What Are Algorithmic Stablecoins?

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Stablecoins were invented for a fairly straight-forward reason: to help traders combat the innate volatility of cryptocurrency by letting them move their assets to a coin pegged to a stable asset (in most cases, the US dollar). Stablecoins function as a safe haven when the market crashes, and a way to secure profits during a bull run.

For years, the most widely used stablecoins have been those backed by actual USD, such as Tether (USDT, issued by Bitfinex) and USD Coin (USDC, issued by Coinbase). They’re able to stay pegged at $1 because, well, there is real money backing them. In theory, they should only be minted when someone buys a USD-backed stablecoin on an exchange, a process that takes place within Bitfinex and Coinbase’s accounts. If someone wants to sell their stablecoins, the money used to mint the stablecoin is available in the exchange’s reserves.

For years, DeFi developers have taken the idea of stablecoins and looked for ways to make them work without USD collateral. Recently, this has led to the creation of decentralized stablecoin protocols that only need participation, not USD, to peg their token. The emergence of algorithmic stablecoins is an experimental innovation that helps fulfill DeFi’s mission of transparent, open finance. At this stage, the term “stablecoin” is a bit misleading, as algorithmic stablecoins have substantial price fluctuations (somewhat built by design — their stability tends to increase with market cap and participation). Before we get to how algorithmic stablecoins work, let’s take a look at what came before them.

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Data from January 22, 2021, source: coingecko.com

First attempts at decentralization

The first and most important decentralized stablecoin is DAI, which is pegged to the US dollar through an intricate system of borrowing and lending on Maker. Users deposit ETH in return for DAI and pay a small amount of interest when they return the loan. There’s a whole lot more to how DAI works, but the important takeaway is that DAI has been phenomenally successful since development started in 2014. It is, arguably, the first DeFi protocol, and is currently the third-most traded stablecoin by volume.

Reserve Protocol is another decentralized stablecoin system, although it hasn’t launched its mainnet yet. Reserve Protocol uses two tokens: Reserve Rights (RSR) and Reserve Stablecoin (RSV). Essentially, RSV is a hyper-inflationary stablecoin that stays pegged at $1 through arbitration and profit-taking opportunities. Later, Reserve Protocol will use a basket of real-world assets like securities to back RSV.

The rise and fall of rebase

In the summer of 2020, a new craze started with the introduction of Ampleforth (AMPL), an elastic supply rebase token. Elastic supply means a token supply that expands and contracts to maintain a relatively stable price (in the case of AMPL, $1). It stabilizes to $1 when there’s a rebase, which occurs when the price of AMPL is too far outside its price target. If the price is well above $1, a positive rebase brings AMPL’s price back to $1, and token holders receive more tokens in their wallets. If the price is too far below $1, a negative rebase occurs, and tokens are automatically removed from users’ wallets.

Although innovative, rebase tokens don’t account for the psychological implications of adding and subtracting tokens from users’ wallets. Simply put, people don’t like to see their balance go down, as it feels antithetical to crypto’s “hodl” mentality. In theory, rebases don’t affect the value of your holdings — whether positive or negative, the value should be the same before and after the rebase. In practice, however, there’s a lot of price volatility as traders scramble to buy or sell tokens before and after the rebase, particularly if it’s going to be negative. In late July 2020, AMPL’s value plunged from $2.90 to $0.65, causing a spree of panic selling and negative rebases. Despite the creative mechanism behind them, rebase tokens are simply too volatile to be used as a stablecoin.

A promising way forward

The instability of rebase tokens got some developers thinking: “What if the elastic supply was voluntary?” This burning question eventually resulted in the creation of Empty Set Dollar (ESD), an algorithmic, non-collateralized stablecoin that gradually pegs to $1 as its market cap increases. It’s important to note that right now, algorithmic stablecoins are purely experimental. ESD had a successful, sustained period of maintaining its 1 USDC price target, but has recently plunged to $0.40 due to supply contraction, causing users to remove their liquidity and crash the price.

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There are a lot of moving parts and game theory involved with algorithmic stablecoins like ESD and Dynamic Set Dollar (DSD). Essentially, algorithmic stablecoins reward users for taking part in the system and helping the token hit its price target. Users “bond” their tokens in the DAO or Uniswap liquidity pools to receive interest at the end of every epoch (usually between two and eight hours). The interest might appear low (about 2–3%), but it compounds, resulting in APYs as high as 50,000% in some cases.

Algorithmic stablecoins self-stabilize through voluntary supply expansions and contractions based on Time Weighted Average Price (TWAP). If the price of ESD is over 1 USDC, it enters an expansion phase in which more tokens are minted, thereby creating sell pressure to bring the price down. If ESD is under 1 USDC, it enters a contraction phase in which users are encouraged to burn tokens to bring the price back up. In exchange for burning tokens, users receive coupons that can be redeemed for more tokens when the TWAP goes back above 1 USDC. The system is entirely voluntary and works by rewarding users for doing what’s best for the protocol. It incentivizes good behavior.

The most important aspect of algorithmic stablecoins is that they represent an exciting, creative experiment that’s totally decentralized, voluntary, censorship-resistant, and fair (i.e. no pre-mining of tokens). Although they do face far too much volatility at the moment to replace USDC or DAI, it will be interesting to watch them develop and, hopefully, stabilize.

Please note that algorithmic stablecoins are not part of YIELD App’s portfolio. Due to their experimental nature and a high degree of risk, we do not advise anyone to trade these tokens or use the protocols. This article is for educational purposes only and is not financial advice.

YIELD App offers the easiest way to invest in DeFi using crypto or traditional currencies, regardless of your financial or technological level of expertise.

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