Stablecoins are common knowledge. A digital asset whose value is directly tied to a fiat currency, most often the US dollar. But how is this peg maintained? The USDT and USDC stablecoins from Tether and Circle, respectively, are supported by actual money, Treasury obligations, and other real-world financial assets. But now there's a fresh face in town. Algorithmic stablecoins are coming to conquer the crypto world. How do they function, what are they, and can you put your faith in them? Let’s investigate.
Understanding Algorithmic Stablecoins
A key challenge to the broad adoption of digital assets as they gained traction was their volatility. People were hesitant to embrace the concept of digital currency because their value could fluctuate day to day. What is good for traders, who actively make money on the price fluctuations, was bad for common users who need to be sure they can preserve their wealth in a digital form for the future.
That's when stablecoins made their epic, Hollywood-style appearance. In just a couple years since their introduction stablecoins have become the real blood of the evolving body of the crypto world.
Enter stablecoins: cryptocurrencies designed to maintain a stable value relative to a reference asset, typically a fiat currency like the US dollar. These new digital currencies have a constant price, unlike Bitcoin or Ethereum, which is something we'll get to in a bit.
Stablecoins have emerged as an essential link between the cryptocurrency and conventional financial systems, serving to ease transactions, trade, and protect investors from market fluctuations.
Having said that, not every stablecoin is the same. Their approaches to achieving price stability differ.
Algorithmic, crypto-collateralized, and fiat-collateralized stablecoins are the three most common kinds. Rather than relying on asset reserves, algorithmic stablecoins aim to maintain their value through mathematical formulas and smart contracts.
As a new approach, algorithmic stablecoins aim to offer stability without the need for collateral reserves. This is a huge step forward for an industry that values efficiency and decentralization.
The evolution of algorithmic stablecoins has been fraught with success, failure, and trial and error.
What Is an Algorithmic Stablecoin?
The term "algorithmic stablecoin" refers to a type of cryptocurrency that does not keep any physical reserves but instead relies on smart contracts and algorithms to keep its value constant, usually tied to a fiat currency like the US dollar.
Yes, you’ve heard that right, there is no actual collateral to support the value of the algorithmic stablecoin, and yet the idea works.
The idea arose as a fresh approach to the problems that collateralized stablecoins had, including the inefficiencies of reserve maintenance and the risks of centralization.
Stablecoins that are determined by algorithms have their roots in projects like 2017's Basis (previously known as Basecoin), which offered a model similar to central bank mechanisms for dynamically controlling inflation and demand. Despite its closure owing to regulatory concerns, Basis established a foundation for algorithmic stablecoins that followed.
The idea of supply elasticity is fundamental to algorithmic stablecoins.
The protocol decides to increase the supply of the stablecoin in order to lower its price whenever its price goes above its peg. Supply is decreased in the opposite direction if the price drops below the peg. Most of the time, this is accomplished with the help of on-chain governance and smart contracts that can make these changes automatically, without any human guidance.
While algorithmic stablecoins can run on a variety of blockchains, Ethereum's strong smart contract capabilities have made it the market leader. But other platforms have also hosted algorithmic stablecoin projects, taking advantage of their lower transaction costs and scalability. Solana and Binance Smart Chain are two examples.
Within the crypto ecosystem, these stablecoins serve multiple purposes. They facilitate trading on decentralized exchanges (DEXs), provide a stable medium of exchange in DeFi protocols, and enable cross-border transactions without the volatility associated with other cryptocurrencies.
Technically, algorithmic stablecoins employ mechanisms like seigniorage shares, rebasing, and dual-token models.
For instance, in a dual-token system, one token acts as the stablecoin while the other absorbs price volatility. The interplay between these tokens, governed by the algorithm, aims to keep the stablecoin's price anchored to its peg. Sometimes this link becomes the weak point of the system, and fails. We will talk about that in a minute.
Leading Algorithmic Stablecoins
Below are five leading algorithmic stablecoins, each with unique designs and trajectories. Their stories illustrate the diversity of the algorithmic stablecoin model, its innovation, and the challenges that remain.
FRAX (Frax Finance)
FRAX is a unique example of a hybrid algorithmic stablecoin. It combines both collateralized and algorithmic elements.
The project was launched by Sam Kazemian in 2020. The aim was to create a partially collateralized stablecoin that could dynamically adjust its collateral ratio based on market demand. The token uses a decentralized governance model. All the important decisions about collateral levels are determined by Frax's decentralized autonomous organization (DAO).
Frax stands out for its scalable approach. As of September 2024, the market cap of FRAX hovers around $800 million, making it one of the largest algorithmic stablecoins currently in operation.
