Last updated: 9th Nov 2022
Table of Contents:
WHAT ARE ALGORITHMIC STABLECOINS
HOW DO THEY WORK?
TYPES OF ALGORITHMIC STABLECOINS
ADVANTAGES AND DISADVANTAGES OF ALGORITHMIC STABLECOINS
TOP 5 ALGORITHMIC STABLECOINS
A LOOK BACK INTO LUNA AND UST
The unique nature and overwhelming importance of Web3 cannot be overemphasized. Web3 is immensely contributing to the economic sector of creators and many others. Web3 has embarked on a mission to Shift the centralized power in the traditional world by introducing different decentralized infrastructures.
Foremost, stablecoins are digital currencies pegged to the U.S dollar and operate on the blockchain. Stablecoins, in most cases, are used as currencies for trading crypto assets. Like every other concept, stablecoins are also different with their peg maintenance: centralized and decentralized stablecoins.
The centralized stablecoins form has been the most frequently used; however, over the years, a new type of stablecoin emerged with its different collateralization — Algorithmic Stablecoin.
An algorithm denotes a set of codes or rules that instructs a procedure. In the crypto world, it means codes programmed in a set of smart contracts. Thus, an Algorithmic stablecoin is a cryptocurrency ruled by an algorithm used to reduce the price instability of a particular asset. They are uncollateralized and backed by any external asset, whatsoever. Algorithmic stablecoins consist of TerraUSD, magic internet money (MIM), frax, etc.
For its practical operation, stablecoins rely on two tokens: one stablecoin and the other stablecoin backed by cryptocurrency. The algorithm, aided with transparent and auditable codes, regulates the relationship between the two tokens. This is one of the reasons why stablecoins are considered to be the safest option for investment if a user is trying to avoid volatility in the crypto space. However, like every other crypto asset traded via crypto assets exchanges, algorithmic assets also fluctuate in price depending on demand and supply.
With the basic knowledge, how is Algorithmic stablecoin put into play? Unlike other stablecoins (centralized stablecoins), algorithmic stablecoins are built on several mechanisms to ensure the coin maintains its peg (mostly $1). The pegging maintenance mitigates or stops the price of stablecoins from being unstable. To fully capture the whole operation of algorithmic stablecoin, an instance would be studied.
For instance, by incorporating the functionalities of the ERC-20 smart contract of minting and burning, we can use the same methodology in building an algorithmic stablecoin. The Oracle platform is also needed to allow and help algorithmic stablecoins to fetch prices from diverse exchanges. After the availability of the stablecoin, it is passed into rebase contract occasionally every 24 hours where the contract, therefore, determines whether the supply would be boosted or contracted.
The calculation of the number of tokens to be minted and burned from wallets associated with the contract starts after the provision of data to the stabilizer contract. Just as it would be examined below (A look back into LUNA and UST), the basic logic behind an algorithmic stablecoin is that when the price rises above the predetermined pegged value, the algorithm will start burning tokens. However, if the price falls below the pre-stated pegged value, the algorithm will start mining new tokens. Other examples of Algorithmic stablecoin are UST, USDD, UXD, etc.
There are three main types of algorithmic stablecoins. Each uses a different algorithm to maintain its value.
Rebase: This type of algorithmic stablecoin burns or mints coins depending on the price deviation from $1. That is, if the price is above $1, coins will be minted and if the price should fall below $1, burning occurs. Therefore, it utilizes the base supply to maintain its value.
Seigniorage algorithmic stablecoin: It uses a multi-coins system, whereby one stablecoin is programmed to be stable and the other stablecoin is designed to facilitate the other’s stability.
Fractional algorithmic: this type of algorithmic stablecoin is a combination of the aforementioned types of algorithmic stablecoins. This stablecoin maintains its value by being partly backed by collateral (e.g. fiat currency) and an algorithm that revises the stablecoin supply. Frax Finance happened to be the pioneer in this type of algorithmic stablecoins.
