Algorithmic Stablecoins: Here's How They Work

By 

Marcel Deer

 on August 1, 2022. 
Reviewed by 

Joel Taylor

Hand holding a Bitcoin

If you are familiar with crypto, you probably know that stablecoins are kept “stable” via collateralized assets. Although, not all stablecoins are equal. Some are not backed by tangible assets but are kept stable through contract algorithms.

These stablecoins are called algorithmic stablecoins, and these algorithms typically link two coins and adjust their price conditional on investor supply and demand. Continue reading to learn more about algorithmic stablecoins and if they make a good investment or not.

How Algorithmic Stablecoins Work

Usually, stablecoins maintain a 1:1 peg with the currency they track via a collateralized mechanism and are backed by assets or cash. Backing these stablecoins with assets supports the valuation.

A peg, or “pegged crypto,” is an encryption-secured digital asset with value attached to some other type of exchange medium. These mediums include gold or the fiat currency of the given country.

Algorithmic stablecoins function differently. Instead of having collateral backing them, they use unique algorithms to support and maintain their peg with the fiat currency they are tracking. Algorithms also encourage investors to analyze trends and behaviors to aid in stabilizing said coin’s price concerning the peg.

While algorithmic stablecoins are pegged to the value of real-world assets, they aren’t backed by them.

Are Algorithmic Stablecoins a Good Investment?

Sometimes, algorithmic stablecoins can be a valuable investment since third parties aren’t required, and they can successfully and effectively regulate the number of circulating coins depending on demand.

Many wonder whether or not the collapse of TerraUSD has hindered the future of algorithmic stablecoins and similar crypto. TerraUSD (UST) was an algorithmic stablecoin supposedly pegged to the U.S. dollar. However, it lost its dollar peg, collapsed, and shook the market. This debacle comes with increased attention from lawmakers trying to find risks and issues in the crypto space, likely leading to more regulation.

Co-founder of BLOCKv, Reeve Collins, mentioned that the TerraUSD situation would “probably be the end” of algorithmic stablecoins. So, the future for these coins is unclear.

Pros and Cons of Algorithmic Stablecoins

There are both advantages and disadvantages of stablecoins.

Pros

  • True decentralization
  • Lack of tangible assets eliminates risks of user errors
  • Algorithmic stablecoins reintroduced seigniorage into the crypto space

Cons

  • Demand can change drastically
  • Having no collateral may make their price less stable than you think
  • Some algorithms have an inherently weak structure

Examples of Algorithmic Stablecoins

There are plenty of algorithmic stablecoins on the market today, including:

There are typically three types of algorithmic stablecoins, which are:

1. Rebasing Algorithmic Stablecoins

The total is not fixed and is modified regularly. Instead, corrections are made automatically using the rebase technique, which stabilizes the price of a stablecoin towards a fixed peg.

2. Seigniorage Algorithmic Stablecoins

This model consists of two forms of crypto, stablecoin and seigniorage ownership (shares.) When the price of a currency surpasses the intended peg, shares are used to increase coin supply.

3. Fractional Algorithmic Stablecoins

These stablecoins are associated with less custodial risk and may avoid over-collateralization. They are designed to enforce a tight peg with more security and stability.

Conclusion: Algorithmic Stablecoins

Before investing in stablecoins or any other form of digital currency, you must do thorough research on your own. Understanding the fundamentals and technical side of the token is critical.

The market for stablecoins is unregulated, which means investing may come with devaluation risk. In addition, under-collateralization may make you more prone to speculative targeting. When the supply of stablecoins is linked to the value of the unique governance token, the risk of devaluation increases.

Protecting your stablecoins involves only investing in coins fully backed by stable collateral, preferably liquid U.S. dollar reserves. You could also use smart contracts to prevent over-collateralization. This system manages and enforces liquidation to maintain peg stability.

Furthermore, since there’s no collateral to liquidate, users risk losing their investments if a market crash happens. This risk is another reason users must be mindful and diligent when researching and investing in algorithmic stablecoin projects.

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