Algorithmic stablecoins were a fantasy relegated to academic papers as recently as 2017. However, it’s 2021 and a few cryptocurrencies have used the algorithmic stablecoin model as a basis for how their cryptocurrency functions.
This article will cover how these algorithmic stablecoins function and how the impact they might have on the future dollar.
What Are Algorithmic Stablecoins?
In simple terms, algorithmic stablecoins are a type of stablecoin that relies on an algorithm to maintain a peg to a fiat currency. As mentioned previously, this type of stablecoin was theorized in academic papers in 2017.
The basics work like this:
The supply of the stablecoin will expand or shrink to ensure that the value of the coin stays at the peg, which is usually $1. The important part to note is that an algorithmic stablecoin is not backed by anything nor is it redeemable.
The peg is solely controlled by an increasing or decreasing the circulating supply of the stablecoin.
It’s an interesting model. And it does have a few more differences compared to other stablecoins than just that.
How Are Algorithmic Stablecoins Different Than Other Stablecoins?
This section will cover the other types of stablecoins and explain how they are different from algorithmic stablecoins. We will also cover some of the disadvantages of these other stablecoins.
Fiat Backed Stablecoins
The most popular type of stablecoin is the fairly standard fiat currency backed stablecoin. This type of stablecoin is the simplest to understand.
Basically, a centralized authority holds fiat currency and then issues stablecoins in a 1:1 ratio. The stablecoins are redeemable 1:1 with the fiat currency the central authority holds in reserves.
Of course, this has some pretty obvious problems. The biggest, glaring problem is that a centralized authority must maintain a reserve of fiat currency. And this becomes a problem because the centralized authority does not have to face any legal scrutiny about the reserves they claim to hold.
A notable example of the shortfalls of fiat backed stablecoins is Tether. Many in the cryptocurrency community allege that Tether does not maintain a 1:1 backing of Tether coin. Instead, the detractors allege that Tether simply mints Tether coin without holding nearly enough in reserves to cover the circulating supply.
This seems reasonable when you realize that Tether has never been audited. If it is in fact true that Tether is not 1:1 backed, then Tether has essentially created a fractional reserve cryptocurrency.
Despite that problem, fiat-backed stablecoins are the best type of stablecoin. The only problem is that the holder of the stablecoin must trust that the centralized authority does maintain all the fiat in reserve. A centralized authority also means that certain users can get locked out from exchanging their stablecoin for fiat currency.
Multi-Asset Collateralized Stablecoins
Multi-asset collateralized stablecoins were created in response to the centralization problem that plagues fiat backed stablecoins. A multi-asset collateralized stablecoins works by holding a large amount of different cryptocurrency in a public vault controlled by a smart contract.
The coins are minted only if a peg can be maintained from the vault. Everyone can see the contents of the vault. Users can also deposit funds into the vault to provide some liquidity to the stablecoin.
The most popular multi-asset collateralized stablecoin is MakerDAO.
This type of stablecoin sounds great in theory – it’s decentralized, public, and controlled by a smart contract. But it does have the downside of relying on extremely volatile cryptocurrencies as collateral.
In other words, these stablecoins are extremely susceptible to rapid price swings in the price of cryptocurrency. A massive increase or decrease can shock the value of the stablecoin. Granted, the price always returns to an equilibrium because arbitrage bots will scalp the coin to make money, but it can be risky to hold these stablecoins when cryptocurrency has one of those 30% gain or 30% loss days.
The Algorithmic Stablecoins
We briefly explained algorithmic stablecoins and talked about some of the shortfalls of other types of stablecoins. In this section we will discuss some of the different algorithmic stablecoins.
Ampleforth is the simplest algorithmic stablecoin in existence. It’s also the easiest stablecoin to understand.
It works by expanding the supply to lower the price to $1 or cutting the supply to raise the price to $1. This is possible because Ampleforth is held in an Ampleforth wallet, which will automatically adjust the supply every 8 hours.
For instance, if you have 100 Ampleforth tokens and the supply is increased by 10% to lower the price to $1, then you will have 110 Ampleforth in your wallet. You will also earn a 10% profit because you have 10 new tokens worth $1 each.
It’s an extremely simple system. The drawback, of course, is that the supply can get a little unstable if the price adjusts too much.
The other, bigger problem is that the value of the coin is not really backed by anything. It’s simply based on market sentiment and then adjusted a small amount to ensure it stays at $1.