Arguably, with every platform/protocol, there are always benefits and some disadvantages around the operation. Likewise, the algorithmic stablecoin has its pros and cons. Algorithmic stablecoin's main achievement and advantage over other stablecoins is the control resistance: no governing organization can shut down the protocol, owing to its building on blockchains. Another great advantage of Algorithmic stablecoins is the use of an oracle mechanism, which provides data feed from the external world to the world of the blockchain. It allows smart contracts to perform based on the inputs and outputs from the real world via the decentralized oracle. And this is much of a great deal over the traditional platforms. The use of an Algorithm also helps in the stabilization of value. Depending on the demand, the Algorithmic stablecoins can standardize their coin flow.
Interestingly, Algorithmic stablecoins lack many disadvantages due to their appearance and relevance in the space. However, with the zero assets/collateral back-up, it creates a risk, as the stability of their prices becomes shaky. As reports will have it, algorithmic stablecoins pose a serious threat to investors' wealth and profit. Using the LUNA/UST as a benchmark, another flaw of Algorithmic stablecoins is the falling out of other values during the crash of a single value in the algorithmic pair. Also, prices are not guaranteed, unlike true stablecoins. Algorithmic stablecoins aim to maintain and achieve a stable value but their reliance on the demand to maintain the stability status can be of high risk.
It is a decentralized stablecoin that endeavors to maintain a value of 1 USD. Unlike the centralized stablecoin, DAI is not backed up by the US dollar. Instead, it is backed up by collateral on the Maker platform and MakerDAO as its governance. DAI was launched in 2017 with its ERC-20 compatibility. With the peg maintenance, when the DAI price rises, an incentive is enabled for users to create more tokens. However, if the DAI price falls, an incentive will be created for users to sell their assets back to the pool.
2. TerraUSD (UST)
UST is sponsored by Terra (LUNA); therefore 1 UST can be minted by burning an equivalent amount of LUNA. The burning of 1 UST equals US$ 1 LUNA. It is an algorithmic stablecoin that makes use of the mint and burn process to generate UST and LUNA.
Interestingly, FRAX is the first algorithmic stablecoin system. The protocol’s features make it stand out - openness, permissionless, transparency, and a fully on-chain nature.
4. MIM (Magic Internet Money)
This system gives the algorithmic stablecoin a step further than the centralized stablecoins. The stablecoin is offered by many crypto asset exchanges such as UNISWAP, ASCENDEX, OKCOIN, CURVE FINANCE, etc. Also, members can earn interest by holding assets at abracadabra.com.
To wholly understand the functionality of Algorithmic stablecoin, Coindesk explanatory notes will stand as a benchmark. Terra, as a case study, Terra powers a set of algorithmic stablecoins that uses the coin, LUNA, to maintain its peg.
Structurally, TerraUSD maintains its 1:1 parity with the US dollar. When UST (TerraUSD) supply and demand are small and too high, the UST goes above the pegged $1.
To ensure UST is back at its peg status, the Terra protocol allows users to trade 1 USD (U.S. dollar) of LUNA for 1 UST. This trade takes out 1 USD of LUNA and mints 1 UST, which users can sell for 1.01 USD with a profit of 1 cent. When the supply and demand are ample and low, the protocol allows users to engage in the reserved version of the above trade: users buy 1 USD for 0.99USD and trade 1UST for 1 USD of LUNA. The transaction takes out 1UST and mints 1USD of LUNA, with a gain of 0.01 UST.
Algorithmic stablecoins are the true indication of decentralization with no governing or regulatory body overseeing their operation. The stablecoins market is largely unregulated. There are various algorithmic stablecoins out there but many are still in the testing/experimental stage. It is therefore imperative to conduct intensive research on any stablecoins before investing. As lucrative as algorithmic stablecoins are, their system/operation fails when demand falls below a certain level.