Algorithmic Stablecoin: What It Is & How It Works

Overall, crypto assets are characterized by their high volatility. However, there are the ones which maintain fixed value — stablecoins. There are the following types of stablecoins: collateralized (by fiat currency reserves), algorithmic, and hybrid. This article mainly focuses on the second type. If you would like to learn more about the major collateralized stablecoin, check our article about USDT.

The price stability of algo stablecoins is achieved not through physical collateral, but through algorithms and automated protocols. For that reason, these stablecoins are also referred to as “undercollateralized”.

What Is an Algorithmic Stablecoin?

At its core, an algorithmic stablecoin is a type of digital asset which value is designed to remain stable. This feature makes it stand out among other cryptocurrencies, which can experience significant volatility.

Algorithmic stablecoins are backed by intricate algorithms and protocols that automatically adjust the coin's supply based on market demand. If the demand for the coin increases, the supply expands. Conversely, if the demand decreases, the supply contracts. This dynamic adjustment mechanism ensures that the coin's value remains relatively stable, typically pegged to a traditional fiat currency like the US dollar. The primary goal of these stablecoins is to offer the benefits of digital currency without the typical price volatility.

How Do Algorithmic Stablecoins Work

Algorithmic stablecoins operate based on a unique principle. They employ smart contracts and algorithms to automatically adjust their supply based on market conditions. When the demand for the coin rises, the supply increases, and when the demand falls, the supply contracts. This dynamic adjustment ensures that the value of the algo stablecoin remains consistent. The underlying algorithms monitor the coin's price in real-time.

If the price deviates from its peg, the algorithms trigger a response to either increase or decrease the supply, bringing the price back to its desired level. This automated system functions without the need for human intervention, making it a truly decentralized solution to the problem of cryptocurrency volatility.

Types of Algorithmic Stablecoins

Various mechanisms are in place to ensure stability of an algo stablecoin. These mechanisms are designed to respond to market dynamics, ensuring that the coin's value remains close to its peg. Depending on the used mechanism, algos can be rebasing, seigniorage, and fractional-algorithmic.

1. Rebasing

Rebasing stablecoins or “rebases” have an elastic supply. The total supply of the stablecoin adjusts automatically, or “rebases”, depending on market conditions. If the coin's price is above its peg, the supply increases, diluting the holdings of all coin holders. This dilution causes the price to decrease, bringing it back to its peg. On the other hand, if the coin's price is below its peg, the supply decreases, increasing the value of each coin. This mechanism ensures that the coin's price remains relatively stable, regardless of external market pressures.

One of the examples of rebases is AMPL.

2. Seigniorage

Originally, “seigniorage” means the difference between the face value of currency and the cost of producing it. In terms of seigniorage stablecoins, they deploy a two-token model:

1. Stablecoin, pegged to fiat currency.
2. Shares or bonds token, which acts as a mechanism to contract or expand the supply of the primary stablecoin.

How the two-token system typically works:

• Expansion Phase (when the stablecoin's price is above the peg): the protocol mints new stablecoins. These newly minted coins are often distributed to holders of the shares or bonds token as a reward, effectively providing them with the seigniorage profit.
• Contraction Phase (when the stablecoin's price is below the peg): to reduce the stablecoin's supply and push its price back up to the peg, the protocol sells the secondary token (often called bonds) at a discount. These bonds can be redeemed for stablecoins in the future when the system is in the expansion phase.

3. Fractional-algorithmic

Fractional-algorithmic stablecoins offer a hybrid solution, combining features of both collateral-backed and algorithmic stablecoins. They maintain a fractional reserve of collateral, such as other cryptocurrencies or fiat, and use algorithms to manage the remaining supply. This combination provides a buffer against market volatility while still benefiting from the automated adjustments of algorithmic mechanisms.

FRAX can serve as an example of a fractional stablecoin.

Measuring Algorithmic Stablecoins

Evaluating the effectiveness and reliability of algorithmic stablecoins requires a comprehensive understanding of various factors that influence their performance.

Governance

Governance plays a pivotal role in the world of algorithmic crypto. It pertains to the decision-making processes that guide the development and operations of a stablecoin. Effective governance ensures that the coin's algorithms and protocols are updated and refined based on real-world performance and feedback. It also ensures that the interests of all stakeholders, including investors, developers, and users, are taken into account.

Incentives

Incentives play a crucial role in ensuring the long-term viability and stability of an algo stablecoin. By offering rewards for specific behaviors, these incentives help stabilize the coin's value. For example, users might be incentivized to hold onto their coins during periods of volatility, or they might be rewarded for providing liquidity to the market.

