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What Are Algorithmic Stablecoins? – A Complete Guide 2022 For Beginners

The unexpected recession of the UST stablecoin and its sister coin, LUNA, has even more questions about whether such an algorithmic stablecoin can be trustworthy. Cryptocurrencies are notable for their volatility, with price swings that can reach double digits.

However, one type of cryptocurrency known as stablecoins tries to offer a safe haven for people who desire to escape continual volatility while staying in the online crypto trade. Stablecoins are coins that are invented to be linked to fiat banknotes such as the USD. The price of USD-pegged stablecoins is expected to be 1 US dollar throughout all seasons.

Every stablecoin project varies in how it preserves the peg. The two most significant, Circle’s USD coin (USDC) and Tether (USDT), are very important because they are over-collateralized via fiat resources, which indicates they have cash / cash-equivalent guarantees in their resources. Consequently, each USDT sold to the cryptocurrency market is supported by what the stablecoin developers genuinely own. Likewise, MakerDAO’s stablecoins DAI is distributed but over-collateralized, with ETH placing itself into smart contracts.

Regardless, a new type of stablecoin has arisen in the last year that varies through its collateralization: different algorithmic stablecoins, in addition to TerraUSD, neutrino USD, Magic Internet Money, and FRAX. 

They are named algorithmic since they are supported by an algorithm that enables a variation in reserve and needs between them, the stablecoin, and other different cryptocurrencies.

On the Terra blockchain, which hosts the largest algorithmic stablecoin network, UST and TerraLUNA, Terra’s native digital currency that subsidises the stablecoin, execute the algorithmic drama. 

An algorithmic stablecoin is most often under-collateralized, meaning that it lacks autonomous assets in reserves to back up the worth of its stablecoins. The terms “algorithmic stablecoins” and “under-collateralized stablecoins” are often interchangeable.

What Precisely is Algorithmic Stablecoin?

The term “algorithm” may be ambiguous. It simply guides you to a collection of schooling for a technique. For example, what you glimpse on your social media timelines is governed by algorithms, which include facets, for instance, how applicable the post is to your past searching behaviour. On the blockchain, algorithms are a sequence of instructions that are encoded in a collection of smart contracts.

Algorithmic stablecoins are often based on two tokens: one stablecoin and another cryptocurrency that backs the stablecoins, with an algorithm governing the link between the two of them.

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Stablecoins are digital assets which are pegged to the value of a real-world asset like the US dollar. Stablecoins are designed to make it easier for investors to exit volatile cryptocurrencies by providing a stable alternative to traditional currencies.

There are two types of stablecoins: those issued by a central bank and those issued by a cryptocurrency exchange. Two kinds of stablecoins have their advantages and disadvantages. The most significant advantage of stablecoins is that they provide investors with a way to exit volatile cryptocurrencies. 

When a cryptocurrency rises in value, investors can cash out their holdings and use the money to buy a more stable currency. The downside is that stablecoins can be very volatile, so they aren’t ideal for long-term investors who want to hold their assets for over a few months. 

The second advantage of stablecoins is that they can be used as a form of payment for goods and services. When you use a stablecoin, the seller doesn’t have to worry about fluctuations in the currency’s value, making it easier to pay for things like groceries or rent. But there are also some downsides to using stablecoins as a payment method: They can be more expensive than regular currency and are vulnerable to scams and fraud. When you use stablecoins, you’re essentially betting on the currency’s stability if the currency’s value fluctuates too much. 

How Do Stablecoins Function?

Stablecoins are classified into two types: those backed by deposits made up of commodities such as fiat cash, bonds, and commercial paper, as well as other various crypto tokens, and those backed by algorithms or decentralised systems.

Binance USD and Tether are resource-backed stablecoins in the market that are worth enough in dollars to maintain a 1:1 rate of exchange. A rare of the companies’ stablecoins can always be exchanged for 1 US dollar.

Resource-backed stablecoins have come under fire in recent years for failing to be transparent about their assets and whether these stablecoins have the funds to securely hold all digital currency currently in circulation.

In addition, TerraUSD is the only algorithm stablecoin with no reserves. Meanwhile, a complex mechanism involving the exchange of TerraUSD coins for an open digital currency named Luna is in charge of maintaining its value and regulating supply.

Why Are Algorithmic Stablecoins So Risky?

Algorithmic stablecoins represent a significant risk because they are not guaranteed by any real-world asset and are not properly stablecoins. They do not have any backup; thus, the reliability of their pricing is not as specific as you may expect.

Algorithmic stablecoins, like many other cryptocurrencies, require demand to retain value. We’ve all seen how the demand for a coin in the crypto sector may fluctuate dramatically due to a variety of variables, and this is still a significant drawback for algorithmic stablecoins.

