Algorithmic Stablecoins
What are stablecoins?
Cryptocurrencies are known for their volatility. Their prices can swing up and down drastically, without a moment's notice. But one form of cryptocurrency, known as a 'stablecoin', aims to provide refuge to those who want to exit constant volatility while remaining in the crypto ecosystem.
Stablecoins are cryptocurrencies that are programmed to stay pegged to fiat currencies like the US dollar. For example, USD-pegged stablecoins are supposed to remain pegged to $1 at all times.
Each stablecoin project differs in ways that they maintain the peg. The two biggest ones, Tether (USDT) and Circle's USD coin (USDC), are 'over-collateralized' by fiat reserves, meaning they have cash or cash-equivalent assets in their reserves. So each USDT or USDC traded in the crypto market is backed by what’s actually in the possession of the stablecoin issuers. Similarly, MakerDAO’s stablecoin DAI is decentralized but also overcollateralized –– backed by ether (ETH) deposited into its smart contracts.
A new form of stablecoin: the algorithmic stablecoin
Over the past year, however, a new form of stablecoin has emerged that differs in its collateralization: algorithmic stablecoins, such as TerraUSD (UST), Magic Internet Money (MIM), Frax (FRAX) and Neutrino USD (USDN).
They’re called algorithmic because what backs them is an on-chain algorithm that facilitates a change in supply and demand between them (the stablecoin) and another cryptocurrency that props them up.
Algorithmic stablecoins are typically undercollateralized –– they don’t have independent assets in reserves to back the value of their stablecoins. For this reason, people often use the terms 'undercollateralized stablecoins' and 'algorithmic stablecoins' interchangeably.
An algorithm is simply a set of code that instructs a process. So, for example, what you get to see on your Facebook timeline is determined by Facebook’s timeline algorithms, which track measures like past online behavior to determine what to feed your timeline.
In crypto, an algorithm refers to pieces of code on the blockchain, as encoded in a set of smart contracts.
Algorithmic stablecoins typically rely on two tokens: one stablecoin and another cryptocurrency that backs the stablecoins. The algorithm (or the smart contract) regulates the relationship between the two.
Cryptocurrencies –– similar to assets in other markets, such as houses or stocks –– swing in price depending on the market demand and the supply of the asset. This also includes stablecoins because they’re essentially cryptocurrencies freely traded on the market.
To prevent the price of a stablecoin from depegging while subject to market conditions, algorithms regulate supply and demand. When demand outweighs supplu, the price of that asset goes up – and vice versa.
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