What is an Algorithmic Stablecoin, and How Does it Differ From a Regular One?

As many people feel uncertain about digital currencies, several solutions have surfaced throughout these years. Last year’s survey in the US states that 75% of citizens who have heard about crypto are not confident about its reliability. So, one solution can be a stablecoin, a kind of cryptocurrency whose value is intended to remain constant about a specific item or group of related assets. Its primary function is to reduce the usual price volatility of digital assets by offering a reliable asset for trading, investing, and transactions.

It is essential to understand the various kinds of stablecoins. They all seek to preserve price stability, but how they do so differs significantly. The two primary types are algorithmic and collateralised stablecoins.

In this article, we will discuss the differences between algorithmic and conventional stablecoins. We will explore the list of algorithmic stablecoins, their functionality and discuss the regulatory framework that surrounds them.

Overview of a Stablecoin

Stablecoins are digital currencies backed by a reserve of assets, such as fiat money or commodities like gold, to keep their value steady. They are primarily designed to provide price stability in the generally unstable cryptocurrency market, which makes them more appropriate for regular financial services and transactions.

By associating the value of stablecoins with a less erratic asset, they seek to promote stability. Due to its capacity to reduce price swings, this stability is essential for everyday transactions. Stablecoins are extensively used for lending, trading, and exchange.

Collateralised Stablecoins

To guarantee that their value doesn’t fluctuate, collateralised stablecoins are backed by assets kept in reserve. These assets may consist of other cryptocurrencies or fiat money.

1. Fiat-collateralised Stablecoins have a fiat currency, such as the US dollar, as their collateral. The issuer has a reserve of fiat currencies equivalent to the total number of stablecoins. Tether (USDT) and USD Coin (USDC) are two examples.
2. Stablecoins that are collateralised by other cryptocurrencies are known as crypto-collateralised stablecoins. They are frequently over-collateralised due to the volatility of the underlying assets. For example, to maintain price stability, MakerDAO’s Dai (DAI) is backed by Ethereum and other cryptocurrencies, usually in a ratio greater than 100% of the stablecoin’s value.

How Do They Work

As we said, collateralised stablecoins rely on reserves to support their value. The principal method involves having an adequate reserve asset to equal or surpass the value of the issued stablecoins. Stability is maintained because of this backing, which guarantees that the stablecoin may be redeemed for its corresponding value in the reserve asset.

Let’s examine collateralised stablecoins’ value maintenance in more detail. Consider a stablecoin directly correlating to the US dollar (USD) called X that uses a reserve system to achieve this peg. This is how it operates:

A predetermined amount of US dollars is kept in reserve for each X generated. Depending on the stablecoin, this reserve ratio may change; however, let’s say X employs a 2:1 ratio. This indicates that $2 worth of USD backs every $1 worth of X that is in use. This additional cushion keeps the X price steady and helps to absorb any changes in the dollar’s value.

USD must be deposited into the reserves to issue new Xs. A $200 deposit would be required to purchase 100 X (don’t forget the 2:1 reserve ratio). After that, the issuer would safely hold the $200 that was deposited in their reserves and add that 100 X to the overall amount of Xs in circulation.

Additionally, Xs can always be exchanged for US dollars. If a holder wanted to cash out 50 X, they would return those tokens and receive $100 from the issuer’s reserves as the token’s price. The issuer would then permanently remove those 50 Xs from circulation to guarantee that the total supply represents the amount redeemed.

Through this approach, US dollars and Xs are directly linked. The reserves ensure that there will always be sufficient USD to pay for all overdue X. Regular audits that confirm reserve holdings correspond with the number of Xs in circulation promote transparency and system confidence.

What is an Algorithmic Stablecoin?

An algorithmic stablecoin is a special kind of cryptocurrency made to keep its value constant; it is usually linked to a fiat currency, such as the US dollar. Algorithmic stablecoins, as opposed to conventional stablecoins backed by reserves (fiat or crypto-backed), rely on economic incentives and smart contracts to control supply and achieve price stability.

Below, we will discuss how algorithmic stablecoins work:

Maintaining the Peg 

The fundamental idea is a complex interplay between market capitalization and stablecoin supply. The algorithm constantly observes the stablecoin’s market price.

The algorithm automatically increases the total supply of the stablecoin if the price climbs above the goal value, which in the case of a USD-pegged stablecoin is $1. The price is under pressure to decline and is being pushed back towards the peg by this additional supply.

On the other hand, if the price falls below the intended value, the algorithm burns existing tokens to lower the overall supply. The price rises again because fewer total token supply is available, making the ones that remain more valuable.

To better illustrate the concept, here are a couple of examples of algorithmic stablecoins:

• TerraUSD (UST) and Luna were the two tokens used in this significant algorithmic stablecoin project. Luna tokens were destroyed to generate more UST when the price of UST crossed $1. This increased supply and decreased the cost of UST. It was the other way around when UST dropped below $1. But UST went through a significant de-pegging incident in May 2022, bringing attention to algorithmic stablecoins’ possible dangers.
• There are some differences between Ampleforth (AMPL) and other algorithmic stablecoins. Rather than arbitrarily adding or withdrawing tokens in reaction to market swings, AMPL features an elastic supply that self-corrects every day. The basis for this adjustment is the difference between AMPL’s current and goal prices, which are often based on the US dollar. The total amount of AMPL tokens will somewhat grow if the price of the token rises above its target. Conversely, the supply will somewhat decline if AMPL trades below its objective. This strategy aims to gradually move the price back towards the desired amount.

