Decentralized Finance (Defi) is a complex and rapidly evolving industry that is based on the conceptual and ideological foundations of a more effective, censorship-resistant, and open decentralized financial system.
Algorithmic stablecoins, which combine elements of monetary economics, financial markets, mathematics, and technology, best demonstrate these characteristics.
These innovative and complex technologies, which sit at the intersection of blockchain and money, present several challenges and unresolved issues regarding the future of Defi.
What are Algorithmic stablecoins?
There is no collateral associated with algorithm-based stablecoins. As a result, they’re also referred to as non-collateralized stablecoins. Stablecoins based on algorithms are new cryptocurrency variants that aim to improve price stability. It can also help to balance the supply and demand for the asset in circulation. Most importantly, in terms of capital efficiency, algorithm-based stablecoins outperform collateralized stablecoins.
The ‘central bank’ is the algorithm or protocol that underpins these stablecoins. It helps to increase supply when a token’s purchasing power falls or decreases supply when the stablecoin’s purchasing power rises.
Let’s go through some key features of the algorithmic stablecoins
An algorithmic stablecoin aims to assist traders (both advanced and new users) in becoming acquainted with the concept of trading.
Algorithmic stablecoins have the following characteristics:
- Limited Volatility = Value Addition: Stablecoins are valuable assets because of the limited price volatility associated with them, as well as the ease of use. Stablecoins, as a result, can be easily leveraged for cross-border transactions. These stablecoins also demonstrate collateral diversification, which provides resistance to hyperinflation and market volatility.
- Adaptive Responses to the Market: The algorithm parameters, which are hardcoded into the smart contracts, ensure an automatic reaction to market data without direct manual intervention. After studying underlying market conditions, these parameters aim to stabilize market supply and demand for these tokens.
- Security: Stablecoins can be stored in virtual wallets with a private key to ensure security. The associated funds are only accessible to stablecoin holders. Advanced encryption technology can be used to increase security levels.
Now, what are the types of algorithmic stablecoins & their working?
While different algorithmic decentralized stablecoins have unique characteristics, they all adhere to the same protocols.
The following are the various types of algorithmic stablecoins:
Rebasing Algorithmic Stablecoins:
The supply regulates the value of algorithmic stablecoins by rebasing them. A rebase mechanism’s algorithm automatically reduces the supply of coins when their price falls below a certain threshold and issues additional coins when it rises above a certain level. This mechanism ensures that the coin’s value remains constant regardless of market conditions.
The idea is that if you have 1% of the supply before the rebase, you will still have 1% after it, even if the number of tokens in your wallet fluctuates. This means you keep your network share regardless of the price of the native token.
Seigniorage Algorithmic Stablecoins:
Instead of a “rebasing” currency, the Seigniorage Algorithmic Stablecoin model has two tokens: a supply-elastic currency and network investment shares.
Owners of the latter are the sole recipients of inflationary benefits (from positive supply increases) and bear the debt burden (when demand for the currency falls and the network contracts).
Some Pros and cons of algorithmic stablecoins
Financial product innovation isn’t necessarily a good thing, and some innovations are purposefully engineered to be intrinsically unstable, and algorithmic stablecoins projects are among such inventive currencies.
Pros of algorithmic stablecoin:
Algorithmic stablecoins are the true embodiment of decentralization because the code defines the rules that govern the underlying financial system, with no regulatory agencies monitoring user transactions. Furthermore, the absence of a tangible asset requirement in algorithmic stablecoin eliminates the possibility of user error.
Seigniorage has been reintroduced into the crypto ecosystem by algorithmic stablecoins, which means that calculating the profit or loss made on the production of a currency is possible in the decentralized world of digital assets.
Cons of algorithmic stablecoin:
First, for stable cryptocurrencies to function seamlessly, there must be some level of demand. The system fails if demand falls below a certain threshold.
Second, stablecoins are vulnerable because they rely on self-motivated, independent investors who must be eager to profit from the mechanism that keeps TerraUSD linked to the dollar.
Finally, during a crisis, this type of stablecoin may lose value as a result of traders reacting to ambiguous information and uncertainty. Furthermore, it may encourage the selling of the underlying stablecoin, resulting in a sharp price drop.
Metrics for the Success of Algorithmic Stablecoins
A DAO structure is said to be present in many algorithm-based stablecoin protocols. A functional governance smart contract may appear to be the best option for ensuring governance in non-collateralized stablecoins. However, it is also critical to ensure equitable token distribution while providing adequate governance privileges to all stakeholders.
Certain algorithm stablecoin protocols use the rebase mechanism when they need to ensure active modification of a large number of tokens in a user’s wallet.
Some protocols, on the other hand, are aimed at providing returns on alternative investment vehicles such as coupons for removing or adding supply and matching demand.
The utility of algorithm-based tokens decreases as their exposure to new users decreases. Token adoption is also an important factor in determining the best choices in an algorithmic stablecoins list.
Because of slower liquidity growth, the limited levels of token adoption may pose limitations for stability. The majority of protocols are only implemented by a small number of Defi projects.
Because of a variety of complicated reasons, algorithmic stablecoins struggle greatly to maintain the peg. Certain protocols may become out of control to the point of entering a ‘death loop.’ As a result, a major protocol would be required to help the protocol break free from the ‘death loop.’
What are the risks of Algorithmic Stablecoins?
Influenced by Market Risk:
The algorithm generates more tokens when the price of a digital asset exceeds the valued price. The newly generated tokens circulate on the network, where potential traders can purchase them. The algorithm burns the tokens if the price falls below the value of the digital asset.
This decrease in supply is offset by offering bonds to buyers, who are paid only for the price that rises above the value.
Oracle contracts are in charge of supplying price data for the stablecoin in question. It ensures that supply is adjusted in response to price changes. However, choosing and implementing oracles can be difficult, especially when trust, honesty, and accuracy are taken into account.
Peg breaks are the worst-case scenario for any stablecoin, with uncollateralized stablecoins being the most vulnerable. Why? They rely heavily on market confidence. A token or coin may fade into obscurity if market confidence is lacking.
If a stablecoin suffers two significant peg breaks, it will have a difficult time recovering effectively.
Our thoughts on the future of algorithmic stablecoins
Because the stablecoin market is unregulated, investing in stablecoins entails devaluation risk and may be vulnerable to speculative attacks in the event of under-collateralization. The risk of devaluation increases when the supply of stablecoins is linked to the value of the blockchain’s governance token.
Until now, algorithmic stablecoins have been heavily used in speculative arbitrage trading and liquidity pools. However, the recent Terra fall casts a pall over the future. Legislators closely monitor market trends and have the authority to impose strict rules on these stablecoins.
The introduction of algorithmic stablecoins has undoubtedly provided the best opportunities for ensuring decentralization in the absence of any regulatory bodies. In comparison to other alternatives, you can have a truly scalable solution with the foundational benefits of algorithm-based stablecoins.
Furthermore, the lack of requirements for tangible assets to back up non-collateralized stablecoins reduces the possibility of human error.
Stablecoins have previously been regarded as a new and safer type of cryptocurrency investment. Algorithmic stablecoins, on the other hand, are an exception because they rely on complex financial engineering to maintain their value.
You can now trade some of the top algorithmic stablecoins through the Carret crypto trading platform. Some of the best algorithmic stablecoins you can trade at Carret are TrueUSD and USDC.
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