Furthermore, depending on the sort of algorithmic stablecoin in issue, a drop in the value of one coin in an algorithmic pair can have a knock-on effect on the other. This occurred during the LUNA/TerraUSD crash. In essence, if something goes wrong with an algorithmic stablecoin, it can signal double problems.

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Algorithmic Stablecoins’ Future

Until recently, algorithmic stablecoins were widely used in liquidity pools and speculation arbitrage trading. With the recent TerraUSD crash, the future appears bleak. Furthermore, lawmakers are keeping a close eye on developments in the business and may crack down severely on these stablecoins.

In addition, US Treasury Secretary Janet Yellen has already submitted the Terra case in a hearing calling the stablecoin legislation. Yellen stated during the hearing that UST is a “rising product with fast expanding risks.” She said that it is “critical, if not imperative,” that Congress adopt stablecoin legislation by the end of the year.

How is TerraUSD Intended to Hold Its Peg?

TerraUSD (UST) is intended to have 1:1 compatibility with the USD through an algorithmic interaction with Terra’s native coin, LUNA. Behind the connection is an investment opportunity that arises whenever UST’s peg moves either way.

When UST supply is insufficient and the market is extreme, the cost of UST boosts above $1. To restore UST’s peg, the users are allowed by Terra to get one USD against TerraUST on the Terra forum portal. This deal burns one LUNA to create one UST, which customers can trade for 1.01 US dollars to make a profit of one cent.

Clients can generate as much TerrUSD according to their needs from signed LUNA on this platform until the cost of UST returns to $1. The logic is that as production increases, the price will eventually fall.

When supplies are excessive and needs are low in the market, the value of the UST trip is below $1. Consequently, the protocol permits clients to reverse what is described above: Clients can buy one TerraUSD for 0.99 US dollars and then exchange one TerraUSD for 1 USD of LUNA. The arbitrage merchant earns a profit.01 TerraUSD by selling one UST and coining one US dollar of LUNA.

Once more, the Terra system permits clients to burn TerraUSD and earn LUNA until TerraUSD hits one US dollar.

The second situation, where the value drops under the peg, is additionally a typical issue with algorithmic stablecoin since market fear is more dominant than market delight, impacting more examples of slower growth and more demand.

Considering UST’s algorithmic relationship with LUNA and the latter should bear the volatility of the former. Because fresh LUNA can be constantly created whenever TerraUSD descends below $1, the cost of LUNA can slip hurriedly in the face of the growing token supply.

What Caused the UST to Depeg?

TerraUSD began de-pegging in May when Terra’s essential decentralised finance (DeFi) technology, Anchor, started allowing high-volume transactions. Furthermore, due to these occurrences, the TerraUSD pool on Ethereum’s Curve Protocol and the primary junction for stablecoin pricing on DeFi saw large transactions.

Many people feel TerraUSD’s depegging was the product of a coordinated effort. Others say this was a panicked withdrawal caused by declining global market conditions, mainly the value of bitcoin, which LFG has donated to its reserve to strengthen UST. In either case, the stablecoin has fallen under pressure and dropped to 0.29 USD in May 2022.

How Valuable Are They?

Stablecoins have a market capitalization of around $170 billion, according to cryptocurrency trade figures, making them a modest part of the larger crypto sector, which is now worth around $1.2 trillion.

Stablecoins, on the other hand, have recently received a lot more attention. Tether, the most powerful stablecoin, has a market cap of almost $80 billion, up from $4.1 billion at the start of 2020. USD Coin, the second highest valued stablecoin, is currently worth $49 billion.

Although statistics on the strategic tools of stablecoins are not readily available, they are crucial for market players because they allow them to protect against bitcoin price swings or hold excess assets without transforming them into traditional money.

In one of its latest studies, the US Federal Reserve claimed that stablecoins are quickly being utilized to promote active investing in other cryptocurrencies.

According to Joseph Edwards, head of finance strategy at crypto company Solrise, stablecoins have grown in popularity worldwide as a method to circumvent capital regulations since 2018. He argues that the stablecoin Tether is especially popular in China and South America.

What Do Regulators Recommend?

As regulators worldwide attempt to establish regulations for the cryptocurrency business, some fear that stablecoins may pose a special danger to economic stability, such as if many customers strive to move out of their stablecoins simultaneously.

So, even though stablecoins are backed by items that may lose value in the online market or become unavailable in unfavourable market conditions, they are still highly susceptible to the end of investors. Furthermore, a move on the stablecoin could put a strain on the traditional financial system, causing it to spill over into the payment ecosystem, according to a report.