Token Adoption Rate

The adoption rate of a token is a key indicator of its success and acceptance in the market. A rapidly growing user base and increased transaction volume signify that the token is gaining traction and is being widely accepted by users, traders, and investors. A high adoption rate can also indicate trustworthiness and reliability of the token in the crypto community. Furthermore, as more merchants, platforms, and services accept and integrate the token, its utility and demand can increase, further driving its adoption.

Risks of Algorithmic Stablecoins

Algorithmic stablecoins, while innovative and promising, are not without their challenges and risks. Understanding these risks is crucial for investors and users alike.

Peg Stability

One of the primary concerns with algorithmic stablecoins is the stability of their peg. While these coins aim to maintain a consistent value, external market forces, sudden demand shifts, or unforeseen events can disrupt this stability. For instance, if a significant number of users suddenly decide to sell their holdings, it could put downward pressure on the coin's value, causing it to deviate from its peg. While algorithms are designed to counteract these fluctuations, they are not always successful, especially during extreme market volatility.

Regulation and Compliance

The regulatory landscape for cryptocurrencies is still evolving, and algorithmic stablecoins are no exception. Different jurisdictions may have varying views on these coins, leading to potential regulatory challenges. For instance, a country might deem algorithmic stablecoins as securities, subjecting them to a different set of regulations. Compliance with these regulations is crucial for the long-term success and acceptance of these coins. Moreover, sudden regulatory changes can impact the coin's value and user trust.

How are Algorithmic Stablecoins pegged?

Unlike collateral-backed stablecoins, which are backed by reserves of fiat or other assets, algorithmic stablecoins use software algorithms to automatically adjust their supply based on market demand, aiming to keep their price stable. Here's a deeper dive into how these stablecoins maintain their peg:

Mechanisms of Pegging

• Supply Adjustments. The primary mechanism by which algorithmic stablecoins maintain their peg is by automatically adjusting their supply. If the price of the stablecoin goes above the peg (e.g., $1.01 for a coin pegged to $1), the algorithm will mint and distribute additional coins to increase the supply, driving the price down. Conversely, if the price drops below the peg, the algorithm will buy back and burn coins, reducing the supply and pushing the price up.
• Seigniorage Shares. Some algorithmic stablecoins use a concept called seigniorage shares. When the coin's price is above the peg, the system mints new coins and sells them in the open market. The profits from this sale (the seigniorage) are then distributed to holders of seigniorage shares. When the coin's price is below the peg, the system issues bonds that can be bought with the stablecoin. These bonds can later be redeemed for stablecoins when the price is above the peg, effectively reducing the supply when the price is low and increasing it when the price is high.
• Oracles. Oracles are third-party services that provide real-time price feeds to the stablecoin's algorithm. They play a crucial role in ensuring that the algorithm has accurate and timely information about the coin's market price, enabling it to make appropriate supply adjustments.
• Collateralization. Some algorithmic stablecoins use a hybrid model, combining algorithmic mechanisms with collateral. In these systems, a portion of the coin's value is backed by collateral, while the rest is stabilized using algorithms. This combination can provide additional stability, especially in volatile market conditions.

Neutrino Index Token (XTN) Multi-collateral

The Neutrino Index Token (XTN) is a multi-collateral algorithmic stablecoin. It employs a combination of different Waves Ecosystem assets as collateral, enhancing its stability. This multi-collateral approach diversifies the risks associated with relying on a single asset. The underlying assets can include other cryptocurrencies, fiat currencies, or even commodities. The diversified collateral pool ensures that even if one asset's value drops, the overall value of the collateral remains stable, supporting the coin's peg.

XTN Issuance

The issuance of XTN tokens is governed by smart contracts and algorithms. When the demand for XTN rises, the smart contract mints new tokens to meet this demand, ensuring that the supply matches the market's needs. Conversely, when the demand falls, the smart contract buys back and burns XTN tokens, reducing the supply and maintaining the coin's value.

XTN Price

The price of XTN, like other algorithmic stablecoins, is designed to remain stable. Algorithms monitor the coin's price in real-time, making adjustments to the supply as needed. If the price deviates from its peg, the algorithms trigger a response to either increase or decrease the supply, bringing the price back to its desired level.

Specifically, the price is updated with a smart contract, which collects the values from oracles — tools for accessing external data. Then, the aggregate value from different oracles is used for the XTN price.