Frax operates across multiple chains, including Ethereum and Binance Smart Chain, and plays a pivotal role in DeFi protocols such as Aave and Curve.
Ampleforth (AMPL)
Ampleforth, or AMPL, takes a purely algorithmic approach to maintaining price stability.
Rather than pegging itself to a fiat currency, AMPL adjusts its supply daily based on demand. If the price of AMPL rises above its target ($1), the supply increases; if it falls below, the supply contracts.
This “elastic supply” model is designed to keep AMPL stable relative to its target price.
Launched in 2019 by Evan Kuo and a team of Stanford researchers, AMPL was one of the first algorithmic stablecoins to experiment with non-collateralized models. Its market cap fluctuates due to its elastic nature but typically ranges between $100 million and $200 million. Ampleforth is primarily traded on decentralized exchanges like Uniswap.
Fei Protocol (FEI)
Fei Protocol launched in 2021 with significant fanfare, raising over $1.3 billion in Ethereum during its initial liquidity event.
Created by Joey Santoro, Fei Protocol’s initial goal was to provide a decentralized stablecoin that could be more capital-efficient than collateralized stablecoins. It attempted to use direct incentives to keep FEI close to its $1 peg without requiring over-collateralization.
However, Fei experienced early challenges in maintaining its peg, with FEI dropping significantly below $1 shortly after launch. The team has since introduced changes, including increased collateralization, and FEI has managed to stabilize. As of September 2024, Fei’s market cap stands around $500 million, and the protocol is integrated with major DeFi platforms like Compound and Balancer.
Empty Set Dollar (ESD)
Empty Set Dollar (ESD) is another early algorithmic stablecoin, launched in 2020.
It operates on a seigniorage share model, which means it attempts to maintain its peg to $1 through the issuance and destruction of ESD tokens.
When ESD trades above $1, new tokens are minted and distributed to holders; when it trades below, the protocol offers bonds that can be redeemed for ESD later when the price stabilizes.
ESD was innovative in being one of the first stablecoins to fully embrace decentralized governance, with no centralized control over its monetary policy.
However, like many algorithmic stablecoins, ESD struggled to maintain stability long-term. Its market cap, once over $100 million, now fluctuates around $10 million as interest has waned, though it remains a significant part of DeFi history.
USDD (Decentralized USD)
USDD is the stablecoin of the TRON blockchain. It was launched by Justin Sun in 2022.
It aims to be a decentralized and algorithmic stablecoin, using mechanisms of burning tokens to equal the demand. USDD incorporates more collateralization than other algorithmic stablecoins of this kind usually do. For instance, it holds reserves in stablecoins like USDT and also a significant amount of BTC, to ensure its peg remains stable.
As of September 2024, USDD has a market cap of approximately $750 million and remains a key component of TRON’s DeFi ecosystem.
The Terra/Luna Crash: A Case Study
In May 2022, the crypto world witnessed a dramatic event that shook confidence in algorithmic stablecoins: the collapse of TerraUSD (UST) and its sister token LUNA. TerraUSD was an algorithmic stablecoin designed to maintain its peg to the US dollar through a mint-and-burn mechanism involving LUNA.
When UST traded above $1, users could mint more UST by burning LUNA, increasing supply and bringing the price down. Conversely, if UST fell below $1, users could burn UST to mint LUNA, reducing supply and pushing the price back up.
The system relied heavily on market confidence and arbitrage incentives. However, in May 2022, a series of large withdrawals from UST liquidity pools led to a loss of the peg. Panic ensued, and the mechanisms in place failed to restore stability. The supply of LUNA ballooned as UST holders rushed to exit, leading to hyperinflation of LUNA and a death spiral.
The crash wiped out approximately $40 billion in market capitalization within days. Investors lost significant sums, and the event had ripple effects across the crypto market, leading to increased regulatory scrutiny and a loss of trust in algorithmic stablecoins.
The failure of Terra/Luna highlighted critical vulnerabilities:
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Over-reliance on Market Dynamics: The system assumed that arbitrage incentives would always restore the peg, which didn't hold true under extreme stress.
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Lack of Collateral: Without backing assets, there was no safety net to absorb shocks.
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Feedback Loops: The mint-and-burn mechanism created a negative feedback loop during the crisis, exacerbating the collapse.
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Confidence Crisis: Once trust was lost, no mechanism could prevent the mass exodus.
Pros and Cons of Algorithmic Stablecoins
Let’s take a look at algorithmic stablecoins best features and weakest spots.
