algorithmic stablecoins

Cryptocurrencies are notorious for their wild price swings, making them impractical for everyday transactions. To address this issue, stablecoins and stable assets have emerged leveraging the benefits of cryptocurrencies—such as decentralisation, enhanced security, low transaction fees, and the elimination of intermediaries—while mitigating price volatility. Building on this, algorithmic stablecoins represent the next evolution in digital finance. 

Recently, stablecoins have come under increased scrutiny, partly due to the Lummis-Gillibrand Payment Stablecoin Act and Tether's record profit of over $4.52 billion in the first quarter of 2024. A May 2024 report by Visa and Allium Labs revealed that 90% of stablecoin transactions are conducted by bots, reigniting debate about their role and potential systemic risks.

Unlike stablecoins backed by external reserves, algorithmic stablecoins depend on mathematical formulas and protocols to adjust their supply and demand dynamically. This innovative approach aims to peg their value to benchmarks such as the US dollar without the need for physical reserves.

Algorithmic stablecoins, such as Frax (FRAX) and Ethena (USDe), represent a departure from traditional stablecoins. While stablecoin projects like Tether (USDT) and USD Coin (USDC) rely on fiat reserves or decentralised assets like ether (ETH) to maintain their pegs, algorithmic stablecoins take a different approach. They use on-chain algorithms to dynamically balance supply and demand with another cryptocurrency. 

Algorithmic stablecoins and collateralised stablecoins represent two distinct approaches to obtaining value stability.

Difference between algorithmic and collateralised stablecoins

Essentially, algorithmic stablecoins rely on algorithms for stability without collateral, offering scalability but with higher risks. On the other hand, collateralised stablecoins are backed by reserves, providing stability, but requiring careful management and compliance with regulations.

how do they work?

Algorithmic stablecoins achieve stability by maintaining a peg to an external asset, such as a fiat currency. Take MakerDAO's Dai as an example. Dai, an Ethereum-based stablecoin, is backed by a diversified portfolio of crypto assets held as collateral in smart contracts. Users lock up their crypto assets and generate Dai against this collateral. 

The system maintains Dai's value through a complex mechanism involving decentralised governance and automated adjustments. If Dai's price fluctuates, the system encourages users to take actions that restore its peg through incentives. While this model has proven successful, it's not without risks. 

The over-reliance on volatile crypto assets as collateral can leave the system vulnerable to sharp market downturns, as seen with Terra's Luna and UST, where collapsing collateral values led to a complete system failure.

Algorithmic stablecoins come in various types, each employing unique mechanisms to maintain their value relative to a target asset, like the US dollar:

> Rebasing Stablecoins: (Example: Ampleforth - $AMPL)

• These stablecoins have an elastic supply that adjusts automatically based on market conditions

• If the coin's price is above its peg, the total supply increases, diluting each holder's share and bringing the price down towards the peg

• Conversely, if the price falls below the peg, the supply contracts, increasing the value of each remaining coin and pushing the price back up

• This mechanism directly influences supply according to demand fluctuations, ensuring price stability

> Seigniorage Stablecoins: (Example: Basis Cash - $BAC)

• Operating on a two-token model, with the primary stablecoin and a secondary token, often called shares or bonds

• During expansion phases, when the stablecoin's price is above its peg, new stablecoins are minted and distributed to holders of the secondary token, providing them with seigniorage profit

• During contraction phases, when the price is below the peg, the protocol sells the secondary tokens at a discount, reducing the stablecoin's supply and pushing its price back up

• This model borrows from traditional finance and adjusts the stablecoin's supply through the issuance and redemption of secondary tokens

> Fractional-Algorithmic Stablecoins: (Example: FRAX)

• These stablecoins combine features of collateral-backed and algorithmic stablecoins

• They maintain a fractional reserve of collateral, such as other cryptocurrencies or fiat, and use algorithms to manage the remaining supply

• This approach provides a buffer against market volatility while benefiting from the automated adjustments typical of algorithmic mechanisms. FRAX, for instance, uses a partial collateral protocol to ensure stability, enhancing capital efficiency by reducing the need for full collateralisation.

> Synthetic Stablecoins: (Example: USDe)

• These stablecoins are minted by pledging assets, meaning users lock up their existing assets to generate the stablecoin.

• This approach eliminates the need for external reserves and relies on the value of the pledged assets to maintain the stablecoin's peg.

The evolution of algorithmic stablecoins has been marked by experimentation, iteration, and occasional controversy. They emerged in the early days of cryptocurrencies to tackle volatility. BitShares, launched in 2014, pioneered this idea using a DAO model. In 2017, MakerDAO introduced Dai, which was pegged to the US dollar and backed by collateralized debt positions (CDPs). However, problems emerged, notably the risk of under-collateralisation. Projects like Ampleforth and Frax have since diversified approaches, introducing elastic supply models and hybrid mechanisms. 

Algorithmic stablecoins have undergone several iterations, with early attempts often failing to maintain stability. For instance, Basis Cash (BAC), launched in December 2020, struggled to maintain its peg to the US dollar and eventually collapsed. Similarly, Empty Set Dollar (ESD) reached a peak market cap of $560 million before crashing within a month. Iron Finance introduced IRON in June 2021, but experienced a "death spiral" due to panic selling and insufficient collateral reserves.

