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What Are Algorithmic Stablecoins? Here’s How They Work

Vance Wood

Vance Wood

December 7, 2022

6 min read

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Considering the highly volatile nature of cryptocurrency, the unpredictability of market conditions and its supply-demand dynamics could be viewed as one of the main risks associated with the digital finance market.

At the same time, the emergence of stablecoins within the DeFi field has greatly affected the crypto industry. What is the exact role of this newly emerged crypto variant? In this article, we will take a deep dive into the technology behind algorithmic stablecoins and identify several outstanding examples.

What is an algorithmic stablecoin?

To understand what makes algorithmic stablecoins different, let’s first start with the more familiar term – ‘stablecoin’. To put it simply, this type of cryptocurrency is designed to hold a certain value by being pegged to a fiat currency (for example, US Dollar) via collateral. Some stablecoins (USDT, USDC) are collateralized off-chain; whereas others use the on-chain mechanism.

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N.B. Learn more about stablecoins – safe haven amid crypto rollercoasters – here

On the contrary, algorithmic stablecoins, while also being pegged to a fiat currency, do not utilize any collateral mechanisms, their value is not backed by a physical asset, but by optimized algorithms – in other words, rules, designed to manipulate circulating supply and achieve stable results.

Types of algorithmic stablecoins

Different in types of algorithms, there are three main types of algorithmic stablecoins: rebase, seigniorage, and fractional-algorithmic.

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Rebase

The rebase model manipulates the base supply of ERC-20 tokens to stabilize and maintain its value (peg). If the fixed peg is set at $1, the algorithm is set to mint coins (when the price is above $1) or burn them (less than $1).

Seigniorage

Seigniorage (the difference between the money face value and money production costs) is implemented in multi-coin systems. According to this model, there should be a specific stablecoin provided within the system and at least one more coin stabilized by the algorithm. In the majority of cases, Seigniorage uses a combination of mint-and-burn and free market (no government involvement) mechanisms.

Fractional algorithmic

The combination of fully algorithmic and fully collateralized stablecoins, these fractional algorithmic stablecoins are designed to enable top-grade stability by being backed by collateral and an algorithm at the same time.

Examples of algorithmic stablecoins

DAI

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MakerDAO’s DAI is an Ethereum algorithm-based stablecoin soft-pegged 1:1 to the US Dollar. DAI issuance is controlled by an entity. Instead, DAI offers a unique stablecoin model. The token relies on ETH-based smart contracts, which are utilized by users as collateral. Therefore, DAI is often called ‘decentralized and collateralized stablecoin’.

Another crucial factor that makes DAI special is that it can utilize an array of cryptocurrencies as collateral: from ETH to USDC, wBTC, BAT, and others, hence DAI is now multi-collateral.

Launched in December 2017 as part of the MakerDAO’s roadmap, DAI is an ERC-20 token often used in DeFi, GameFi, e-commerce applications.

FRAX

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The world’s first fractional algorithmic stablecoin, FRAX is backed by an algorithm and collateral. There are two stablecoins within the Frax protocol’s ecosystem - FRAX and FPI: the first one is pegged to the US Dollar and the second - to the US Consumer Price Index, respectively.

The protocol’s mechanism works in a way that burns FRAX if the trade is above $1 and mints the token if it reduces below $1. The overall stability of the protocol is provided by the FXS governance and utility token, which has over 60% of its overall supply allocated to yield farmers and liquidity providers, and the FRAX stablecoin.

FRAX’s novel hybrid design enables access to highly decentralized and scalable algorithmic assets, which can, in fact, show extreme resistance to volatility in the crypto world.

MIM (Magic Internet Money)

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Magic Internet Money, or MIM, is Abracadabra.money platform’s stablecoin soft-pegged to US Dollar. MIM’s algorithm works by keeping its peg via arbitrage incentives within the ecosystem. In the case that a specific CDP (Collateralized Debt Position) exceeds its liquidation price, liquidators then borrow the CDP and sell it at a premium; however, should the coin trade below $1, it is purchased at a discounted price and used to pay off the debts at a cheaper price.

MIM is an ERC-20 token, backed by collateral, which lets the users of the Ethereum-based Abracadabra platform grow their collateral. When it comes to the loan liquidation processing mechanism, its ecosystem differs from MakerDAO by enabling unique prices for each CDP.

USDD (Decentralized USD)

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USDD is an overcollateralized decentralized stablecoin issued by the TRON DAO Reserve. The coin is pegged to the US Dollar and collateralized by several mainstream digital assets (such as BTC, USDT, and TRX). USDD’s monetary policy enables self-stabilization against volatility. The current collateral minimum ratio is set at 120%. What’s more, the USDD protocol strives to show full transparency, therefore all collateral assets are listed on the TRON DAO Reserve’s website.

N.B. Check out this GetBlock’s guide to learn how you can easily implement TRON blockchain nodes into your web3 product

Pros of algorithmic stablecoins

  • No regulatory entities are involved;
  • High-level decentralization;
  • No physical assets are needed, therefore the user error possibility is reduced;
  • Introduction of seigniorage in crypto;
  • Provides grounds for future development and innovations.

Cons of algorithmic stablecoins

  • Dependent on self-driven investors;
  • Investors could sometimes have malicious intent;
  • Uncertainty and misinformation could lead to decreased investor demand; therefore an algorithmic stablecoin could lose its value;
  • At this time, no algorithmic stablecoin has managed to maintain a stable peg status.

Final thoughts

The growth and further adoption of cryptocurrency have resulted in the emergence of new web3 technologies - a great example of which is algorithmic stablecoins. This type of coin not only brings advances for the DeFi industry but also opens up new doors for the entire web3 industry and makes it a step closer to achieving full decentralization. Crypto’s biggest concern regarding its volatile nature could potentially be solved with the help of algorithmic stablecoins, as the overview shows.

On the other hand, this is still a relatively novel term, therefore we highly advise doing your own thorough research before investing in any algorithmic stablecoin.

Vance Wood

Vance Wood

December 7, 2022

6 min read

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