Algorithmic Stablecoins: Here's Why They're So Risky
Published August 1, 2022.
Stablecoins typically maintain a 1:1 peg with the tracked currency with a collateralized mechanism and are backed by cash or other assets. Algorithmic stablecoins function differently, utilizing specialized algorithms to maintain the tracked peg. These unique algorithms inspire investor trends and behaviors, which help stabilize the coins' price.
While algorithmic stablecoins are pegged to the value of certain tangible assets, they are not backed by them like traditional coins are, and thus come with certain risks.
Potential Risks Involved With Algorithmic Stablecoins
There are some risks involved with algorithmic stablecoins, including the following:
- Demand can change drastically and remarkably quickly
- Having no collateral may make the coin value less stable
- Some algorithms have a weak system and may not be worth your investment
- Prone to devaluation risk
- Prone to speculative targeting
- If enough capital is available, there’s an inherent risk of manipulation
How Algorithmic Stablecoins Work
Algorithms are essentially codes that trigger a process. For example, think about when you log into your social media accounts. What you see surfacing on your feed is determined by the algorithms of said platform; they are unique to you and your online trends and habits.
The algorithm simply translates to code segments on a blockchain encoded in smart contracts in crypto. Algorithmic stablecoins rely on dual tokens, one stablecoin and another form of crypto that backs said stablecoins. The algorithm, AKA the smart contract, manages the link between the two.
Most assets fluctuate in prices, such as real estate and stocks. Cryptocurrency is similar, as it depends heavily on market supply and demand. Stablecoins are freely traded within the market. Therefore, this applies to these coins as well.
When many people want something but there is simply not enough to go around, the price of the asset increases, and vice versa. Algorithms also help regulate supply and demand; this may prevent the value of a stablecoin from depegging. The whole goal of the algorithm is to keep all of this maintained and regulated.
Key Features of Algorithmic Stablecoins
Algorithmic stablecoins help traders get their feet wet regarding crypto trading. Here are some of the critical features of algorithmic stablecoins:
Stablecoins are associated with limited price volatility and convenience. That said, you can readily and simply leverage stablecoins for cross-border transactions. In addition, stablecoins also divulge collateral diversification, creating more aversion to hyperinflation and instability.
Algorithms have parameters hardcoded into the smart contracts associated with them. These parameters ensure automatic reaction and response to current, up-to-date market data. This aspect of algorithms helps manage supply and demand for these tokens, as they react to the underlying market conditions and adapt to them without needing a person to execute the required tasks.
Stablecoins are stored in a virtual wallet with a private key. The stablecoin holder is the only individual permitted to access the assets/funds in that wallet and the only one with the private key.
Algorithmic Stablecoins: Best Options
If you’re looking for a platform that offers the option of algorithmic stablecoins to make money from, consider checking out some of the following exchanges.
- DeFi Dollar (DUSD)
- Empty Set Dollar (ESD)
- Frax (FRAX)
- Ampleforth stablecoins (AMPL)
Many investors plan on earning passive income via algorithmic stablecoin yield farming. Using yield farming strategies, users can earn interest on otherwise idle crypto assets. The concept behind yield farming stablecoins is that lending your digital assets to a liquidity pool ultimately results in appealing APY. Hwever, you must be aware of the risks of yield farming.
Conclusion: Algorithmic Stablecoins
Algorithmic stablecoins don’t seem to be a viable option for most investors because of the risks they carry. In addition, since they aren’t backed by dollars and are using a complicated arbitrage system to maintain the value of the coins—some experts claim that this makes algorithmic stablecoins innately unreliable.
Investing in algorithmic stablecoins, whether for yield farming or not, should know that risks are involved. So do your research, empower yourself with knowledge, and go into investments with a clear head and a comprehensive understanding of what you are committing to. Being prepared is a great way to minimize risk.