Algorithmic Stablecoins – a New Crypto Trend

The ubiquitous USDT and USDC stablecoins seem to be facing more and more aggressive young challengers. So let’s take a look at the so-called algorithmic stablecoins, as well as stablecoins backed exclusively by cryptocurrencies, to try and understand the situation in the market.

The introduction of the Tron network’s USDD on May 5 was an event that put the spotlight on the entire algorithmic stablecoin branch. And if you have been paying attention lately, you must have noticed how they are all the rage in the cryptosphere.

In mid-April, algorithmic stablecoin Terra USD (UST) exceeded $17.53 billion capitalization, bypassing Binance USD (BUSD) to take third place in the stablecoin rating. And at the end of April, Near Protocol developers launched their own algorithmic stablecoin – USN – pegged to the US dollar and backed by the native NEAR token. It will be managed by the Decentral Bank DAO, with pegging provided by the reserve NEAR and USDT fund. The reserve size will be determined later.

The Cardano blockchain is the next one in line for its algorithmic stablecoin. Their enthusiasts have already developed a project called Djed, which operates as an autonomous bank. The idea is for an independent smart contract to support the token price by reselling the asset, using reserves, and charging a commission. The ultimate beneficiaries of the Djed turnover will be the holders of the “reserve coins”, who also bear the risk of cost fluctuations. However, the timeframe for the project’s launch is still unclear.

Frax Finance, an algorithmic stablecoin platform, has plans to buy billions of dollars worth of tokens to create a backup resource for their FRAX algorithmic token, project founder Sam Kazemian told reporters.

FRAX is backed by a Frax Shares project token (FXS) and a centralized stablecoin – USDC. The platform uses a fractional-reserve system, the parameters of which depend on the ratio of FXS liquidity to the total FRAX supply.

All that being said, some of you may still be wondering what algorithmic stablecoins actually are. Allow me to explain.

There are three types of stablecoins: those backed by fiat and other liquid assets (stocks, bonds, gold, etc.), those backed by cryptocurrency, and the algorithmic ones. Fiat-backed stablecoins (e.g., BUSD) are pegged to traditional currencies using fiat reserves and securities. Stablecoins supported by crypto, such as DAI, have to stack up excess coins and tokens, while the algorithmic ones control the supply without storing reserves. Still, unlike the very distinct first group, the line between the second and third is often difficult to draw.

Cryptocurrency-backed stablecoins are more similar to those reinforced by fiat. But since the crypto market is highly volatile, they usually require much larger reserves to protect against price fluctuations. The system is made more reliable with the use of smart contracts to create and burn coins.

Algorithmic stablecoins, on the other hand, try to avoid building up reserves. Instead, the issuance of tokens is controlled by algorithms and smart contracts that operate similarly to how central banks handle their monetary policy. Until recently, this model was much less common than the previous two because of how hard it is to manage.

The algorithm reduces the supply of tokens if their price falls below the value of the tracked fiat currency. It can be done through fixed staking, burning, or redemption. In turn, if the stablecoin price exceeds the fiat rate, new tokens get brought into circulation to lower it. The complexity of the algorithms that ensure the coin’s stability is what distinguishes this crypto industry branch.

At the moment, Tether (USDT) and USD Coin (USDC) are the most prevalent fiat and securities-backed stables on the market. With a firm grip on the top 10 rankings, their market capitalization has long exceeded $100 billion.

However, centralized stablecoins are subject to counterparty risk, as users are forced to trust the issuer’s words that their tokens are backed by reliable resources. In practice, such stablecoins may not be 100% secured by fiat – some issuers include bonds and other highly liquid (or not very liquid) securities in their reserves. The opacity of centralized stables contributes to potential misallocation.

Notably, companies that produce centralized stablecoins seem quite hostile towards algorithmic stablecoins. For example, Tether CTO Paolo Ardoino has recently claimed that the UST stablecoin is a threat to the cryptocurrency market because of its approach to collateral.

UST is backed by a smart contract that maintains the $1 price through arbitrage transactions with Terra coins (LUNA). Additionally, January marked the launch of the Luna Foundation Guard, whose assets are designed to increase the resilience of the UST. By mid-April, its volume had exceeded 42,500 BTC. According to Ardoino, a $5 billion or $10 billion stablecoin does not pose a major danger to the crypto industry, but the situation is changing as more coins enter circulation.

“If you have a liquidation [with an algorithmic stablecoin of UST’s size] with this market, you can still handle that. But imagine if you have an $80 [billion] or $100 billion market cap stablecoin like Tether that’s [primarily] backed by digital assets. It’s really hard to predict what will happen and [know] if there will be enough liquidity to backstop that immense cascade,” he stated.

Nevertheless, on April 18, UST bypassed BUSD, as the algorithmic stablecoin’s capitalization had grown from $180 million in early 2021 to $17.6 billion. Much of the demand for UST is generated by users of the decentralized Anchor protocol, which offers more than 19% annually on stablecoin deposits.

Keep in mind that an audit conducted in August 2021 showed that 49% of Tether’s own reserves were made up of commercial paper – short-term debt obligations, while the share of cash and bank deposits was only 10%. There was also evidence that part of their collateral included bonds from the bankrupt Chinese developer, the infamous Evergrande Group.

To sum up, we still have to answer an essential question: Which is more reliable – algorithmic stablecoins backed by crypto and sophisticated maintenance algorithms or traditional stablecoins with murky and somewhat unreliable backing of fiat money and securities with varying degrees of liquidity.