The emerging cryptocurrency market is filled with manifold categories of digital assets including stablecoins, utility tokens like DIFX Token, privacy coins, governance tokens, meme tokens, shitcoins, and others.
If you are just joining the crypto industry, it is therefore pertinent to have an understanding of these different asset types available in the crypto market to help you make the right investment decisions.
You don’t want to be like a certain user who bought a bunch of stablecoins, expecting that their investment would appreciate in the future. As you rightly guessed, the user ended up disappointed. The why is part of what this article discusses.
By the end of this article, you will have an in-depth understanding of a class of stablecoins dubbed algorithmic or algorithm–based stablecoins.
Here, you will learn about the fundamentals of algorithmic stablecoins, their mechanics, the obstacles they encounter, their possible impact on the future of finance, and how stable they can be.
Before getting to algorithmic stablecoins, let’s quickly discuss stablecoins, in general.
Stablecoins are one of the most widely adopted tokens in the cryptocurrency market given their unique design and use cases.
Unlike conventional crypto assets like Bitcoin (BTC), Ether (ETH), or Avalanche (AVAX) which may experience sharp price fluctuations, stablecoins are designed to hedge against price volatility by maintaining a value close to their underlying asset.
Stablecoins allow market members to enjoy the benefits of cryptocurrencies while hedging their assets against abrupt market movements during unstable market conditions.
A stablecoin is usually pegged 1:1 to either a fiat currency like the US Dollar, a commodity like gold, another cryptocurrency, or a combination of these.
We have different types of stablecoins:
Algorithm-based stablecoins are those stablecoins that employ sophisticated programming codes (algorithms) to achieve their stability without the need for a centralized authority to oversee their management.
These assets are often correlated to another crypto token and their value is maintained stable through decreasing or increasing the supply of the supporting token.
A typical example of an algorithmic stablecoin is TerraClassicUSD (USTC) (formerly known as TerraUSD (UST)) which has lost its peg almost completely.
TerraUSD was founded by the Terra blockchain founder Do Kwon but the project failed dramatically in May 2022.
The algorithm that guides the stablecoin is complex.
The algorithm takes into account various factors such as the price of the underlying assets, demand for the stablecoin, and overall market conditions to determine if the stablecoin’s value needs adjustment.
The algorithmic stablecoin’s supply and price control mechanisms are often complicated, involving several layers of decision-making and feedback techniques.
However, the algorithm’s complexity and efficiency are vital to maintaining the stablecoin’s stability without relying on a centralized authority.
To ensure their stability, algorithmic stablecoins rely on several methods including rebasing, seigniorage, and fractional.
Let’s consider Stablecoin A which is pegged to the US Dollar. Here’s how each model tries to keep the peg:
Rebasement adjusts the stablecoin’s supply depending on its price compared to its target value. Let’s say Stablecoin A has lost its peg and is trading below $1.
In this situation, the algorithm will reduce the stablecoin’s supply through burning to recover its peg to $1.
With rebasing stablecoins, the holdings of users will change based on the market condition and how the algorithm is working to maintain the peg.
In this model, another coin or asset is used to maintain the peg.
When the value of Stablecoin A is above $1, the demand is more than the supply which needs to be adjusted.
This is achieved by incentivizing holders to sell the underlying asset which will increase the circulating supply of the asset.
In simple terms, the price of the second token is controlled by tweaking its supply through minting and burning mechanisms. And with the help of the second asset, the stablecoin will be able to maintain its peg.
Fractional stablecoins sit somewhere between the completely-collateralized and completely-algorithmic stablecoins.
By combining the two models, fractional stablecoins try to maintain their peg by leveraging the benefits of both.
Algorithmic stablecoins currently encounter several challenges that need to be addressed for their continued success. These challenges include:
Price volatility remains one of the primary challenges for algorithmic stablecoins.
Despite being designed to maintain price stability, changes in demand or unexpected events can cause fluctuations in the value of an algorithmic stablecoin.
Liquidity refers to the sufficient availability of an asset in the crypto market.
This is another challenge as algorithmic stablecoins seem to have lower liquidity in the market compared to other stablecoins. This low level of liquidity makes it more challenging to buy or sell them.
Like other cryptocurrencies, algorithmic stablecoins are prone to hacking, fraud, and theft.
Considering that this type of stablecoins is reliant on smart contracts, ensuring the security of the smart contract and the platform it runs on is therefore quite essential.
This is the issue the cryptocurrency industry is facing as a whole.
Just recently, some stablecoins were labeled as Security which adds to the uncertainty around stablecoins and crypto assets in general.
The most important advantage of algorithmic stablecoins over other types is their decentralization factor.
This decentralization can create a fair and transparent financial system that is not vulnerable to the same issues we have seen with other collateralized stablecoins that rely heavily on the treasury the central party is maintaining.
Like any other stablecoin, algorithm-based stablecoins can also facilitate cross-border payments, making international remittances faster and cheaper.
This eliminates the reliance on traditional banks, helping the unbanked to have access to financial services as well.
In other words, as a form of cryptocurrency, algorithmic stablecoins can provide an alternative financial system that is accessible by anyone with an internet connection, irrespective of their location or financial status.
This feature boosts financial inclusion even further.
Over the years, almost all algo-based stablecoins have de-pegged at one point or the other. That is, they lost parity with their target value.
The most notable de-pegging event occurred in May 2022 and it involved TerraUSD (UST).
Consequently, this incident triggered the meltdown of numerous well-known crypto companies including Three Arrows Capital, Celsius Network, and Voyager Digital.
While the stability of algorithmic stablecoins has been questioned by many, it bears mentioning that the innovation is still in its early stages. As it continues to develop, it is expected that algorithm-based stablecoins may become more stable and reliable.
Nonetheless, you should always remember that cryptocurrencies, and especially algorithmic stablecoins, are quite volatile and need to be approached with caution.
You should always employ proper risk management techniques to manage your potential loss and never invest more than you can afford to lose.
To learn some of the useful risk management techniques in financial markets, read our “5 Risk Management Techniques For Traders” article.