Fractional Algorithmic Stablecoins

The more recent variant, fractional algorithmic stablecoins aim is to integrate the advantages of collateralised and algorithmic techniques. By maintaining price stability, these initiatives usually combine algorithmic mechanisms with a partial collateral reserve to lower the risks of under-collateralisation and dependence on complicated algorithms. A fractional algorithmic stablecoin project is called Frax.

Algorithmic Stablecoins: Advantages and Challenges

After understanding the functionality of algorithmic stablecoins, it’s time to discuss its characteristics. In contrast to conventional, collateralised stablecoins, they have a distinctive combination of benefits and drawbacks.

Pros

• Algorithmic stablecoins are usually thought to be more decentralised. Since they don’t rely on a single organisation to manage reserves, they promote a more independent and unrestricted system.
• Algorithmic techniques may establish a more efficient system for preserving a steady price peg than keeping an asset reserve.
• Due to their lack of reliance on traditional financial systems or central authority, algorithmic stablecoins may be more widely available to consumers globally.
• The design and functionality of algorithmic stablecoins could continue to be innovative, marking a new chapter in the history of stablecoin technology.
• Compared to certain traditional stablecoins, algorithmic stablecoins allow for greater transparency because their underlying code and procedures are frequently open-source.

Challenges

• They are prone to de-pegging incidents during extreme market volatility. If there is a significant sell-off, the program may find it challenging to keep the peg through automatic changes alone.
• There is a degree of risk since the complex algorithms controlling supply modifications might be challenging to comprehend and forecast.
• Market dynamics and liquidity play a significant role in the stability of algorithmic stablecoins. A sharp decrease in demand may cause the value to decline quite quickly.
• The laws governing algorithmic stablecoin regulation are still changing. Because of the unclear regulatory frameworks, users and businesses may experience more uncertainty.

Key Differences Between Algorithmic and Regular Stablecoins

The two primary strategies for preserving price stability in the market are algorithmic stablecoins and regular stablecoins, sometimes called collateralised stablecoins. Below is a summary of the algorithmic stablecoin vs stablecoin:

Maintaining the Peg

Unlike algorithmic stablecoins, which control supply and demand through smart contracts and algorithms, regular stablecoins keep their peg through collateral reserves. These reserves are made up of real-world assets like basis cash, gold, and other cryptocurrencies. Stability is ensured because a similar underlying asset value effectively backs each stablecoin unit.

Decentralisation

Stablecoins are characterised by varying degrees of centralisation. On the one hand, centralized stablecoins are managed by a single party, frequently a business or financial organisation. This central body is responsible for managing reserve assets and ensuring enough of them to support all outstanding stablecoins.

Users rely on this organisation to keep the peg in place. Conversely, decentralised stablecoins automate reserve management and peg maintenance through distributed ledger technology and smart contracts. The network maintains the stablecoin’s stability, and there is no one point of control in this system.

Price Stability Mechanisms

Stablecoins are not tied to an underlying asset and must have a redemption mechanism. This system allows users to trade their stablecoins for an equivalent asset quantity, usually at a 1:1 ratio. As a result, a natural market force is created, aiding in price stability. Users are motivated to exchange their tokens for the underlying asset if the price of the stablecoin climbs above the peg, which increases the asset’s supply and lowers the stablecoin’s price.

On the other hand, people can purchase stablecoins with the underlying asset if the stablecoin price falls below the peg. This would decrease the amount of stablecoin in circulation and raise the price back towards the peg.

Risks and Vulnerabilities

Even though regular stablecoins provide more security through collateralisation, they come with dangers. The collateral’s target value is subject to change, and a large decline might put the stablecoin’s peg in danger. Furthermore, customers risk losing their money if the organisation maintaining the collateral reserves goes bankrupt (counterparty risk). Conversely, algorithmic stablecoins present a distinct set of risks. Their complex algorithms may struggle to keep the peg during exceptionally high market volatility.

They also depend on timely and accurate pricing information from outside sources, which is only sometimes dependable. Smart contracts on algorithmic stablecoins may be their greatest weakness. If these contracts are exploited or have faults, the results could be disastrous.

Key Considerations

Regular stablecoin collateralisation involves a trade-off that needs to be considered. An additional degree of protection is provided by over-collateralised stablecoins, in which the value of the collateral supporting the stablecoin supply exceeds the total value of stablecoins in circulation. This indicates sufficient assets to cover all outstanding stablecoins, even if the collateral’s value slightly decreases.

This strategy, meanwhile, may also be less capital-efficient. On the other hand, lower collateralisation ratios can enhance capital efficiency by enabling the issuer to produce more stablecoins with the same amount of collateral. Liquidity and network effects may arise as a result, but there is also an increased danger if the collateral supporting the stablecoin loses value.

So, each type of stablecoin offers unique benefits and drawbacks. Regular stablecoins could be less decentralised, but through collateralisation, they offer more stability. Although they provide a more decentralised method, algorithmic crypto carries a higher inherent risk. The decision between the two is based on risk tolerance and personal needs.

Final Thoughts

To sum up, both stablecoins have unique characteristics and pros and cons. Although regular stablecoins may be less decentralised, they offer higher price stability since collateral reserves back them. Algorithmic stablecoins, on the other hand, encourage decentralisation by utilising smart contracts and algorithms. However, they can find it difficult to hold onto their peg during significant market volatility. They depend on outside pricing data and are open to smart contract violations.