By Nathan Ferguson
The cryptocurrency market has been facing the issue of volatility for quite some time now, as price valuations can fluctuate, going back and forth, however one variation of cryptocurrency by the name of stablecoin that exists to ease out the pressure for those individuals who are not looking to take on the volatile nature of standard cryptocurrencies when trading in the crypto space.
The reason to why stablecoins are not subject to such levels of volatility is because they are meant to get associated with traditional currencies such as the United States Dollar (USD). For the stablecoins that are associated with USD, their price valuations must sit at a constant $1 and must maintain this valuation.
The level of maintenance of this price valuation is different for every type of stablecoin. For instance, looking at the stablecoins tether (USDT) and Circle (USDC), their collateralization levels have over flown because of their superior reserves.
This basically means that hard cash or an equal amount of assets are present inside of their reserves. Furthermore, every single stablecoin that is moved around in the space has the support of the reserves that the stablecoin providers carry.
An example can be taken such as the MakerDAO stablecoin called DAI, which is decentralized in nature, however their collateral levels are also over the roof, mostly supported by the Ethereum assets which are deployed with smart contracts.
Now that we have understood the basics surrounding stablecoins, we will now move towards getting to know about the concept of algorithmic stablecoins are how they differ from regular stablecoins.
About Algorithmic Stablecoins
With the passage of time, stablecoins have evolved into a unique variation known as the algorithmic stablecoins that are separated from their method of collateralization. There are many examples of algorithmic stablecoins that include the terraUSD (UST), magic internet money (MIM), Frax (FRAX) and many others more.
The term algorithmic is seen as complicated to many, however the meaning to it is quite trivial, as it basically refers to a collection of code that is used to guide a certain process. Regarding the concept of cryptocurrencies, algorithm is generally referred to as the collection of code that is present in the blockchain using the likes of smart contracts.
To better understand this, we can take the example of the latest algorithms that are used to power social media platforms like Instagram by META. The algorithms utilize user platform usage data to suggest posts and advertisements that are relevant or are of interest to different users around the world, which lets companies and businesses to target specific user bases.
Working of Algorithmic Stablecoins
To work as intended, algorithmic stablecoins need continuous demand support, but the important thing to keep in mind is that the complete system will result in failure if the demand is unable to maintain to a particular degree.
As mentioned previously, the difference between normal stablecoins and algorithmic stablecoins is that while normal stablecoins are supported by cash or asset reserves, algorithmic stablecoins ae supported through an on-chain algorithm which handles the fluctuation in supply and need of the stablecoin and the asset that is associated with it. The algorithm’s job is to manage the connection of the two tokens.
In terms of collateralization, algorithmic stablecoins have a much lower level compared to standard stablecoins, because they are not supported by any assets present inside of their reserves which would help to support the price valuation.
Algorithmic stablecoins are dependent upon the unfettered entities that help to manage the stabilization of the price valuation that will enable them to grab market benefits. However, this dependance with the abundance of any legal functions is seen to be a risk.
Looking at the example of Terra, currently known to be one the most popular algorithmic stablecoin providers, the connection is stablished between the stablecoin UST and Terra’s own native currency known as terra (LUNA). For future referencing in this article, we will recognize terra (LUNA) as just LUNA.
With that out of the way, we must also investigate the concept of de-pegging. A stablecoin de-pegging means that it is straying away from the price valuation of $1. In order to stop this from happening, the algorithms analyze the market and control the level of supply and demand. If the level of demand exceeds the level of supply, then it means that the price valuation of the stablecoin will rise.
Subsequently, if the level of supply exceeds the level of demand, then it leads to a downfall in the price valuation, so the algorithm must work in such a way that it creates a sort of balance between the two aspects.
Variations of Algorithmic Stablecoins
For algorithmic stablecoins, there are basically three variations that we need to look at.
- Rebasing Algorithmic Stablecoins
These types of stablecoins are responsible for taking care of ERC-20 tokens, meaning that the complete supply levels of the stablecoin are not static and are changed according to regular updates. But the thing here to see is that the changes taken are done autonomously by utilizing the process of rebasing, that helps in keeping the price valuation of a stablecoin to be in line with $1.
