What is the reason that Stablecoin Algorithm was born?

As we all know, traditional Stablecoins will be collateralized with tangible assets at a ratio of 1:1 and will usually be USD. It means that conventional stablecoins are potentially at risk from the adverse effects of the US dollar if the market crashes. And to avoid that, Algorithmic Stablecoins was born to reduce this risk.

What Are Algorithmic Stablecoins?

There are currently three main types of algorithmic stablecoins: Rebase algorithmic stablecoins, Seignorage algorithmic stablecoins, and Fractional-algorithmic stablecoins.

Algorithmic Stablecoins that are minted without any backed reserve keep the price stable by algorithms to adjust the circulating supply: UST, BAS, … constantly.

• Rebase algorithmic stablecoins: Control the supply of a coin to maintain its value. (AMLP)
• Seignorage algorithmic stablecoins: Use a burn-mint multi-coin mechanism by minting or burning one coin to balance the value of the other. (UST/Luna; USDD/Tron; USN/Near)
• Fractional-algorithmic stablecoins: Are partly collateralized, meaning a real-world asset somewhat backs them. (DAI, FRAX)

How it works (Seignorage algorithmic stablecoins)

The Stablecoin Algorithm uses price adjustment algorithms to maintain a pegged level in the value of any fiat currency, usually the US dollar.

Different from traditional Stablecoin (Collateralized with tangible assets at a 1:1 ratio). Algorithmic Stablecoins are usually collateralized with a cryptocurrency, and Algorithmic Stablecoins are minted; in this way, the two coins are linked together, creating a mining or burning mechanism depending on the needs of the market to maintain a peg.

Example: A famous coin pair that everyone knows is UST and LUNA. The algorithm works the mechanism of the pair; if UST prices exceed $1, the algorithm will burn Luna and mint more USTs to balance supply and demand. This will make Luna rare and can increase in value, and UST will more is minted to serve the existing demand, thereby bringing the price of UST back to $1.

Conversely, if the UST loses the peg and the price drops below $1. UST will be burned, and more Luna will be minted. At this time, Luna’s supply will increase, leading to its price decrease if the quantity demanded is less than the supply. The supply of UST will decrease, creating scarcity and bringing the price of UST back to $1.

In fact, all users can participate in this process.

Suppose: The price of UST on the Binance exchange is $0.9.

• Users can buy UST for cheap $0.9 at Binance.
• Bring it to Terra Station and swap UST with Luna at the rate (UST = $1).
• Sell the Luna you just swapped and gain a profit of $0.1

Risk of Algorithmic Stablecoin

The biggest disadvantage of Algorithmic Stablecoin also comes from the reason it was born.

Algorithmic stablecoin does not have any collateral with real assets.

Is its stability really stable?

Depends on the demand of users to maintain the price, but in fact, many ecosystems still want to create their own Algorithmic Stablecoins to complete the Ecosystem and provide more value to the users. But the demand for a certain coin in the Crypto market is always changing rapidly and drastically, which can cause the supply or demand for a certain coin to fluctuate sharply, especially with algorithmic stablecoins. If the demand is high, everyone is happy, and nothing will happen, but on the contrary, if the demand drops suddenly, the consequences of the collapse are inevitable.

The collapse of unsustainable algorithmic stablecoin models can be across-the-board. We have seen the collapse of the recent UST/Luna model as an example. The collapse of UST led to the fall of Luna, and the fall of Luna take a hand to the crash of Bitcoin and the entire market.

The future of algorithmic stablecoins

After the collapse of UST/Luna and USDD lost the $1 peg last month and so far has not been able to regain $1. The future of Stablecoins currently remains a big question mark.

It can be said that DAI is currently the most stable algorithmic Stablecoin in the market based on collateral in USDC and USDT. But if so, will algorithmic stablecoins really escape the control of real assets (USD)?

If you want to know more about the DeFi world, let’s take a look at our DeFi 101 Series.

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