If you have been involved in the cryptocurrency space then you have probably heard about stablecoins. But have you heard about algorithmic stablecoins?

If not, don’t worry. I will be covering all aspects of algorithmic stablecoins so you can navigate the space with ease. So without further ado, let’s jump right in.

While most stablecoins are backed by FIAT currency, algorithmic stablecoins maintain their peg by changing the total supply or influencing demand through incentives. This is all done automatically and dynamically based on market conditions through the use of an algorithm.

What are algorithmic stablecoins?

Algorithmic stablecoins are cryptocurrencies that maintain their value against traditional types of currencies. For instance, the Ethereum-based project FRAX is pegged to the US dollar. In most cases, algorithmic stablecoins maintain this peg through the use of a program that regulates the stablecoin supply to match the demand.

Essentially, this automated process removes coins from circulation if the price goes below the peg and increases the supply if the price rises above the peg.

Additionally, stablecoins can utilize seigniorage processes. This is when a corresponding cryptocurrency is used as additonal backing. In essence, the non-stablecoin is used as an incentive to push the stablecoin towards its peg.

For instance, arbitrage opportunities are created to maintain the peg. When the price moves above the peg to say $1.02, the protocol can allow users to trade 1 US dollar worth of the non-stablecoin crypto for 1 unit of the stablecoin cryptocurrency. In turn, this incentivizes participants to sell the non-stablecoin and pocket the $0.02 difference.

Moreover, this trade burns the non-stablecoin crypto and inflates the supply of the stablecoin. As a result, this mechanism returns the stablecoin to its peg.

Lastly, like other cryptocurrencies they utilize blockchain technology. This makes them transparent, permissionless, and decentralized.

The good

Complete decentralization – unlike most other stablecoins such as tether and USDC there is not a centralized asset that is used to back the currency. Instead, it is completely decentralized. This means there is not a single point of failure in the network.

Moreover, as there is no intermediary it is censorship resistant and the overall costs are reduced as there is no middleman to take a cut.

Hedge against volatility – as the algorithmic stablecoins are pegged to traditional currencies they have little volatility. This is especially important in the cryptocurrency space due to the price swings. Ultimately, they are a great method to minimize risk.

Quick transfers – algorithmic stablecoins ultimately act as a bridge between currencies and crypto. Users can quickly trade between the two as they utilize the same technology. This eliminates the need of having to wait for bank transfers. Not to mention, they can be stored in the same crypto wallets.

Cross-border payments – stablecoins can act as a great solution to cross-border payments. Users can transfer money over the internet almost instantly and for a few cents. This is a huge improvement over traditional cross-border payments which take up to 3 days with high commissions.

Transparent – thanks to the open-source nature of blockchain technology the data is completely transparent. It can be verified by anyone. As a result, this highlights any malicious activity and facilitates auditing.

Permissionless – anyone can access stablecoin markets, as there is not a single authoritative entity controlling the system it is a more democratic solution. This is especially important for developing countries that are unbanked. Now they have an opportunity to interact with various financial products and services.

DeFi compatibility – as algorithmic stablecoins utilize smart contact tech they can be used for decentralized finance (DeFi) apps. For instance, users can lend their stablecoins to generate a yield. Additionally, they can be used for margin trading, borrowing, staking, etc.

The bad

Scalability- blockchain technology is less scalable when compared to the traditional finance world. Querying the data slows down the network considerably. For instance, stablecoins using Ethereum handle just 7 transactions per second, while Visa can handle over 23,000.

Hacks – like other cryptocurrencies, algorithmic stablecoins are susceptible to hacks. From phishing scams to smart contract exploits they are endless. This is why it’s imperative to use a cold wallet to protect against them. The cold wallet I recommend is the ledger nano X. You can check out my review by clicking here.

Regulation – as algorithmic stablecoins continue to garner the attention they will ultimately face greater regulatory scrutiny. This can prove either beneficial or detrimental to their adoption depending on what laws are passed.

Lower returns – due to the low volatility of sovereign currencies this makes algorithmic stablecoins have lower returns. Although this leads to less risk it can also be disappointing for investors. This is especially relevant in the crypto space where Ethereum and Bitcoin can move over 20% in a week.

Losing the peg – at the end of the day, most algorithmic stablecoins are a faith-based concept. If the user base does not believe in the system then it can crash and burn. This was evident by the Luna collapse as shown below.

The ugly

To highlight the ugly side of algorithmic stablecoins let’s look at the most notable example, Luna:

Terra luna (UST) – this is by far one of the biggest cryptocurrency exploits in history. From big hedge funds like 3AC to your average retail investor, everyone was affected.

So what caused it? Ultimately, this was caused by the depeg of the algorithmic stablecoin UST. Arbitrageurs were redeeming UST for Luna at discounted prices. This meant that the circulating supply of Luna was hyper inflating. As it continued to decline more people panicked. 

Consequently, a bank run type event occurred driving both cryptocurrencies to zero. Overall, over $50 billion was lost in this incident. If you want to learn more about cryptocurrency exploits, click here.

Conclusion

Overall, algorithmic stablecoins are an interesting experiment. From decentralized finance to cross-border payments they have several use cases.

However, the technology is not without its risks. As shown by Terra luna it is still a fragile concept. Nevertheless, I am optimistic that this technology will only become more resilient with time. I hope you found this article useful and thanks for reading.

Want to learn more about stablecoins? Click here to read my previous article.