Pros:
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Decentralization: Without the need for collateral reserves held by a central entity, algorithmic stablecoins align with the decentralized ethos of blockchain technology.
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Capital Efficiency: They avoid the over-collateralization required by crypto-backed stablecoins, making them more capital efficient.
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Scalability: Algorithmic models can adjust supply without the limitations of collateral, potentially allowing for unlimited scaling as demand increases.
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Innovation: They push the boundaries of financial engineering, contributing to the development of new economic models and DeFi applications.
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Reduced Regulatory Risks: By not holding fiat reserves, they may face fewer regulatory hurdles related to money transmission and reserve audits.
Cons:
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Price Instability: Maintaining the peg purely through algorithms has proven challenging, with many algorithmic stablecoins experiencing significant price deviations.
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Lack of Confidence: Users may distrust a system without tangible collateral, leading to lower adoption rates and liquidity issues.
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Vulnerability to Speculative Attacks: Manipulators can exploit the mechanisms designed to maintain the peg, causing rapid devaluation.
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Complexity: The underlying mechanisms can be complex, making it difficult for average users to understand and trust the system.
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Historical Failures: Past collapses of algorithmic stablecoins have eroded confidence in their viability as a stable store of value.
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Regulatory Scrutiny: Despite potential regulatory advantages, they may attract attention due to their innovative and untested nature, leading to uncertain legal status.
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Market Dependence: They often require continuous market participation and confidence, which can wane during market downturns.
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Smart Contract Risks: Being entirely code-driven, they are susceptible to bugs and exploits in smart contracts.
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Governance Challenges: Decentralized governance can lead to slow responses to critical issues, exacerbating problems during crises.
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Limited Adoption: Compared to collateral-backed stablecoins, algorithmic stablecoins have yet to achieve significant adoption in mainstream crypto activities.
The Future of Algorithmic Stablecoins
The Terra/Luna incident served as a cautionary tale, prompting a reevaluation of algorithmic stablecoins' role in the crypto ecosystem.
In contrast, traditional collateral-backed stablecoins like Tether (USDT) and USD Coin (USDC) maintained stability, reinforcing their perceived safety.
While there is no doubt that stablecoins will continue to grow in popularity and will become the most popular form of digital money, the question remains - can algorithmic stablecoins become a real challenge to collateralized stablecoins like USDT and USDC.
Collateralized Stablecoins Pros:
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Transparency and Trust: Backed by reserves of fiat currency or equivalent assets, providing a tangible guarantee of value.
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Regulatory Compliance: Increasingly aligning with regulatory requirements, offering audits and disclosures to build confidence.
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Market Dominance: USDT and USDC collectively hold the majority of the stablecoin market share, widely accepted across exchanges and platforms.
Algorithmic Stablecoins:
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Innovation Potential: Despite setbacks, they continue to explore new models for decentralized stability.
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Challenges Ahead: Must address issues of trust, robustness, and transparency to regain confidence.
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Hybrid Models: Projects like Frax suggest a middle ground, combining collateral with algorithmic elements.
Which Are Better?
Collateral-backed stablecoins currently offer great stability and acceptance, they are a default payment option now. And there is nothing to indicate that their popularity may soon decline.
In the meantime, algorithmic stablecoins represent an ongoing bold experiment in financial innovation. The future may see improved designs that mitigate past flaws, but widespread adoption will require overcoming significant hurdles.
Conclusion
Algorithmic stablecoins embody the pioneering spirit of the crypto industry. What spirit? Well, the one that makes us seek to solve complex problems with innovative solutions.
Their quest for stability without collateral addresses fundamental issues of capital efficiency and decentralization.
However, the challenges they face are non-trivial.
The Terra/Luna crash underscored the risks inherent in algorithmic approaches. It emphasized the need for robust mechanisms and perhaps a reevaluation of entirely non-collateralized models.
Collateral-backed stablecoins currently provide the reliability and trust required for widespread use. At the same time they benefit from transparency and regulatory compliance. As the crypto industry matures, these stablecoins play a crucial role in integrating digital assets with traditional finance.
The future of algorithmic stablecoins may lie in hybrid models that blend collateralization with algorithmic adjustments, aiming to harness the advantages of both systems.
Continued innovation, rigorous testing, and perhaps new regulatory frameworks will be essential for their development.
Ultimately, the stablecoin landscape will likely continue to diversify, offering various options to meet different needs within the crypto ecosystem. While algorithmic stablecoins have yet to prove they can deliver stability without collateral reliably, their ongoing evolution keeps them at the forefront of crypto's most intriguing experiments.