorithmic stablecoins. Here are some of the best algorithm-backed stablecoins which can help you learn more about the functionalities of such stablecoins.
RAI
RAI provides a stablecoin protocol that allows stablecoins to avoid the fiat-pegging aspect. It shares many similarities with MakerDAO’s deprecated single-collateral DAI. Users could store Ether in a “safe” similar to DAI vaults. In the case of this example in the algorithmic stablecoins list, the minimum collateralisation rate is just under 150%. Users would be compensated with RAI tokens. RAI’s algorithm includes a dedicated PID controller that receives an input of RAI’s current price. Then, a continuous feedback loop adjusts the supply in response to the price.
All parameters are hard-coded in the algorithm alongside ensuring responsive, automatic responses to market data without the need for direct manual intervention. Aside from the value benefit of ‘self-peg,’ RAI differs significantly from DAI in terms of governance. It aims to remove various governance parameters from the process by 2022, reducing the need for reliance on governance.
FEI
FEI is also another notable protocol that focuses on addressing the capital inefficiencies identified in stablecoins such as DAI. FEI has plenty of differences when compared to other algorithm-based stablecoins. One of the most notable differences is that it lacks the mechanism for exchanging collateral for stablecoin. In fact, digital wealth comes in to the system via a bonding curve that sells FEI in exchange for ETH. The digital wealth is then locked in the Protocol Controlled Value, or PCV, which is essentially the stablecoin’s collateral pool.
PCV contributes to the peg’s stability by managing liquidity on exchanges such as Uniswap. With limited sell-side liquidity, FEI is one of the best algorithmic stablecoins for avoiding the ‘death spiral’ scenario. The FEI protocol uses its TRIBE token to allow holders to determine the following aspects of governance:
- Addition of new bonding curves for the sale of additional FEI
- Determine a strategy for allocating PCV value
- Changes in other governance parameters
FRAX
FRAX follows the assumption that a stablecoin can be both secure and partially collateralised, using an arbitrage-based system. FRAX collateralisation with USDC at a ratio that keeps total USDC backing lower than total FRAX supply.
Aside from its under-collateralised nature, FRAX also prefers USDC over ETH. Another important aspect about FRAX as one of the top algorithmic stablecoins is its governance. FRAX takes a governance-minimised approach to enable considerably lesser algorithmic dials for the community to modify.
Case Study: TerraUSD (UST)
Who created Terra?
Terraform Labs, founded in 2018 by Do Kwon and Daniel Shin, developed the Terra ecosystem.
How does Terra work?
Terra mints and burns tokens to maintain its stablecoins’ equilibrium while incentivising arbitrage. Here’s what that means:
Before you can purchase UST, you must first mint some. You’ll have to pay the going rate in LUNA to do so. The protocol takes those LUNA and burns them, limiting their supply and slightly raising the price of LUNA. The same works in reverse: in order to mint LUNA, you must first convert UST stablecoins. Those are burned and they push up the price of UST.
Why would you want to do something like this? There is a potential arbitrage opportunity in addition to using the assets for some service or utility. Arbitrageurs, or traders who profit from small price differences, help to keep the price of UST stable by selling LUNA for UST when the price of UST is less than $1 and buying LUNA when the price of UST is greater than $1. If UST falls to $0.95, for example, traders can buy a bunch at that price and sell it for $1 of LUNA. As a result, UST supply is reduced, and the price rises again—theoretically.
This mechanism also powers Terra’s other stablecoins, including a stablecoin pegged to the South Korean won and another pegged to a basket of the world’s leading currencies maintained by the International Monetary Fund (called Special Drawing Rights).
According to Terra’s whitepaper, the elasticity of LUNA’s supply ensures that the stablecoins will never fall out of kilter. Nonetheless, its success is contingent on arbitrageurs’ continued interest in UST. Some analysts fear that if arbitrageurs determine that UST is doomed to fail or move their funds to another project, they will not arbitrage UST back to its $1 peg. As with many crypto projects, community spirit is of the utmost importance.
