January 31, 2023 - 7 min read
High volatility has long been one of the major barriers to the adoption of crypto assets. This problem is addressed by stabilizing the highly volatile market by fusing the benefits of cryptocurrencies with the price stability people expect of their fiat currencies.
Stablecoins are more transparent compared to other cryptos as they maintain verifiable and auditable reserves of their underlying assets. For investors wishing to participate in the cryptocurrency ecosystem, stablecoins offer a more stable, safe, and easily accessible choice. Stablecoins make it possible to move money swiftly, cheaply, and without incurring the risk of asset price volatility. This can be done at any hour of the day and on weekends since stablecoins often circumvent the need to use banks or other legacy payment systems.
A fundamental aspect of stablecoins is that they aim to maintain a consistent value equivalent to the underlying asset to which they are pegged. For instance, a stablecoin pegged to the U.S. dollar should always hold a value of $1, regardless of overall market performance.
The most widespread stablecoins available on the market are those backed by fiat currency, with each unit issued being equivalent to a national currency such as the U.S. dollar, Euro, or Pound sterling at a 1:1 ratio. This means that for every unit of stablecoin in circulation, there is an equivalent unit of fiat currency held in reserve by the issuer.
The stablecoin trilemma is analogous to the blockchain trilemma, which states that simultaneously incorporating scalability, safety, and decentralization into one blockchain solution is difficult. According to the stablecoin trilemma, ”each available stablecoin on the market necessitates a compromise between varying degrees of decentralization, price stability, and capital efficiency.”
The stablecoin must maintain its peg to its reference value for price stability. Tether (USDT), the first stablecoin to be released with the highest volume, is one of the most widely used stablecoins. USDT is pegged to the dollar and is backed by U.S. dollar reserves. Additionally, one central body controls the issuance and asset backing of these stablecoins. Thus, price stability and capital efficiency are maintained with trade-offs of decentralization.
Moreover, crypto-collateralized stablecoins are a different class of stablecoin backed by decentralized entities like Bitcoin or Ethereum. An example of a stablecoin in this category is DAI, built on Ethereum, soft-pegged to the U.S. dollar, and collateralized by various other cryptocurrencies.
One of the main risks is that because the employed collaterals are subject to price fluctuations, the stablecoin may become under or over-collateralized depending on the value of the underlying cryptocurrency. So, it needs more capital to stabilize the stablecoin, which could be more capital efficient. Capital efficiency refers to the amount of value that must be locked up to mint one unit of a stablecoin. As a result, capital efficiency is compromised here for decentralization and price stability.
This has increased the concerns about the security and management of the stablecoin ecosystem. So, the importance of algorithmic stablecoins has increased because a set of smart contract laws governs them. However, algo stablecoins come with the risk of failing to maintain price stability.
Luna’s scalable and decentralized UST stablecoin runs on a reflexive system that creates existential risk. Burning $1 worth of LUNA at market price results in the creation of UST, which is then redeemed by exchanging 1 UST for $1 worth of LUNA. When demand for UST declines, buyers will sell for lower prices than the market price, causing inflation of the LUNA supply. In return, it risks price stability. Thus, it’s hard to create stablecoins that are efficient, decentralized, and have a steady price.
Algorithmic stablecoins do not rely on collateral backing to maintain a fixed exchange rate with its reference currency. Decentralized algorithmic stablecoins utilize a predetermined algorithm to control the stablecoin’s supply and demand, increasing market price stability and giving users a trustworthy asset.
Some smart contracts have preset and encoded stabilizing measures. The most efficient algorithmic stablecoins must incorporate programming that increases the supply of a cryptocurrency during deflationary periods. In contrast, when major purchasing power reductions occur due to various market events, the supply of stablecoins is reduced through automatic stabilization operations.
There are mainly three types of algorithmic stablecoins:
The protocol’s mechanism requires using an oracle to confirm the price of the stablecoin periodically. For instance, if the price is above the target, the algorithm will produce more coins, but burning will take place if the price is below the target. One example of a rebasing stablecoin that uses an elastic supply method to maintain a stable price is Ampleforth (AMPL).
Seigniorage algorithmic stablecoins provide two distinct tokens: a supply-elastic currency and investment shares in the network. It encourages users by providing incentives to engage in transactions that support the currency’s stable value. For example, the Empty Set Dollar (ESD) protocol utilizes Digital Standard Unit (DSU) as the stablecoin and Empty Set Share (ESS) as investment shares.
Fractional algorithmic stablecoins combine aspects of collateralized and algorithmic stablecoins. For example, the partially collateralized protocol Frax provides the FRAX stablecoin, linked to $1, and the FXS governance token.
Generally, the stablecoin market has been dominated by centralized coins like USD Coin and Tether. In late 2020, Terra launched UST, an algorithmic stablecoin, to challenge this dominance. UST was launched to sabotage the dominance of centralized stablecoin in the market.
Unfortunately, the initiative suffered a serious setback in May 2022 when the price of TerraUSD outpaced the value of LUNA currency. As a result, while centralized stablecoins have briefly benefited from this failure, algorithmic stablecoins have suffered.
Due to its high yearly return of 19.5% for staking on the Anchor protocol, the UST stablecoin quickly ascended to become the third most capitalized stablecoin on the market. However, the constant upward pressure on UST caused problems as the market started to fall, resulting in LUNA burn. As a result, UST investors sold LUNA to profit from the arbitrage opportunity, further lowering its value.
The UST price falls, and the arbitration process fails due to a concurrently dramatic collapse in the price of LUNA, starting a vicious cycle. The circulating supply of LUNA keeps increasing, accelerating its collapse and preventing the UST from regaining its peg to the dollar despite efforts by the Luna Foundation Guard to spend its reserves and protect itself.
A stablecoin that had once been valued in the billions of dollars failed due to this downward cycle, leaving many investors with nothing. It is hard to break the loop in the case of algorithmic stablecoins because they are only as good as their programming.
Algorithmic stablecoins offer greater transparency by enabling users to view all transactions, making it harder to manipulate the system. Also, algorithmic stablecoins are decentralized and follow the essential tenets of cryptocurrencies, strengthening their resistance to censorship. Decentralization lowers the risk of corruption and the abuse of power, encouraging greater accountability and openness.
However, decentralized stablecoins are frequently stabilized or backed by volatile cryptocurrencies, which presents a substantial difficulty for algorithmic stablecoins. Due to their reliance on unstable cryptocurrencies, algorithmic stablecoins are subject to volatility and unpredictable price changes.
The future of algorithmic stablecoins is still being determined because of these problems. Stablecoins backed by cryptocurrencies behave more like risk coins and are more prone to de-pegging because of their volatility during bear markets. As a result, it is more challenging to evaluate the risk attached to them.
The cryptocurrency community has debated stable algorithmic currencies, especially after the UST crash. Algorithmic stablecoins have a bright future despite voiced worries regarding their stability and susceptibility to unexpected market changes.
Algorithmic stablecoins are a useful option due to their benefits like efficiency and cost-effectiveness. In addition, they do not require a reserve of fiat currency to support the stable coin’s value. After all, the potential of stable algorithmic currencies shouldn’t be overshadowed by their risks.
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