Arguably, however, none of these were as catastrophic as Terra's UST loss of its peg in May 2022, resulting in billions of dollars in losses. Before 2022, algorithmic stablecoins were relatively unknown in the cryptocurrency world. However, the high-profile collapse of the UST currency and its parent ecosystem, Terra, brought algorithmic stablecoins into the spotlight for all the wrong reasons. The crash of LUNA, now known as Luna Classic (LUNC), resulted in a dramatic loss of value. On May 7th, it was valued at $73.89, but now it's nearly worthless at just $0.000123. This decline occurred alongside the depreciation of UST, causing significant losses for both coins. The implosion of Terra Luna left many industry insiders pondering the future of algorithmic stablecoins.

Despite these setbacks, RAI by Reflexer Labs, launched in February 2021, has offered a more successful iteration. Unlike other stablecoins, RAI does not peg to an external reference, instead using an algorithmic controller to adjust the redemption rate for price stability with minimal governance.

Despite challenges, algorithmic stablecoins continue to evolve, driven by innovation and the quest for stability in the crypto space. With this evolution, new proposals emerged to address challenges and enhance stability mechanisms. One notable example is the Ethena protocol, poised to transform this landscape. Let's explore the Ethena proposal's innovative approach and its implications for the future of algorithmic stablecoins.

the Ethena proposal

The Ethena protocol, introduced by prominent cryptocurrency figure Arthur Hayes, aims to redefine the landscape of algorithmic stablecoins. Hayes, an investor in the project, envisioned Ethena as a solution to enhance stability and scalability within the decentralised finance (DeFi) space, setting it apart from traditional financial frameworks. 

Central to Ethena is the introduction of USDe, a synthetic dollar minted by pledging assets. This means that users can mint USDe by locking up their existing assets, providing a mechanism for generating the stablecoin without relying on external reserves. 

Ethena, under the guidance of its founder, has implemented advanced strategies to counteract volatility, such as shorting Ethereum (ETH), which involves betting on a decline in the price of Ethereum, thereby creating a hedge against market fluctuations. This is achieved through features like Over-the-Counter Escrow (OES). OES allows for secure and transparent transactions outside of traditional exchange platforms, reducing counterparty risk and enhancing the overall security of the protocol. 

Hayes envisions Ethena as a leader in the DeFi space, merging algorithmic stability with robust risk management. The implementation of Ethena, overseen by its founder, reflects a careful design process, offering a promising solution for stable and scalable DeFi ecosystems.

The debate about stablecoins is featured by compelling arguments on both sides. Critics cite the Tether incident of 2022, which raised concerns about centralised stablecoin issuers’ claims of full collateralisation. Centralised stablecoins are also vulnerable to regulatory interference, potentially making them worthless if a government decides to freeze their bank accounts. Algorithmic stablecoins, designed to be decentralised, are seen as inherently fragile, relying on consistent demand, independent arbitrage, and reliable price information—factors difficult to control often leading to catastrophic losses. Thus, strong regulatory frameworks with risk disclosures are deemed essential for their safe deployment.

On the other hand, proponents argue that algorithmic stablecoins, being decentralised and independent of fiat reserves, can avoid regulatory crackdowns, aligning with the vision of a decentralised global financial system. The stablecoin market itself is expanding, with around 27.5 million active users and rising human  transaction volumes underscoring positive sentiment. Traditional finance firms are embracing stablecoins, as evidenced by PayPal's stablecoin launch, Stripe's partnership with Circle, and Visa's tokenized payments. The Visa report indicating a 90/10 split of bot-driven versus human transactions has sparked debate with critics arguing it overlooks the significant role of high-frequency and institutional trading. 

Despite these critiques, the market's organic growth and adoption by major financial entities highlight the ongoing relevance and potential of stablecoins in the evolving financial landscape.The future of stablecoins appears promising as the cryptocurrency sector matures, with anticipated regulatory clarity expected to boost trust and stability. Technological advancements will further enhance algorithmic stablecoins by improving their algorithms and supply mechanisms, ensuring greater reliability. As a result, stablecoins will continue to play a crucial role in lending, borrowing, and liquidity provision within DeFi.

New Bill in U.S. mandates 1-to-1 reserves for stablecoin issuers, involves state and federal regulators in oversight, limits state non-depository trust companies to issue payment stablecoins up to $10 billion, and restricts stablecoin issuance to those backed by the U.S. Dollar and approved by US regulators, preventing algorithmic stablecoins.

Despite regulatory uncertainty, cash-generating stablecoins compete for trillions in money-market funds and dollar deposits globally. PayPal sees stablecoins as potentially reducing internet payment costs, separating payment capability from money-market fund yields.

Nomura Holdings and GMO Group Partner to Issue Yen and Dollar Stablecoins in Japan, with a focus on regulatory compliance and stablecoins-as-a-service. Nomura's CEO Kentaro Okuda emphasises stablecoins' importance in financial markets.

Top DeFi Tweets

@zGuz discusses the rapid growth of Ethena's USDe stablecoin: In just four months, USDe has reached a $3 billion market cap. The tweet also highlights the 33% yield offered by USDe, emphasising that USDe is backed by Bitcoin and Ethereum futures positions rather than another floating token. The potential risks associated with USDe's yield and its reliance on the derivatives market are also discussed.

@DeFi_Made_Here questions the use case of FRAX stablecoin: The tweet points out the significant drop in FRAX's market cap from $3 billion to $394 million and questions the coin's utility. It raises the issue of whether FRAX's primary use case was simply to mint $1 with $0.80 if users had a pre-allocation of FXS tokens.

@MHiesboeck announces Uphold's decision to end support for USDT, DAI, FRAX, and other stablecoins: This decision is attributed to the upcoming Markets in Crypto-Assets (MiCA) regulations in Europe. The tweet suggests that Uphold is prioritising regulatory compliance by delisting these stablecoins.

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