What else is special about Terra?
The coins are built on the Cosmos ecosystem, which is a blockchain framework that is shared by Cosmos Hub, Cronos and Thorchain. In contrast to Ethereum, where all tokens are secured by proof-of-work mining from the main Ethereum chain, Cosmos protocols are backed by independent, app-specific miners.
Since Cosmos, and by extension Terra, is a smart contract blockchain protocol, Terra coins can be used in any of the applications built on the protocol. Terra coins can also be used across blockchains via Terraform Labs’ Mirror Protocol, which provides stocks whose prices mirror major US firms’ prices.
Terra released the Columbus-5 upgrade at the end of September 2021. This enhancement to the Inter Blockchain Communication (IBC) protocol allowed Terra to become interoperable with other blockchains. Notable examples include the Ozone insurance protocol and UST support from the Wormhole V2 cross-blockchain bridge.
The future of Terra
The future of Terra’s protocol is essentially a discussion about the future of the stablecoins that underpin it. Will centralised U.S. dollar stablecoins become so entrenched in the U.S. financial system (possibly via a central bank digital currency) that decentralised alternatives become obsolete?
Will decentralised stablecoins, on the other hand, abandon US dollar pegs and become backed by protocol-owned liquidity? Or will arbitrageurs tire of LUNA and crash the prices of all stablecoins within its protocols, consigning them to the same graveyard as Basis and Empty Set Dollar?
The 2022 UST crash
In May 2022, these questions were thrown into sharp relief when Terra’s native stablecoin UST lost its dollar peg in the midst of a broader crypto market crisis.
On May 11, UST fell as low as $0.30, erasing more than $11 billion from UST’s market capitalisation. At the time of publication, it had recovered some of its losses but had not regained its dollar peg, despite the Luna Foundation Guard’s efforts to deploy billions of dollars in Bitcoin reserves to keep UST pegged to the dollar.
LUNA suffered the same fate as UST. During the de-pegging event, the native asset lost more than 955 of its value as the market lost faith in its mint-and-burn mechanism’s ability to stabilise UST.
Regulators are also paying closer attention to UST’s de-pegging. In a hearing on May 10, US Treasury Secretary Janet Yellen cited the collapse of UST as yet another reason why stablecoins should be regulated in 2022.
The collapse of Terra’s native stablecoin in May 2022 has threatened the entire Terra ecosystem. This is because it is the only native stable asset on this network that can be used for various decentralised finance (DeFi) activities such as lending and borrowing or even simple swaps. Many of these activities become extremely risky in the absence of an effective stablecoin.
Are Algorithmic Stablecoins a Good Investment?
Algorithmic stablecoins aim to stabilise market volatility by utilising hardcoded smart contracts to automatically decrease or increase the coin’s supply based on market conditions. Many investors see this emerging technology as a potential game-changer in the crypto world. The stablecoin market is expected to reach $1 trillion in the next two years.
Investors in a centralised stablecoin system are vulnerable to interference from government regulations in the jurisdictions where they are incorporated. If the government decides to freeze issuers’ bank accounts for any reason, the stablecoin’s redeemability becomes zero, negating its value. An algorithmic stablecoin is immune to such risks due to its decentralised nature.
The UST-LUNA collapse has undoubtedly shaken up the crypto industry. According to some regulatory experts, this could be the end of algorithmic stablecoins; indeed, the future of algorithmic stablecoins appears bleak. For the time being, we expect investors and institutions to avoid algorithmic stablecoins, and it’s unclear what their future holds.
Closing Thoughts
Stablecoins have previously been regarded as a new and safer type of cryptocurrency investment. Algorithmic stablecoins, on the other hand, are an exception because they “[rely] on complex financial engineering to keep their value steady.” The UST-LUNA incident has raised some potential red flags. Perhaps current technology isn’t advanced enough, and some level of regulation/control is required… even for stablecoins.
