What Are Algorithmic Stablecoins?

Stablecoins are the lifeblood of the cryptocurrency market. Without them, it would not be easy to trade crypto.

Let us take Binance, for example. It lists only 80 coins. If we did not have stablecoins, each of these coins would have to have a pair with the rest of the 79. That would put the number of combinations into thousands. For exchanges that list more than a thousand coins, it would be impossible to function. Stablecoins serve an invaluable purpose as trading pairs and a stable store of value.

Over the years, a new type of stablecoin has been gaining popularity. Algorithmic stablecoins are backed by an on-chain protocol that pegs their value to a supply/demand ratio maintained by an algorithm. They are backed by another cryptocurrency to absorb any fluctuations in price.

How are Algorithmic Stablecoins pegged?

All stablecoins need to be ‘pegged’ to another asset to ensure that their value does not fluctuate. In the cryptocurrency world, stablecoins primarily maintain a value that is close to the dollar.

There are different types of stablecoins out there. Fiat-collateralized stablecoins use fiat money in their reserves to ensure that their value does not fluctuate. Similarly, crypto-collateralized stablecoins use reserves of other cryptocurrencies and are often over-collateralized to prevent fluctuations in the case of sudden price movements in the market.

Algorithmic stablecoins have a special status amongst stablecoins because, unlike the two other types, they do not have tangible assets to fall back on, the reason why they are often also referred to as “undercollateralized stablecoins.”

What is an Algorithm?

The term “Algorithmic Stablecoin” feels alien and overwhelming at first glance. An algorithm is a piece of code that is designed to perform a task. For example, if you write a piece of code to perform simple arithmetic tasks, you just created an algorithm! In its most basic form, an algorithm is nothing more than a set of instructions.

A more complicated example of an algorithm would be the YouTube/Instagram/Facebook suggestions system, which suggests you more content based on the content that you are currently consuming.

An algorithm for an algorithmic stablecoin is a piece of code on the blockchain that maintains the relationship between the stablecoin and the cryptocurrency that backs it. Its job is to make sure that too much supply does not devalue it or that too much demand does not overinflate the value.

Magic Internet Money (MIM)

MIM is an algorithmic stablecoin introduced by the company Abracadabra. There are several ways it maintains its peg to the USD. If the price of MIM falls below a dollar, for example, users who have incurred a debt in MIM can buy it off at a price lower than a dollar, allowing them to effectively reduce their own debt while reducing the supply of MIM and pushing up its price.

Similarly, users holding MIM as collateral might want to profit off it by selling it when its value goes above 1 dollar, increasing MIM’s supply in the market and bringing down its value.

Lastly, people can engage in speculative trading on MIM, selling other cryptocurrencies to obtain MIM. This can also have a stabilizing effect on the currency’s value. Collateral is generated in this way or by depositing collateral by interested parties who want to mint new MIM coins.

Frax Finance (FRAX)

FRAX coin claims that it is the world’s first stablecoin that is both dual-collateralized and algorithmically pegged. They argue that their unique pegging mechanism makes the FRAX coin more scalable and capital efficient than all other forms of stablecoins since crypto and fiat collateralized coins use a lot more capital for backup than is necessary.

FRAX utilizes Algorithmic Marketing Operations to generate intrinsic value and revenue for the project while also increasing the security and threat protection of the project.

As for being dual-collateralized, a part of FRAX is backed up by external collateral in the form of USDC. The rest is backed up by FXS, the protocol’s native governance token, which collects fees, seigniorage revenue, and profits from marketing operations to maintain FRAX’s value.

The protocol that decides how much of each type of collateral should be maintained is governed by a PID controller.

TerraUSD and LUNA

The logic behind how TerraUSD or UST maintains its peg using Terra’s native currency, LUNA, is quite simple. Since the UST must always be tradable for a dollar, its price has to be constant.

There are two scenarios the algorithm has to address: decreased supply resulting in the increase of UST’s price and increased supply resulting in the decline of UST’s price.

In the event of UST’s price going above 1 dollar, the solution is quite simple. Users are encouraged to burn 1 USD of LUNA to mint a new UST. The user can then sell the new UST for whatever value above the dollar UST currently has, which is usually around a cent. This might look like a small value that is not worth the trouble but remember that with large volumes, the profits can be huge.

The increase in supply brings down the value of UST, and everyone is happier. But is the process as smooth the other way around?

Inflation in TerraUSD

Algorithmic stablecoins do well in bull markets – the value of their backing currency is usually going up, so they have little to worry about. However, when there is uncertainty in the market and the value of the stablecoin is going down, the burden falls upon the cryptocurrency that backs it to absorb the shock.

When the value of UST falls, its supply is decreased by using UST to mint LUNA USD. This means that in particularly dire conditions, the value of the backing currency, in this case, LUNA, can fall drastically. This is exactly what happened in May 2022.

The Hyperinflation of LUNA

With the bull cycle coming to an end, cryptocurrency prices have been going down for a while. The public trust and interest in cryptocurrency are decreasing, spelling the start of a bear cycle. On the unfortunate day of May 7th, there was sudden dumping of UST in the market. Since that happened without any rhyme or reason, a lot of people think the dumping to be highly suspicious and likely an attack on Terra.

Whatever it may have been, the dumping sealed the fate of UST. The burden now shifted to Terra to decide what to do. The first issue that they faced was the speed of their algorithm. It was not designed to mint new LUNA USD at such a pace. Hence, it could not keep the price from going down any further in time. The team behind Terra decided to make adjustments to the code to allow the minting process to improve its speed.

The increased minting meant that the market was flooded with LUNA tokens. The price of LUNA, which was around $68 on May 7th, fell to around $0.0001 on May 13th! The death of LUNA also spelled the end for UST, which fell to $0.12 from the initial shock, and is currently trading at a little more than $0.03, a fraction of its original value.

What Does the Public Think?

With LUNA’s fall from grace, thousands of people lost their entire life savings. LUNA is quite an old project. People trusted the vision of the team behind it, and that trust was shattered by the UST and LUNA debacle. Events like these shake the trust of the general public in cryptocurrency as well as in under-collateralized stablecoins.

What does this mean for other algorithmic stablecoins? It will certainly take away a lot of traction that algorithmic stablecoins have gained over the years. A setback like this hits the entire industry, especially projects that are new to the market.

The Future of Algorithmic Stablecoins

Nonetheless, the future of algorithmic stablecoins looks bright, with promising projects like MIM and FRAX taking the lead and introducing innovative ways to ensure stability.

The problem with crypto-collateralized stablecoins is that they are “over-collateralized”, meaning that for you to mint a coin worth 1 dollar, you will need 2 dollars in collateral to account for any swings in the market. With fiat-collateralized stablecoins, the issue is that they are tied to assets outside the blockchain, stagnating their growth and limiting the amount of change and innovation that they can undergo.

Algorithmic stablecoins have had a rocky journey in the cryptocurrency market. Continuous innovation can pave the way for a better future, but on the other hand, any setbacks like LUNA and UST could spell the end of algorithmic stablecoins.

The editorial content of OriginStamp AG does not constitute a recommendation for investment or purchase advice. In principle, an investment can also lead to a total loss. Therefore, please seek advice before making an investment decision.