What are algorithmic stablecoins, their different types and how they work? Scroll down to find out more
Stablecoins were designed to protect investors from the volatile nature of cryptocurrencies. These coins are usually pegged 1:1 with a fiat currency, such as the US Dollar, to ensure price stability. There are also different kinds of stablecoins, each using different techniques to maintain its peg with the currency it tracks.
Over the last week, there has been a lot of talk about algorithmic stablecoins. An amalgamation of technology, mathematics and monetary economics, algorithmic stablecoins represented everything the modern DeFi world stands for, i.e., experimentation, innovation, efficiency, etc.
However, all that has changed after the crash of TerraUSD (UST), the largest algorithmic stablecoin by market cap. After briefly losing its peg with the US Dollar, UST began to tumble wildly and is currently trading at $0.12, per data from CoinMarketCap. The crash also sent the entire Terra ecosystem on a massive downward spiral, casting doubts on the efficacy of algorithmic stablecoins and their future in the cryptocurrency industry.
But what are algorithmic stablecoins, and how are they different from their counterparts? Let's find out!
What are algorithmic stablecoins, and how are they different?
Most stablecoins maintain a 1:1 peg with the currency they track through a collateralised mechanism. The stablecoins in circulation are backed by cash or other assets to support the stablecoin's valuation. For instance, Tether (USDT), the largest stablecoin by market cap, is collateralised by off-chain assets like cash (USD) and cash-equivalent bonds stored in a bank or other centralised entity.
However, it is not always feasible to follow this approach as protocols need to keep adding to their collateral stockpile as the circulation of the stablecoin increases. This is where algorithmic stablecoins enter the picture.
Algorithmic stablecoins function a bit differently. They usually do not have any collateral backing and instead use complex algorithms to maintain their peg with the fiat currency they track. These algorithms can also incentivise and manipulate investor behaviour to stabilise the coin's price around the peg.
Types of algorithmic stablecoins and how they work
There are two types of algorithmic stablecoins — rebase and seigniorage. Rebase stablecoins manipulate the supply of a stablecoin to maintain its peg with fiat currencies. The protocol mints (adds) or burns (removes) coins in line with the price movement of the stablecoin to keep its valuation stable. If the price of the stablecoins slips below $1, coins are removed from circulation and vice-versa.
Seigniorage stablecoins work similarly. However, they also pair the stablecoin with other cryptocurrencies to have more control over its valuation. Along with a mint and burn mechanism, the protocol also offers incentives to market participants to buy/sell the paired cryptocurrencies to maintain the price of the stablecoin.
TerraUSD is a prime example of a seigniorage stablecoin. It uses Terra's native cryptocurrency, LUNA, to maintain its valuation with the USD. However, this innovative pegging approach also led to its downfall.
What happened to the TerraUSD algorithmic stablecoin?
The LUNA-UST pair works in a pretty straightforward manner. Users can exchange 1 UST for $1 of Luna and the other way around. When $1 of LUNA is swapped for 1 UST, LUNA is burned, and UST is minted. It's the other way around when 1 UST is swapped for $1 of LUNA. This works fine when UST's valuation is stable and in line with the US Dollar.
However, when the price of UST drops, market participants may start swapping it for LUNA to earn a quick profit. In the process, the circulating supply of LUNA skyrockets, resulting in a price drop. For instance, if the UST falls to $0.5, users can purchase 20 UST for $10. They can then swap their 20 UST for $20 of LUNA and sell it in the open market, resulting in a quick 100 percent profit.
This is what happened to the Terra ecosystem. On 8 May 2022, a whale dumped nearly $193 million worth of UST. This resulted in a brief de-peg wherein UST slipped to $0.98. While UST showed signs of recovering from the de-peg, fear and panic had already set in, resulting in a massive LUNA sell-off.
LUNA dropped from $87 on May 5 to $0.00018 at the time of writing. UST has also failed to regain its peg and is currently languishing at $0.14.
The future of algorithmic stablecoins
Until now, algorithmic stablecoins have been used extensively in liquidity pools and speculative arbitrage trading. However, with the recent Terra crash, the future looks bleak. Moreover, regulations could come down hard on these stablecoins, with lawmakers keeping a close eye on developments in the industry.
In fact, the Terra case has already been presented by the US Treasury secretary Janet Yellen in a hearing that called for stablecoin legislation. During the hearing, Yellen noted that UST is a "growing product and there are rapidly growing risks". She added that "it is important, even urgent" that Congress pass stablecoin legislation by the end of this year.