An example for this is the Ampleforth protocol, which possesses the ability of rebasing, which fluctuates the supply levels, meaning that weighted average regarding to token valuation will be responsible for the AMPL tokens that are stored by the user. The time frame regarding the weighted average is roughly around one day.
- Seigniorage Algorithmic Stablecoins
This concept involves the Seigniorage sharing model in which a pair of cryptocurrencies, with one being the stablecoin and the other being the dividends. If the valuation of the stablecoin crosses the $1 threshold, the dividends are used to stimulate a gain in the supply.
Another thing about this type is that if the valuation manages to drop down from the threshold, bonds are provided to the ones who purchased as a benefit and that bond can also be redeemed.
A good example to look at is Basis Cash, which utilizes the concept of Seigniorage algorithmic stablecoin and is powered by three separate cryptocurrencies that include the BAC stablecoin, the BAS which means Basis Shares and BAB which is known as the Basis Bond.
- Fractional Algorithmic Stablecoins
This concept involves fusing the powers of both complete algorithmic stablecoins and stablecoins that have achieved complete collateralization. The benefit of using such type of stablecoins is that the level of collateral remains intact and reduces the number of overall risks.
Its main job is to make sure that the peg is solid, while also being quite stable. The example for this is the Frax stablecoin which utilizes this concept, keeping the collateral levels intact and involves a basis for a pair of tokens.
Advantages surrounding Algorithmic Stablecoins
The advantage of using algorithmic stablecoins is that they lack the supervision of any regulatory authorities that look to keep track of user activity and because the code is the thing that is responsible for handling the regulations of the entire system, there is a huge level of decentralization that is achieved, which is seen as a fully win-win situation.
Alongside that, there is also an abundance of tangible asset needs which helps to reduce any risks or errors coming in from the user base.
Additionally, because algorithmic stablecoins also brought back the concept of seigniorage inside the crypto space, it helps to analyze financial aspects that are associated with the development of certain currencies.
Disadvantages surrounding Algorithmic Stablecoins
Wherever there is good, there is also bad. Disadvantages involved with algorithmic stablecoins include a fragile level of overall architecture. Stablecoins that rely on algorithms to maintain their level of pegging are seen is very unstable and always carry the huge risk of de-pegging. In addition to that, there are three main drawbacks of algorithmic stablecoins that need to be discussed separately.
Firstly, in order to function that way, they are intended to be, stablecoins must have an established level of demand, because in the case of the level of demand not meeting the expectations, the entire system has a risk of falling under its own set of legs.
Furthermore, another issue with algorithmic stablecoins is the previously mentioned reliance on unfettered entities, which gives rise to making the stablecoin algorithm susceptible to being a medium of gaining profits for those individuals.
And lastly comes the risk of the stablecoin losing its valuation in the situation of a financial crisis. This happens mostly because the traders work using vague pieces of information and several uncertainties. This can also contribute towards the development of massive selling campaigns which can result in the immediate falling of the price valuation of the stablecoin.
Now that those have been discussed, we will now take a deeper dive into the case of UST and LUNA and what was the famous incident that involved the two assets to experience massive chaos back in the month of May this year.
UST and its relationship with Luna and the US Dollar
As mentioned in the above section, the TerraUSD (UST) stablecoin was keeping in line with USD through an algorithmic connection with LUNA, which is known as the native currency of Terra. At the backend side of things, this connection brings forth a sort of arbitrage chance that comes up when the peg fluctuates.
If the level of supply for UST was short and the level of demand raised, the valuation of UST crossed more than a dollar. In order to restabilize this situation and bring the peg back, the Terra protocol allowed its user base to performing trading by exchanging one USD worth of LUNA for one UST via a platform.
This leads users to gain a small profit of a single cent with every UST sold. The cent value might not be seen as much, however as the number of trades begin to swell; this value also grows to impressive levels. This trading activity keeps on going until the peg returns to the $1 threshold. But because of the growth in supply, the valuation can cross that $1 threshold, so to bring the peg back yet again, the trading activity continuous however in a completely opposite manner.
