Summary
- Algorithmic stablecoins are digital assets effectively pegged to fiat currencies.
- They differ from other types of stablecoins in that they aren’t backed by real assets, instead relying on algorithms to maintain a stable price.
- The systems used to achieve a fiat peg vary, but they usually involve dynamically adjusting the token supply.
- For more articles like this, please visit our Explainers pages.
Defining an algorithmic stablecoin
An algorithmic stablecoin is a digital asset that mirrors the price of a fiat currency, usually the US dollar. Using mechanisms that adjust the circulating token supply, these types of stablecoins attempt to maintain their peg with the underlying currency.
They have proven to be important tools in the crypto space, spanning a range of use cases including storing value and remittances.
How do algorithmic stablecoins work?
Today’s most popular stablecoins are fiat-backed stablecoins. These are relatively simple in their design: for every blockchain-based token issued, a dollar/euro/yen is held in reserve. This means that any person holding these tokens should be able to redeem each token for one unit of the underpinning currency.
The result is a token that trades at—or close to—the price of the underlying fiat currency. After all, no one wants to pay more than $1 for a token that can only be exchanged for a dollar, nor will anyone sell it at a discount.
In contrast, algorithmic stablecoins are not “backed” by any real-world asset(s). As the name indicates, their price is dictated entirely by algorithms.
Types of algorithmic stablecoins
A seigniorage or dual-token algorithmic stablecoin usually relies on two tokens: the stablecoin itself, and a second one called the bond token. Together, these two tokens work to maintain price stability via market incentives.
When the stablecoin trades above a dollar, it suggests that demand outpaces supply. The protocol rectifies this by minting new units and distributing them to ecosystem participants (e.g. those that hold a governance token). With this supply increase, it’s expected that prices will return to parity.
When the stablecoin trades below a dollar, supply exceeds demand, and the protocol must reduce the circulating supply. This is where the bond token comes into play. For example, if the stablecoin currently trades at $0.75, the protocol allows users to purchase the bond token at this price.
The bond token can be redeemed for $1 upon the stablecoin’s return to parity — meaning that buyers will make $0.25 on every bond they buy now. Meanwhile, the protocol reabsorbs the stablecoins used to buy bonds, effectively reducing the circulating supply, and returning the stablecoin to parity
Rebasing stablecoins are similar to those of their seigniorage counterpart in that when prices exceed a dollar, the circulating supply is increased. When they drop below a dollar, the circulating supply decreases.
The key difference here is that rebase stablecoins have an elastic supply, with the number of tokens in circulation changing (i.e. rebasing) based on their price.
For example, 10 tokens in a wallet would be worth a total of $10, but if the token’s value doubled (becoming worth $20), the rebasing mechanism will halve the total supply of tokens, including those in wallets (so the 10 tokens halve to five, and remain valued at $10). The token holder doesn’t lose any of the dollar value but the supply has contracted to account for the value increase, and vice versa.
Not considered to be “pure” algorithmic stablecoins (in that they rely on collateralized stablecoins), fractional-algorithmic stablecoins are worth noting. They offer a hybrid approach, which partially collateralizes the system’s digital assets.
Crypto assets are used to back a portion of the stablecoin and the remaining value is then made up of an algorithmic mechanism.
The advantages of algorithmic stablecoins
Current data suggests that the market prefers fiat-backed and, to a lesser extent, crypto-backed stablecoins, over their algorithmic counterparts. That said, algorithmic alternatives have some advantages over traditional stablecoins.
Decentralization: Fiat-backed stablecoins are inherently trust-based. Those using them believe that a centralized party maintains 1:1 dollar reserves. This counterparty risk could prove catastrophic for their peg should it emerge that they don’t, or in case of regulatory interference.
Conversely, the algorithmic stablecoin model is based entirely on-chain, and it doesn’t require fiat backing. Anyone can audit the smart contracts that underpin the system.
Scalability: Unencumbered by real-world reserves, algorithmic stablecoins can rapidly adjust their circulating supply to respond to increased demand, requiring no external intervention.
The disadvantages of algorithmic stablecoins
Reflecting their complex mechanisms, algorithmic stablecoins face some major disadvantages.
De-pegging risk: A de-pegging event occurs when a stablecoin loses its parity with the asset it tracks. This scenario is precisely what the mechanisms of the stablecoin aim to prevent, but as historical examples have shown, they’re often insufficient to prevent the system’s collapse.
A de-peg can happen due to a fault in the code, or, more commonly, due to a loss of trust in the stablecoin (e.g. the Terra collapse).
No backing: Lack of collateralization can be viewed as a strength and weakness in a stablecoin system. It eliminates centralized risks, but it can also aggravate “death spirals” in the case of a de-peg. Without the safety net of underlying reserves, any loss in confidence in the system could result in rapid sell-offs and price collapse.
Among stablecoins, algorithmic ones are perhaps “truest” to the crypto ethos — in theory, serving as a decentralized, stable store of value in an otherwise volatile cryptocurrency market. Their complexity, however, make it difficult to establish one that works robustly over time.
A version of this explainer first appeared on CCI member site, Kraken.
