Acryptoinvest.news: Algorithmic stablecoins became the talk of the town after the Terra-Luna collapse, which wiped out over $40 billion of investor wealth in a matter of days in May 2022.
The historic depegging of the TerraUSD stablecoin last year sent shockwaves through the financial world and many crypto investors remain skeptical about such algorithmic stablecoins. In this explainer, the editors of Acryptoinvest.news will delve into the basics of what can be considered algorithmic stablecoins and the risks that come with them.
What are algorithmic stablecoins?
Algorithmic stablecoins are a type of digital currency that uses computer algorithms and smart contracts to stabilize its value, usually by pegging it to another asset such as the US dollar. Unlike centralized stablecoins like Tether, which are backed by physical assets, or decentralized stablecoins like MakerDAO's DAI, which are overcollateralized by cryptocurrency, algorithmic stablecoins are often undercollateralized. This means that they do not rely on a reserve of assets corresponding to their value.
These stablecoins use a system of “balancer” or “equity” tokens to absorb market volatility and maintain their peg. For example, in the Terra blockchain system, the algorithmic stablecoin TerraUSD interacted with the Luna governance token in an attempt to maintain its value at a stable level. When the value of TerraUSD rises above $1, Luna holders will profit by exchanging their Luna for TerraUSD. Conversely, when the value of TerraUSD fell, traders could benefit by exchanging it for Luna, thereby reducing supply and increasing the price.
The stability of these algorithmic stablecoins is highly dependent on market demand. If demand falls below a certain threshold, the entire system may fail. Additionally, these stablecoins rely on independent investors to arbitrage to stabilize prices, which can pose significant risk. Despite these potential drawbacks, the transparency and decentralization offered by algorithmic stablecoins may be attractive to some users as their operations are entirely governed by verifiable code and are not subject to regulatory oversight.
Types of algorithmic stablecoins
Let's dive deeper into the different types of algorithmic stablecoins to better understand their unique characteristics and how they function.
First, there is a “rebasing” of algorithmic stablecoins. These stablecoins typically use price-elastic ERC-20 tokens, the total supply of which is not fixed and is adjusted regularly. For example, the Ampleforth protocol uses a rebasing function that changes the supply of tokens over time depending on their price.
Secondly, there are “seigniorage” algorithmic stablecoins. This model typically includes two forms of cryptocurrencies—stablecoins and seigniorage shares.. Examples include Basis Cash, which adjusts its supply to maintain a stable BAC price, and Luna/UST.
Finally, there are “fractional” algorithmic stablecoins. These stablecoins combine the features of fully algorithmic and fully collateralized stablecoins to avoid overcollateralization and reduce the risks associated with custody. An example is Frax, which uses a partial provisioning protocol.
Trading risks, benefits
Algorithmic stablecoins carry a unique set of risks and benefits that are important for traders to understand. On the one hand, they represent the true embodiment of the principle of decentralization, operating solely through verifiable code without any regulatory oversight. The lack of physical asset requirements eliminates the risk of user error and reintroduces the concept of seigniorage into the crypto ecosystem, allowing the profit or loss of currency creation to be assessed in the world of digital assets.
However, the architecture of these algorithmic stablecoins also has its drawbacks.. These unbacked digital assets, which use algorithms and market incentives to attempt to peg to the price of a reference asset, are vulnerable to depegging risk. They require a certain level of demand to function properly, and if that demand falls below a certain level, the system can collapse.
It is important to note that their stability can be seriously affected during a crisis, where traders acting on ambiguous information can cause the stablecoin to lose value, causing a herd mentality that can cause the price of the stablecoin to drop significantly. For example, the stablecoin TerraUSD experienced a significant unpegging event when its price fell below $1, leading to a massive sell-off and subsequent drop in the price of Luna, the governance token of the Terra blockchain system.
Are algorithmic stablecoins regulated?
While the decentralization and transparency offered by algorithmic stablecoins can be attractive, it is important to understand that they currently operate in a largely unregulated space.
Lack of regulation can present both opportunities and risks. On the one hand, the lack of regulatory oversight allows for greater innovation and flexibility in the market. On the other hand, this also means that there are fewer protections in place for investors.
For example, when the price of TerraUSD fell significantly below its target of $1, investors suffered significant losses. The incident highlighted the potential risks associated with algorithmic stablecoins and prompted calls for tighter regulation.