Pros and Cons of Algorithmic Stablecoins

Algorithmic stablecoins offer a unique solution to the volatility challenges of traditional cryptocurrencies. However, they come with their own set of advantages and disadvantages.

Pros of Algorithmic Stablecoins

• Decentralization. Unlike collateral-backed stablecoins, which might rely on centralized entities to hold and manage the collateral, algorithmic stablecoins operate in a decentralized manner. This decentralization reduces the risks associated with central points of failure.
• Transparency. The operations of algorithmic stablecoins are governed by smart contracts, which are open-source and transparent. Users can verify the coin's operations, enhancing trust.
• Scalability. Algorithmic stablecoins can quickly adjust their supply to meet market demand, ensuring scalability and responsiveness.

Cons of Algorithmic Stablecoins

• Peg Stability Concerns. As mentioned earlier, the stability of the peg is a concern. External market forces can disrupt the coin's value, causing it to deviate from its peg.
• Regulatory Challenges. The evolving regulatory landscape can pose challenges for algorithmic stablecoins, impacting their adoption and acceptance.
• Complexity. The underlying algorithms and protocols can be complex, making it challenging for average users to understand the coin's operations fully.

List of Algorithmic Stablecoins

The world of algorithmic stablecoins is diverse, with various coins employing different mechanisms to ensure stability.

1. Dai (DAI)

Dai is one of the most well-known algorithmic stablecoins in the market. It operates on the Ethereum blockchain and employs a system of smart contracts to maintain its peg to the US dollar. Users can generate Dai by locking up collateral, such as Ether, in a smart contract. The system automatically adjusts the collateralization ratio to ensure that the value of Dai remains stable.

2. Pax Dollar (USDP)

Pax Dollar, or USDP, is another prominent algorithmic stablecoin. It combines features of both collateral-backed and algorithmic stablecoins, offering a hybrid solution. USDP maintains a fractional reserve of collateral and uses algorithms to manage the remaining supply. This combination provides a buffer against market volatility.

3. Magic Internet Money (MIM)

Magic Internet Money, commonly known as MIM, is a newer entrant in the algorithmic stablecoin space. It aims to offer a decentralized and transparent stablecoin solution. MIM employs a combination of algorithms and smart contracts to adjust its supply based on market demand, ensuring that its value remains consistent.

MIM tokens are minted by members of the multisig vault on Ethereum. Only after being collateralized by users, the tokens are injected into circulation.

4. Frax (FRAX)

Frax (FRAX) is an innovative algorithmic stablecoin that operates on a fractional-algorithmic mechanism. This means that a portion of its value is backed by collateral, while the rest is stabilized using algorithms. The dual system provides a unique balance, ensuring stability while benefiting from the flexibility of algorithmic adjustments. As market conditions change, FRAX adjusts its collateral ratio and uses algorithms to maintain its peg, ensuring a consistent value.

5. Neutrino USD (XTN)

Neutrino’s XTN is a multi-collateral algorithmic stablecoin. It employs a diversified pool of assets as collateral, ranging from cryptocurrencies to traditional fiat currencies. This diversified approach reduces the risks associated with market volatility of a single asset. The Neutrino protocol ensures that the value of XTN remains stable by dynamically adjusting its supply in response to market demand.

6. USDD

USDD is another player in the algorithmic stablecoin arena. It operates on a seigniorage model, where coins are minted or burned based on market demand. This model relies heavily on trust, as there's no collateral backing the coin. The smart contracts governing USDD are designed to respond swiftly to market changes, ensuring that its value remains close to its peg.

The Future of Algorithmic Stablecoins

The future of algorithmic stablecoins looks promising. As the cryptocurrency market matures, there's a growing demand for stable digital assets that can serve as a medium of exchange, store of value, and unit of account. Algorithmic stablecoins, with their ability to maintain a stable value without the need for physical collateral, are well-positioned to meet this demand. Advances in technology, combined with increased understanding and acceptance of these coins, will likely drive their adoption further. Moreover, as regulatory frameworks evolve, it's expected that these coins will gain more legitimacy and trust among users.

Are Algorithmic Stablecoins Safe?

When it comes to algorithmic stablecoins, their safety is determined by several factors. The underlying algorithms and protocols, the transparency of operations, and the governance model all play a role in determining the safety of these coins. While algorithmic stablecoins offer a decentralized and transparent solution, they are not without risks. The stability of their peg, potential regulatory challenges, and the complexity of their operations can pose challenges. However, with proper governance, continuous monitoring, and user awareness, these risks can be mitigated. It's essential for users to conduct thorough research and understand the intricacies of these coins before investing or using them.

*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.