Traders purchase UST using dollars and then exchange that 1 UST they got to acquire exactly $1 worth of LUNA, this brings forth LUNA, giving profits to traders and bringing the peg back. This cycle keeps going and helps to keep the peg in check.
The connection between UST and LUNA is made to make sure that LUNA is supported to handle the volatility and because LUNA has the function of getting mined whenever UST falls below the one-dollar threshold, the valuation of LUNA can significantly drop with respect to a rise on the supply levels.
There are additional use cases for LUNA tokens that include being utilized for staking to gain the ability of governance voting, being used to pay the fee to lock in transactions and to produce earnings through decentralized finance (DeFi) loaning and lending platforms.
UST had to face many skeptics and critics that complained about how UST is fragile and has nothing to support it. As a counter measure, the CEO of Terra Terraform Labs, Do Kwon established the LUNA Foundation Guard which had the responsibility to keep the peg in check and had a mission to obtain billions of dollars’ worth of Bitcoin to keep the peg stable.
The massive de-pegging event of UST
All hell set loose when UST started to experience massive de-pegging at the start of May 2022, as sudden massive withdrawals started to occur in the decentralized finance (DeFi) protocol named as Anchor. M
any have speculated that this de-pegging was some sort of planned strike that led to the huge withdrawals that happened in conjunction to the state of the market. As a result, the stablecoin was unable to take the hits and its value dropped at a massive low of 0.29 within a couple of days.
Because of the massive market crash, especially with the likes of UST that was experiencing massive de-pegging, the valuation of the top cryptocurrency Bitcoin also experienced a significant drop and because of this horrible situation, traders started to dump their UST over at different exchanges around the world, putting even more constraint on UST, leading to further dep-pegging.
With that, individuals started to question that algorithm that should have taken the matter into its hands and should have started to mint LUNA to mitigate the damage, however the market situation was so bad the algorithm essentially failed to keep up. The only solution here was to revolutionize the code base for it to change the minting limit and keep up with the market.
Since the peg of UST depended on the minting of LUNA, the supply of LUNA skyrocketed to insane levels, leading to the violent drop in its valuation, dropping by over 97%, reaching a recorded low of $0.88. In conclusion it was highlighted that Terra was unable to keep the UST peg intact in accordance with the sudden market shift, while also failing to keep LUNA stable.
The State and Future of Stablecoins
Because of no regulatory authority in check of stablecoins, so there is a huge risk of the valuation drop and planned strikes if the stablecoin doesn’t have sufficient collateral to mitigate the situation. It is clearly understood that if the supply of the stablecoin is associated with the valuation of a governance token, then the risk of fall of valuation grows even more.
Additionally, taking about the example of the chaos behind Terra and LUNA mentioned in the previous section, it must be made sure that the stablecoins must be supported through sufficient collateral either in terms of direct cash or the equal amounts of assets.
The utilization of smart contracts system can also help to keep a good level of collateral. For instance, to keep the peg in check, the structure can force out stablecoin liquidation.
Collateral is the key to making a stablecoin function as it is intended to. Loss in collateral leads to the loss in overall valuation of the stablecoin, which can lead to sudden withdrawals and severe de-pegging situations, thereby destroying the stablecoin. If there is not enough collateral present to support the stablecoin, the user base also gains a huge risk of loss in investments if a market crash is to occur.
So, it is important to understand that if you are looking to invest into stablecoins or any other types of cryptocurrencies, you must perform an extensive study over them and try to grasp the basics and advanced concepts behind them to be a successful trader in the market.
You must have a clear mind when taking decisions involving investments into cryptocurrency projects such as algorithmic stablecoins, as it can make or break your motivation for a potentially successful trading career.
The risks and disadvantages might seem to stimulate demotivation, but if you as a trader understand the concepts and have a strong grip on the world of cryptocurrencies, then you can surely be successful with any type of cryptocurrency at hand, whether it is standard cryptocurrency or stablecoins.
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