In other words, it relies on market sentiment to ensure the proper price peg. It has worked well so far, but if the value of the coin crashes, then it’s unlikely that it will ever recover because of this system.
Despite this, Ampleforth is the most popular algorithmic stablecoin. The popularity of Ampleforth is likely due to the simplicity of the algorithm – it’s just so easy to understand for most people. And it does a decent job at maintaining the desired peg.
Basis Cash is an algorithmic stablecoin that uses a multi-coin strategy to maintain a peg. The two coins in the case of Basis Cash are BAC for normal trading, Basis Cash Shares that allow a user to cash in on inflation when the supply expands, and Basis Cash Bonds that are sold at a discount when the market shrinks and then redeemable when the market stops shrinking.
Now, Basis Cash is interesting because it operates in a manner somewhat similar to regular fiat currency with bonds. Users like it because the supply in their wallet is not impacted when the currency rebases.
However, the downside is that the price of multi-coin stablecoins like Basis Cash are more difficult to control than something like Ampleforth where the total circulating supply itself can be controlled.
Empty Set Dollar (ESD)
Empty Set Dollar (ESD) is a hybrid between Ampleforth and Basis Cash. It has a bond structure that works by burning ESD when a bond is purchased, which reduces supply. The bond is then redeemable after the supply has been reduced to a suitable amount.
The difference is that ESD does not have any inflationary token. Instead, it relies on users staking ESD into a decentralized autonomous organization (DAO). The shares of the expansion are then dispersed during the expansion.
ESD has undergone a few supply adjustments, so it does have some proof of concept to it. It’s not a purely academic stablecoin.
In our opinion, ESD is the best algorithmic stablecoin. It combines the benefits of the multi-coin algorithm with the benefits of a purely algorithmic stablecoin. The DAO dispersing shares during inflationary periods is a great strategy because it matches the reward to those that take a little more risk with the coin.
The Problem With Bitcoin as Currency
We have covered algorithmic stablecoins, but it still leaves a question.
Why can’t Bitcoin be used as a currency?
The answer is a little complicated, but the basics are that Bitcoin is deflationary. This makes it a great store of value because the price goes up if the demand stays flat or increases.
However, a deflationary currency is generally terrible because it is used for holding more than spending. This is why fiat currencies work great for an economy that relies on consumption – people would rather spend a fiat currency now than hold it and watch the value of it decrease to nothing.
The other problem with Bitcoin as a currency is that the price is far too volatile. It simply does not make sense to use something as a currency when the value can change by over 30% in a single day.
That’s just too risky for people to handle for the day-to-day use of a currency.
The Future Dollar – Algorithmic Stablecoin?
Idealists have proposed that the future dollar could rely on some type of algorithmic stablecoin model. It likely would not be Ampleforth, but some form of multi-coin stablecoin algorithm.
This would be a truly great system because the price of the currency would remain stable with little to no inflation because of the large amount of people using the stablecoin.
There is one major problem with a future dollar relying on an algorithmic stablecoin algorithm – the current fractional reserve system is so corrupt that it’s unlikely any change will occur to a fair system.
It’s a sad reality, but that’s simply how the world operates. It would be extremely beneficial if an algorithmic stablecoin algorithm was used as the standard currency, but it seems so unlikely that it’s barely worth considering.
There is something worth considering about algorithmic stablecoins, though.
Will Algorithmic Stablecoins Overtake Centralized Stablecoins?
Algorithmic stablecoins will likely not overtake standard fiat currency anytime soon. However, these algorithmic stablecoins could one day overtake the centralized stablecoins like Tether.
This is especially true if one of the centralized stablecoins, most likely Tether, were to be shut down by the government or regulators.
The shutdown of a centralized stablecoin seems probable at some point in the future because, well, centralized stablecoins are never audited. And that makes it much more likely that some type of fraud is occurring.
With that in mind, we expect algorithmic stablecoins to gain popularity in the short term, medium term, and long term future. It’s reasonable to think that an algorithmic stablecoin like Ampleforth or ESD could become the de facto stablecoin of cryptocurrency similar to Tether.
That covers it for the different algorithmic stablecoins and the impact they will have on the future of cryptocurrency. It’s our opinion that these algorithmic stablecoins will only grow in popularity as the trust in centralized stablecoins slowly erodes.
This makes it a good time to invest in these stablecoins. Remember, your holdings in some of these algorithmic stablecoins will literally inflate as demand for these stablecoins increases.