What is an Algorithmic Stablecoin?
Stablecoins are cryptocurrencies that retain a fixed price at all times. An algorithmic stablecoin is a type of stablecoin that is not pegged to external assets such as fiat, commodities, or cryptocurrencies.
In its stead, the stablecoin makes use of smart contracts and algorithms to maintain the fixed value of the stablecoin by maintaining supply and demand balance.
Algorithmic stablecoins prevent investors from the risk of getting exposed to the price volatility of the backing reserves. Nevertheless, this product contains problems such as de-pegging on account of technical exploits or the price of one of the stablecoins supported by the algorithm that underwent a considerable supply inflow or demand crunch.
In the case of Terra, the peg was broken on account of a bank run on UST coin issuer Anchor Protocol, where a massive amount of UST coins were staked.
Different Types of Algorithmic Stablecoin Models
Seigniorage Stablecoins
This type of stablecoin is based on seigniorage model where an issuer increases or decreases total coin supply based on market conditions.
Dual-Token System
The stablecoins based on the dual-token model issue two tokens. The first one balances price volatility by printing new tokens or sending them to burn addresses. The second coin, allow investors to vote and serve as governance token.
Rebase Model
Rebase is the method of assigning a base value or price for a given investment product to serve as a reference point. Rebase stablecoins fix a base supply count for the total token. In this manner, if the supply grows out of the base value when prices rise and vice versa.
Collateralized Debt Position-based Model
Collateralized debt position-based models allow investors to lock a given token as collateral and issue stablecoin against its value. The price of the stablecoin remains fixed based on the forces of over-collateralization and liquidation.
How does Algorithmic Stablecoins Work?
Algorithmic stablecoins depend heavily on smart contracts and programming. Conventional stablecoins are backed by other assets such as cryptocurrencies, commodities, and fiat currencies that serve as their peg.
However, algorithmic stablecoins use different types of programing and trading mechanisms to maintain the fixed value of the issued stablecoins. One such method is controlling the total supply of stablecoins in circulation.
For this, the algorithmic stablecoin has smart contracts that automatically control the total supply of stablecoins when it fluctuates from the target price. In case, the price of a unit stablecoin has started to increase above the target price, the smart contract will print more tokens to balance it and vice versa.
What is Collateralized Stablecoin?
A collateralized stablecoin is a token that is backed another asset class such as fiat currencies, commodities, and other cryptocurrencies. Therefore, this type of stablecoins is dependent on the value of external assets that are added to the underlying backing reserves.
Depending on the form of backing assets, Collateralized stablecoins can be classified into various types such as fiat-backed, crypto-backed, and commodity-backed etc.
Algorithmic Vs Collateralized Stablecoins
Evaluation Method
Collateralized stablecoins are backed by other assets such as fiat, commodities, and cryptocurrencies etc. In contrast, algorithmic stablecoins utilize smart contracts and programming to maintain the base value and supply of issued tokens.
Reliance
Algorithmic stablecoins are not dependent on external assets to retain their peg for the most part. However, collateralized stablecoins have a direct reliance on the reserves that are backing them to add value to their products.
Collateral Option
There is usually no or negligible collateralization when it comes to algorithmic stablecoins. In contrast, collateralized stablecoins utilize collateralization in the form of fiat currencies or other assets such as cryptocurrencies.
Decentralization
Algorithmic stablecoins are sufficiently decentralized on account of limited reliance on regulated asset classes. On the contrary, collateralized stablecoins maintain a certain degree of centralization.
Flexibility
Algorithmic stablecoins are often subjected to intraday price fluctuations on account of the dynamic forces of the market. Meanwhile, collateralized stablecoins have a fixed peg on account of strict reliance on external assets.
Conclusion
Algorithmic stablecoin offers various benefits such as fairing independently of conventional collateralization, more decentralization, and working as an international substitute. Meanwhile, investors also have to be aware of various risks associated with them such as frequent price changes and unpredictable behavior.
