What Are Algorithmic Stablecoins?

By Manoj Sharma

What on earth are algorithmic stablecoins? And how do you use them? Here, we give you the lowdown.

There are few industries that dedicate themselves so rigorously to problem-solving as crypto. The crypto ecosystem emerged as an alternative to the problems of traditional finance. It has since that point continually found ways to improve itself and offer users newer, better options. Stablecoins are one of the most recent examples of this.

With the crypto market booming, but still nascent, the value of coins and tokens remains relatively volatile. While this might make for an exciting speculative market, it creates a problem for traders and anyone using crypto as a payment method. Let’s take a closer look at that problem.

Practical Limitations of Crypto

Imagine you’re using crypto to pay a bill: you agree to pay X amount of Bitcoin for a particular good or service. When you made the arrangement, it had a value of about 100 dollars. But guess what – a few days later, the value of Bitcoin sees an upturn. You end up shelling out the equivalent of 120 dollars instead. You wouldn’t have agreed to pay 120 – so you feel you’ve lost out. The point?: the changing value of crypto denies users price certainty.

Similarly, this impacts traders. How can you retain the profits of your trades, if the value of your holdings is constantly changing? The exact same amount of Bitcoin might be worth more, or less, tomorrow, making it impossible to “bank” your earnings.

 In both these instances, it’s easy to see how the lack of price certainty for crypto is problematic for users.

…So Crypto Made Stablecoins

In typical fashion, crypto overcame this issue via innovation, and this innovation came in the form of stablecoins.

As the name suggests, these are blockchain-based coins designed to maintain a stable value. Something that is normally achieved by “pegging” them to a real-world commodity such as fiat money or gold.

These coins are the lifeblood of the crypto. Particularly Decentralized Finance (DeFi), ecosystem – they are used for trading and settlements, because of the price certainty they provide.

This can be observed commonly on exchanges: you can rarely do a straightforward swap from asset A to asset B. Instead, in most cases, you must go from asset A to ETH or a stablecoin to asset B. 

Stablecoins also provide an “offramp” from the price fluctuations of crypto, without offramping from crypto itself. So, whether you want to keep your holdings stable or simply exchange your assets, almost all crypto users will need to use stablecoins at some point.

How Do Stablecoins work?

Just like Bitcoin and Ethereum, stablecoins are also digital currencies that exist on the blockchain. However, they are different in the sense that they are backed by real-world assets. This can be fiat money or commodities such as gold and real estate.  

Whatever the collateral, the mechanism is always the same. The core idea is to back up the stablecoin with a real-world asset held in a reserve. This physical assurance is what gives the currency its stability – there is an expectation that the collateral could be redeemed on request. 

The existence of a reserve is, therefore, the fundamental source of stablecoins’ stability. It’s also a key weakness for the system as a whole. Let’s take a closer look.

Collateral Reserves are Vulnerable

Crypto was conceived to be a completely decentralized monetary system. In other words, a system where there is no single point of failure and which does not rely on, at any point in the process, just one entity.

But a central reserve is at odds with this. A reserve is necessarily kept all in one place, and run by a single entity. By tethering crypto to an asset that is controlled by a single entity, the crypto once again becomes…centralized.

As we know too well, this comes with its own risks. The party involved might default or make mistakes; the issuer may go bankrupt, taking the reserve with them, or may refuse to redeem the tokens; or the reserve itself could be vulnerable to regulation or seizure by authorities. In other words – many of the problems crypto was designed to prevent once again become a concern.

To solve this problem, stablecoins should provide regular audits from third parties. But how reliable could those audits be if it’s done by independent third parties who may or may not show the reality of the reserves? 

Inflation Creeps into Crypto

And there’s another, even more fundamental issue too. Fiat currency is subject to inflation –  the USD, for example, has lost more than 96% of its purchasing power since the creation of the FED in 1913. So if your crypto is tied to fiat, the value of that crypto will suffer the effects of inflation. Making it an unstable store of value over time. 

