Revisiting Algorithmic Stablecoins

algo stablecoins

The formerly small corner of the cryptocurrency space has become the center of attention after being a core party in the biggest crypto story in 2022. The depegging of TerraUSD (UST) and the subsequent fall of the Terra project had everyone asking about algorithmic stablecoins. In this article, we will explore the different algorithmic stablecoins in the crypto space. 

In case you forgot, stablecoins were created to help traders and general users hedge against the volatile nature of regular cryptocurrencies. For instance, the chart below shows Bitcoin price action for seven days (May 29th to June 4th, 2022). The Bitcoin (BTC) price swung between $28,000 and $31,000 at different times during this period.

A quick swing between a $3,000 price difference range may not be something some traders or users can take. It could even be worse for merchants accepting crypto, who will have to worry constantly about whether the Bitcoin they collected a day before will match the US dollar value of sales made a few days later. To provide some stability in token prices, stablecoins were made. The concept took the underlying technology of cryptocurrencies and built a token on the blockchain, but this time, the tokens are pegged to fiat currency or other traditional financial assets. For example, if you purchase a US dollar stablecoin, owning a single stablecoin will mean you own an asset that is worth a dollar. There are several types of stablecoins: fiat-collateralized, commodity-collateralized, crypto-collateralized, and algorithmic stablecoins. 

Cryptocurrency innovators are constantly finding new ways to reimagine existing financial structures in an attempt to achieve decentralization. One of such experiments led to the idea of algorithmic stablecoins. Instead of having a stablecoin backed by fiat or commodities placed in the custody of a centralized institution, algorithmic stablecoins make every aspect of managing and maintaining the peg decentralized. This is achieved using complex smart contracts to match the price to another asset. In recent times, these algorithmic stablecoins have become popular on decentralized finance (DeFi) apps, decentralized exchanges (DEXes), centralized exchanges and the Metaverse. These algorithmic stablecoins use different mechanisms to maintain the peg; here are the three main ways they do that:

Rebase

Rebase algorithmic stablecoins manipulate the supply of the stablecoin to maintain the expected value. The smart contract is written to mint (add) or burn (remove) supply from circulation in proportion to the token’s price deviation from $1, the value peg. If the token rises above $1, the protocol mints new tokens. However, if the token drops below $1, the protocol removes coins from circulation. 

Seigniorage

This is another mechanism through which algorithmic stablecoins maintain their peg. It uses a multi-coin approach, where one coin is developed to be stable, and another is designed to enable stability. A combination of mint and burn mechanisms and free market mechanisms are expected to create an incentive for market participation or trading of the non-stablecoin to drive the stablecoin’s price closer to the peg.

Fractional-algorithmic stablecoins

This mechanism combines aspects of seigniorage and fiat-collateralized mechanisms. Fractional-algorithmic stablecoins are built to maintain their peg by relying on the decentralized methods deployed by fully algorithmic stablecoins and their centralized alternatives. 

Here are some of the most common algorithmic stablecoins of 2022: 

Terra USD – UST

The most popular and most controversial of all the tokens on this list is UST. After the deppeging debacle that saw the stablecoin lose its stability, the future of the project is still up in the air, with some conversations by the Terra community on how to revive it. 

At its peak, UST became the third largest stablecoin by market cap, only behind fiat-collateralized alternatives – Tether USD (USDT) and USD Coin (USDC). It was built primarily on the Terra blockchain and was launched in September 2020.

UST uses LUNA (the native token of the Terra blockchain) to absorb short-term volatility of the stablecoin peg. The mechanism for pegging is developed to guarantee that the cost of minting UST will be equal to the face value of the minted stablecoin. That means that if you mint 5 UST, only $5 worth of LUNA will be burned. 

An arbitrage opportunity is created every time the UST peg falls below $1 or above $1 since LUNA holders can exchange their LUNA for the equivalent amount in UST.

Besides being the third largest stablecoin before the depegging incident, TerraUSD (USDT) had become the stablecoin of choice for many DeFi users on protocols like Anchor. Users were earning low-volatility yields of over 20% by saving their UST on various DeFi platforms. 

USDD 

This is the newest algorithmic stablecoin on the list. Launched in the midst of TerraUSD’s downfall, the new stablecoin will be built on the TRON network with heavy backing from founder Justin Sun.

Sun is betting on an algorithmic stablecoin reserve strategy to prevent USDD from facing similar problems to UST. 

“When USDD’s price is lower than 1 USD, users and arbitrageurs can send 1 USDD to the system and receive 1 USD worth of TRX. When USDD’s price is higher than 1 USD, users and arbitrageurs can send 1 USD worth of TRX to the decentralized system and receive 1 USDD,” Sun said.

The TRON DAO reserve would hold TRX and BTC as collateral for the stablecoin alongside $10 billion spread across existing stablecoins – USDT, USDC, BUSD, DAI, and TUSD. The mechanism described in the white paper suggests that USDD will maintain its peg by converting 1 USDD TO $1 worth of TRX or burning $1 of TRX to create 1 USDD.

UXD

UXD is a Solana-based algorithmic stablecoin backed by Alameda Research, CMS Holdings, Defiance Capital, Mercurial Finance, Solana Foundation, and Solana founders Anatoly Yakovenko and Raj Gokal.

The stablecoin has taken a new approach to ensure that the coin maintains its peg. Delta-neutral positions, a term notable in traditional finance as a hedging strategy used by portfolio managers back the UXD peg. The UXD delta-neutral position is a long Bitcoin position and a short Bitcoin perpetual-swap position. 

Further, UXD is an interest-bearing stablecoin. When you create a delta-neutral position, you receive a funding rate from the perpetual swap when the price is higher than the spot price. The current expected yield is about 10% APY.

Basis Cash

Basis Cash (BAC0) uses a 3 token seigniorage system. It ensures that BAC maintains its 1 USD peg through bonds and shares. The project borrows the method through which banks trade fiscal debt to expand and contract supply. There is no need for a rebase or collateral risk. 

Providing liquidity for the stablecoin comes with rewards. This is to ensure that project is censorship resistant since several people are incentivized to provide liquidity and prevent a lack of liquidity and a potential bond death spiral from happening. 

The project is not backed by any venture capital firm. The project’s development and its ecosystem is the Basis Cash community that manages the Community Development Fund (CDF) through a decentralized mechanism.  

Final Thoughts

There are a number of algorithmic stablecoins to choose from and they are still in the experimental early stages of development. Although they appear to be promising, algorithmic stablecoins have been faced with setbacks and challenges since Terra (LUNA)’s dramatic downfall. Algorithmic stablecoins have the benefit of being decentralized. However, their arbitrage mechanism is a trade-off that can lead to instability. Alot of research still delves into perfecting the algorithmic stablecoin and with the level of innovation akin to the crypto industry, there is no doubt that further innovation is to be expected from stablecoins.

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