What Are Some Examples of Algorithmic Stablecoins?

  • UXD

UXD is the algorithmic stablecoin supported entirely by the delta stable position on the Solana blockchain.

  • Ampleforth (AMPL)

Ampleforth is an algorithmic stablecoin linked to the 2019 CPI-adjusted USD.

  • Cash Basis (BAC)

Basis Cash employs a three-token system to maintain its 1 US dollar peg by utilising shares & bonds.

  • USDD
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Justin Sun, the founder of Tron, created a Tron ecosystem decentralised stablecoin in May 2022.

How did UST Depeg in May 2022?

In May, TerraUSD began depegging when sizable withdrawals through Terra’s major decentralised finance (DeFi) system, Anchor, resumed. These knocked on Ethereum’s Curve Protocol’s TerraUSD pool, the central hub for stablecoin volatility in DeFi, which also saw elevated withdrawals.

Some believe TerraUSD’s depegging in May was the result of a planned effort. Others think this was a sequence of panicked withdrawals caused by the deterioration of wider market circumstances, particularly the price of bitcoin, which LFG has added to its resources to support TerraUSD. In any case, the stablecoin hasn’t been able to withstand the pressure long enough to keep its peg, finally sliding as low as 0.29 US dollar in May 2022.

Because LFG, the institution that protects TerraUSD’s peg, has so much BTC in reserve, some analysts believe it may have spurred bitcoin’s price decline, as many thought the organization might abandon millions of dollars. But there’s a twist: the LFG now has fewer weapons in its armoury as the cost of BTC falls.

The algorithm intended to burn TerraUSD and generate LUNA when the price of TerraUSD falls below $1 hasn’t worked as effectively; it hasn’t kept up with this challenging environment. According to the recommendation given by Kwon in May 2022, this algorithm couldn’t encourage the production of fresh TerraLUNA at the rate needed to re-peg TerraUSD. Consequently, a suggested code update will alter the mint limitation and race up the algorithmic procedure. If the vision is approved, additional LUNA will be issued in a short period.

Is Algorithmic Stablecoin Secure?

Since the stablecoin markets are uncontrolled, trading in stablecoins entails a devaluation hazard. It may be risky to speculative episodes on the occasion of under or over-collateralization. The risk of devaluation increases when the production of stablecoin is linked to the worth of the blockchain management token.

Therefore, before engaging in stablecoins online trade or any other type of digital currency trade, you must conduct your study and grasp the fundamentals and analytical signals of the token in question.

Additionally, stablecoins such as TerraUSD require to be fully backed by security, liquid US dollar reserves, and its blockchain equivalents in stablecoins to be protected. Another way to preserve over-collateralization is to use smart contracts. For example, suppose the collateral for the stablecoin ratio drops below a given threshold. In that case, the system requires liquidation to preserve entire peg stability as well as collateralization.

It is also necessary to notice that collateralization determines the stability of all stablecoins. This means, a loss of trust and confidence in the effort and any outcomes for upholding collateral can be detrimental to the economy. Any drop in the collateral’s worth reduces the obligatory price of the coin (stable), potentially resulting in a significant effort to redeem all stablecoins. The repercussions of this circumstance are the same as those of a traditional bank run.

Since a stablecoin initiative is a dynamic interplay of various pieces, understanding the interdependencies between the components is crucial. Flaws in a single part can reaffirm each other, especially if the expectations and responsibilities are ambiguous. Moreover, consumers risk losing their assets in the event of a crash because there is no collateral to liquidate the stablecoin. As a result, users must exercise caution while engaging in algorithmic stablecoin programs.

Algorithmic Stablecoins Are a Bit of a Gamble

While the concept of algorithmic stablecoins appears to have some appeal, there remain several factors that can quickly influence their worth and cause significant financial loss. So, before engaging in any stablecoin, make sure to examine whether it is algorithmic or not so you know what you are getting into when you invest in this market.

Final Thoughts

While algorithmic stablecoins appear to be a great concept, in theory, they have a long way to go before they can be considered trustworthy repositories of value. At the time of publication, no algorithmic stablecoin had achieved a consistent, stable peg. As a consequence, speculative arbitrage investors are their target market.

In contrast, algorithmic stablecoins offer a conducive environment for innovation in the digital asset market. They give people the opportunity to push the frontiers of what is possible in DeFi by bringing together a unique and creative set of intellectuals and builders who are developing and improving existing models.


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Mubashar Nawaz (United Arab Emirates)

Mubashar Nawaz is an experienced crypto writer working for Tokenhell. Having passion for writing, he covers news articles from blockchain to cryptocurrency.

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