A beginner’s guide on algorithmic stablecoins

Crypto Wiki Markets

In Brief

A stablecoin is a type of cryptocurrency that has its value pegged to a real-world asset, such as fiat currency or gold.

They are also highly secure due to their decentralized nature and the use of smart contracts to maintain a peg between the stablecoin and its underlying asset.


The Trust Project is a worldwide group of news organizations working to establish transparency standards.

In blockchain ecosystems, algorithmic stablecoins are the proposed solution for maintaining a store of value and providing price stability. 

Algorithmic

A stablecoin is a type of cryptocurrency that has its value pegged to a real-world asset, such as fiat currency or gold. Algorithmic stablecoins, on the other hand, are created and managed by algorithms rather than being backed by collateral from an external source.

What is an algorithmic stablecoin?

Stablecoins are blockchain-based digital currencies that are pegged to the US dollar. They are utilized as vehicle currencies for exchanging digital assets since operating on the blockchain has fewer intermediation costs.

A stablecoin is called algorithmic when the value is maintained using smart contract algorithms rather than backing it with fiat money or other digital assets. This can provide a number of benefits, such as faster settlements, lower transaction costs, and higher liquidity. A popular example of an algorithmic stablecoin is Maker DAO’s Dai (DAI).

A key feature of Dai is that it is a decentralized stablecoin not owned, regulated, or printed by any government. This means that anyone can use it regardless of which country they live in. Algorithmic stablecoins are usually backed by collateral held on the blockchain, either deposited by the users themselves or provided by third parties such as loan providers and investors.

This creates a CDP (Collateralized Debt Position) which is an agreement between the borrower and lender to exchange one asset for another at a certain point in time or when certain conditions are met. A smart contract algorithm will then use this CDP to maintain the peg of the stablecoin and ensure that it remains pegged to its target currency.

How does an algorithmic stablecoin work?

How stablecoin works

The term “two-coin” system refers to a common algorithmic stablecoin structure in which one coin is used to “absorb” market volatility while the other works to maintain the peg. This previous token, also known as a balancer or share token, is regularly exchanged on secondary decentralized exchanges (DeXs), such as Uniswap (UNI).

A portion of the total supply of the stablecoin is purchased by users on DeXs, and then “burned” when they are exchanged for fiat currency.

The share token also works to absorb price fluctuations in the underlying asset, meaning that when market prices fluctuate, it takes the brunt of the impact rather than the stablecoin. This allows the price of the stablecoin to remain more stable and reduces volatility. A portion of the total supply is also released from circulation whenever users exchange fiat currency for the stablecoin in order to maintain a pegged value.

Algorithmic stablecoins are still relatively new, but they offer a number of advantages over traditional forms of money, such as faster transaction speeds, lower fees, and global accessibility. At the same time, they are highly secure due to their decentralized nature and the use of smart contracts to maintain a peg between the stablecoin and its underlying asset. As such, they could become increasingly popular in the blockchain ecosystems as more people realize their potential.

Types of algorithmic stablecoins

The following sections describe the three main subcategories of algorithmic stablecoins.

Seigniorage algorithmic stablecoins

Seigniorage algorithmic stablecoins are created and managed by algorithms. A popular example of this type of stablecoin is Maker DAO’s Dai (DAI), which is backed by Ethereum’s Ether (ETH). A portion of the total supply of ETH is held in a smart contract as collateral, ensuring that the value of Dai is maintained.

The algorithm also works to absorb the volatility of ETH and prevent it from affecting the price of Dai, allowing users to exchange digital assets without having to worry about market fluctuations. A portion of the total supply is also released from circulation whenever users exchange fiat currency for Dai in order to maintain a pegged value.

Backed algorithmic stablecoins

Backed algorithmic stablecoins are similar to seigniorage algorithmic stablecoins. However, they are backed by collateral held on the blockchain. A popular example of this type of stablecoin is Tether (USDT), which is backed by US dollars held in reserve. A portion of the total supply of USDT is released from circulation whenever users exchange fiat currency for USDT in order to maintain a pegged value.

Hybrid algorithmic stablecoins

Hybrid algorithmic stablecoins are a combination of the two previous types of algorithmic stablecoins. A popular example of this type of stablecoin is Basis (BAS), which is backed by a basket of digital assets held on the blockchain. A portion of the total supply is released from circulation whenever users exchange fiat currency for BAS in order to maintain a pegged value.

Algorithmic stablecoins: advantages and disadvantages

Stablecoin

Financial product innovation isn’t always a desirable thing, and some innovations—such as algorithmic stablecoins projects—are deliberately designed to be innately unstable.

Advantages

Low fees: Algorithmic stablecoin projects are designed to offer low fees compared to other financial products.

Increased privacy: By using a decentralized system, algorithmic stablecoins provide an increased level of privacy for users.

Global accessibility: A stablecoin is accessible to anyone with internet access, allowing users to easily make payments and investments around the world.

Speed and efficiency: Transactions are faster and more efficient than traditional currencies, allowing users to quickly make payments and investments without waiting for confirmation from a third party.

Disadvantages

Volatility: A stablecoin is still susceptible to price fluctuations, which can make it difficult for users to predict its value.

Regulatory uncertainty: A stablecoin is not subject to the same regulations as traditional currencies, making it difficult for governments and other regulatory bodies to monitor its use.

Lack of liquidity: A stablecoin may lack liquidity if it is not widely traded or accepted. This makes it more difficult for users to exchange their holdings for cash or other assets.

Conclusion

Algorithmic stablecoins offer an innovative way to manage digital assets by pegging their value to real-world assets. The advantages of algorithmic stablecoins include low fees, increased privacy, global accessibility, and speed and efficiency. 

However, there are also some disadvantages, such as volatility, regulatory uncertainty, and lack of liquidity, that must be considered before investing in this type of token. A beginner’s guide to algorithmic stablecoins will help users understand the risks and benefits associated with these types of tokens, as well as how they can make educated decisions when using them.

Related articles:

Disclaimer

Any data, text, or other content on this page is provided as general market information and not as investment advice. Past performance is not necessarily an indicator of future results.

Ken Gitonga

Ken Gitonga is passionate about writing. His work involves writing crypto articles on SEO, TAs, News writing, Web3 articles, crypto price prediction, and white paper drafting. Ken is a content writer and marketer. He has worked in the SEO and content marketing industries for over 3 years and has helped businesses grow their online presence and traffic.

Follow Author

More Articles