In short, stablecoins face two huge vulnerabilities: they are only as stable as their collateral, and their central reserve makes them susceptible to external risk, which undermines the blockchain ecosystem. So, how do we find a solution that maintains a stable value and isn’t controlled by any central entity?

Algorithmic Stablecoins: A New Approach to Stability

Crypto responded to this issue in a typical fashion – with a new wave of innovation. Algorithmic stablecoins aim to bring greater decentralization to the stablecoin market by using an algorithm to guarantee the value of crypto instead of a reserve of fiat. This means no intermediary is required to manage the reserve, and the reserve itself is not subject to changes in value or central control. There are a few different approaches currently emerging:

Rebasing Model

One of the mechanisms for achieving this is called “rebasing”. This system regulates the value of its coins via the supply itself. The algorithm automatically decreases the supply of coins when the price falls below a certain level. It issues more coins when the price increases a specific threshold, thus maintaining the value of the coin regardless of other market activity. 

For example, say the protocol wanted the price of each stablecoin to consistently equal a dollar – you have ten of these in your wallet. Overnight, the value of the stablecoins rises to 2 dollars so, to account for this. To keep its value stable, the protocol will double the total number of tokens in circulation – including the ones in your wallet. So, in this case, the number of coins in your wallet would double. But each one will still be worth a dollar, same as yesterday. Conversely, if the value of the currency falls, the number of coins in your wallet will rise. In all cases, the value remains fixed.

The idea is to ensure if you had 1% of the supply before the rebase, you would still have 1% after it. Even when the number of tokens in your wallet has changed. It means you retain your share of the network irrespective of the price of its native token. 

Coupon-Based Model

While most protocols use rebasing to maintain the peg, some use coupon-based burn or mint techniques. This means when the price of a stablecoin is above $1, new tokens are minted. Then given to specific holders who are a part of the governance. If the peg goes below $1, these holders are incentivized to burn their stablecoins in exchange for coupons that can be redeemed back during the next supply expansion phase.

Decentralized Reserve Model

There is one more innovation worth mentioning here: although it is not technically a stablecoin, it nonetheless seeks to overcome the problems associated with central reserves and deliver a coin of “floating value”. 

Decentralized reserve currencies use a protocol, controlled by smart contracts instead of a central entity, to maintain a reserve. The coins are backed by that reserve but not pegged to them. Which means the value of the currency can increase freely, but cannot drop below a certain point. 

Limitations of Algorithmic Stablecoins

Algorithm-based coins provide true decentralization by removing third-party involvement altogether, but they also have their fair share of tradeoffs.

With rebasing, the problem arises when there is a huge influx of new tokens or when there is an exponential reduction of supply. It puts immense pressure on the nominal price, and, at times, can shrink or increase the price to unprecedented levels. 

With coupon-based burn or mint, there have been several cases where the price of a stablecoin never returned to its peg. Leaving the coupon holders with nothing. 

You might be wondering: if algorithmic coins are also pegged to a fiat currency, like USD, won’t it lose its value since USD is also falling? The answer varies from coin to coin. Elastic supply coin AMPL (Ampleforth Stablecoin), for example, is pegged to the value of the 2019 US dollar, meaning its value won’t accommodate inflation. So each project has its own methods of enshrining value and those are sure to be grounds for innovation too.

The Future of Stablecoins

Ultimately, the success of algorithmic stablecoins can only really be tested over time, and across different types of market. But one thing is certain: they feature some truly exciting new approaches to the economics of coins. Something that’s generating some pretty heated debate in the industry.

For now, the real value of algorithmic stablecoins is that they show the crypto ecosystem’s unwavering, single-minded commitment to eradicating all forms of centralization. For you and me, this means more options and a fairer balance of power that’s not available in traditional finance. So go forth, stay ahead of the game and explore the beginnings of this exciting new take on tokenomics! It could come to change everything.

Knowledge is Power.

Trust yourself and keep on learning. Check out this School of Block episode to understand what stablecoins are, how they work and how they’re being affected by regulation.