Even if you are familiar with Cryptocurrency, you might not know what are Algorithmic Stablecoins. In this article, we will explain Algorithmic Stablecoins. Stablecoins often eschew the major price surges and crashes we see in most other cryptocurrencies. After all, that's what they exist for. However, there is one exception to this rule, and that is algorithmic stablecoins.
What Are Algorithmic Stablecoins?
Stablecoins are cryptocurrencies designed to hold a certain value relative to other things; usually fiat currencies such as the US dollar. Because stablecoins are tied to an expected and stable value, investors or traders often use them to stay in the crypto market while protecting themselves from market price fluctuations.
Stablecoins facilitate transactions on crypto exchanges, including staking and lending activities on crypto networks. Additionally, stablecoins can be used to reduce transaction fees on most exchanges, as no fees are charged when converting USD to stablecoins.
As the name suggests, this stablecoin uses an algorithm to maintain a consistent value. These algorithms typically link two coins and then adjust their prices based on supply and demand from investors. While algorithmic stablecoins are tied to the value of real-world assets, they are not backed by anything.
Algorithmic stablecoins are different. Algorithmic stablecoins, in their purest form, are completely uncollateralized. Their value is not backed by any external assets. Instead, they use algorithms for specific instructions or rules (usually by a computer) to follow to output some result. These algorithms are optimized to incentivize the behavior of market participants and/or manipulate circulating supply, so the price of any given coin should theoretically stabilize around the peg.
How do algorithmic stablecoins work?
Algorithmic stablecoins stabilize the market through a mechanism for buying and selling a reference asset or its derivatives. It uses an Ethereum-based cryptocurrency protocol to issue coins when prices spike and buy from the market when prices drop.
A “dual coin” system is a typical algorithmic stablecoin structure, where one coin is used to “absorb” market volatility, while the other coin strives to stay pegged. Often referred to as a balancer or shared token, this pre-token is often traded on secondary decentralized exchanges (DeX) such as Uniswap (UNI). At first, Terra relied solely on this dual-coin arrangement but more recently has used Bitcoin (BTC) reserves as the backing for its mathematical approach.
An oracle contract is required to help smart contracts communicate outside the blockchain. This oracle contract helps to obtain the price of algorithmic stablecoins from different exchanges. This stablecoin price is then passed periodically (every 24 hours) to a rebase contract so that the contract can determine if the supply needs to be increased or decreased. The contract then begins to calculate the number of tokens that need to be burned and minted from each user's wallet associated with the contract. The basic logic used is that if the price of the coin rises from a predefined stable value, the algorithm will start destroying the coin. Conversely, the algorithm will mint new tokens if the price of the token falls below a predefined stable value.
Now I hope you will now know what are Algorithmic stablecoins and how do they work. While the idea of algorithmic stablecoins certainly seems to have some merit, there are still many factors that could easily affect their value and cause huge economic losses. Therefore, before investing in any stablecoin, be sure to check if it is algorithmic to understand what you are investing your money in.
