Algorithmic Stablecoins

Algorithmic stablecoins explained

Stablecoins are tokens pegged to the price of another asset, such as the US Dollar. The first stablecoin to have been created was Tether (USDT). Currently, it still dominates the market despite its name being tainted by years of rumors, gossip, and concealed records that remain unaudited publicly. When it was created, USDT was a very unique stablecoin product that enabled a broad range of innovation across the crypto economy.

The benefits of stablecoins

Stablecoins make it easier for dedicated investors like day traders to get seriously invested in the crypto space, as it offered a cheap way to transfer fiat between crypto and USD as the market fluctuated. Because stablecoins are cryptocurrencies, they are also easy to transfer between wallets and crypto exchanges, which greatly increased the liquidity in the broader crypto economy, even making it easier for traders to take advantage of arbitrage opportunities between exchanges.

The great DeFi boom that started in 2020 would not have happened in the same way without sizable pools of USD-pegged stablecoins at hand that could move easily between decentralized applications, wallets, and now even across various blockchains. Especially in the borrowing and lending sector of the decentralized finance economy, stablecoins play a key role. Because there is a demand for them, there is usually a high rate for borrowing and lending for stablecoins. Any user is able to earn interest with stablecoins by depositing them into a lending pool, leaving it to the smart contracts to act as the traditional banks in this scenario, where hodlers are providing the liquidity to borrowers. 

Different types of stablecoins

While stablecoins are meant to be stable, they do still involve risk to a varying degree depending on the mechanism that maintains the peg. There are three types of stablecoins: algorithmic, fiat-backed, and crypto-backed. Fiat-backed stablecoins are cryptocurrencies that are collateralized 1:1 with a fiat currency. Crypto-backed stablecoins are backed with a specific cryptocurrency. As for algorithmic coins, they use complex smart contracts to match the price to another asset. 

The first two types of stablecoins are the most established ones, but it’s the third type, the algorithmic stablecoin, that is considered the Holy Grail of Stablecoins. If a project is able to launch a reliable, scalable, decentralized, fully auditable stablecoin that cannot be manipulated or controlled by a central authority, it would quickly become the primary stablecoin of the crypto economy across centralized exchanges, DEXes, DeFi apps , GameFi and the Metaverse.

So let’s take a quick look at some of the algorithmic stablecoins that have been making decent headway so far.

UST

Terra is a blockchain protocol that aims to provide a more scalable experience for a decentralized economy with its interchain and interest-bearing stablecoin UST, powered by the native LUNA token. UST has seen rapid adoption since its launch in September 2020, currently ranking as the 4th largest stablecoin, with a 10 billion market cap.

As an algorithmic stablecoin, UST uses LUNA as the asset that absorbs the short-term volatility of the stablecoin peg. The pegging mechanism is designed to ensure that the cost of minting UST will always be equal to the face value of the minted stablecoin. To mint one UST, only $1 worth of LUNA needs to be burned. When UST falls below or rises above the $1 mark, LUNA holders can exchange their tokens for the equivalent dollar amount in UST which creates arbitrage opportunities that in turn keep the price of UST in check.

The stablecoin has been instrumental to the success of Anchor Protocol, one of the leading decentralized applications on the Terra blockchain. The application is a savings protocol that provides its users with low-volatility yields of about 20%. Anchor has gained immense traction in the DeFi universe. It reached $750M+ in total value locked (TVL) just one month after launching, and currently stands at 11 billion in TVL.

UXD

UXD Protocol, is a newer algorithmic stablecoin that automatically generates interest and is minted on the Solana blockchain. The project is backed by Alameda Research, Defiance Capital, CMS Holdings, Solana Foundation, Mercurial Finance, Solana founders Anatoly Yakovenko and Raj Gokal, and Saber founder Dylan Macalinao.

UXD is taking a very new approach to creating a price pegging mechanism. The peg is backed by delta-neutral positions, a hedging strategy from portfolio management that uses multiple positions with balancing positive and negative deltas – the degree to which an option is exposed to shifts in the price of the underlying asset.

The delta-neutral position that underpins the UXD coin is long one BTC spot position, and short one BTC perpetual-swap position. As an added bonus, UXD is also an interest-bearing stablecoin because when you create a delta-neutral position, you receive the funding rate from the perpetual swap when the price of the perpetual swap is higher than the spot price. UXD coin is still in its testing phase on the Solana blockchain, but the idea is that this yield will eventually go directly into the UXD holder’s wallet, and should average out to about 10% APY.

FEI

FEI is also another notable algorithmic stablecoin. One of the biggest differences refers to the fact that it does not feature the mechanism for swapping collateral for stablecoin. On the contrary, digital wealth comes into the system by leveraging a bonding curve, which sells FEI in exchange for ETH. Then, the digital wealth remains locked in the Protocol Controlled Value or PCV, which is basically the pool of collateral for the stablecoin.

PCV helps in maintaining the peg by managing liquidity on DEXes like Uniswap. With the limitations on sell-side liquidity, FEI is designed to avoid the ‘death spiral’ scenario. The FEI protocol leverages its TRIBE governance token which enables holders to participate in voting for things like the addition of new bonding curves for selling additional FEI, determining the approach for allocation of permanent capital vehicle (PCV) value, and modifications in other parameters of governance.

The stablecoin currently only has a market cap of $420 million, but that could change rapidly if it can prove to be a reliable peg during times of high volatility.

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