Algorithmic Stablecoins

Jun 3, 2022
3 min read

This blog post will cover:

  • Rebalancing algorithm explained
  • Points to ponder

Algorithmic stablecoins have become a popular alternative to centralized equivalents. This format complies with the decentralization ideas of Satoshi Nakomoto, the creator of the first cryptocurrency. It also reflects market participants' desire for independence from regulators. The first algorithmic stablecoin is called MakerDAO (DAI). The project appeared in 2015.

Rebalancing algorithm explained

The decentralized stablecoin rate is controlled by the rebalancing algorithm. All the algorithmic token systems are fully automated. The algorithmic system operating principle is pretty simple. If a stablecoin is sold for more than $1, the system automatically creates new coins until the price gets back to $1. If a stablecoin price falls lower than a dollar, in order to recover binding, the system reduces the stablecoins offer.

Let’s imagine that an algorithm of the UST stablecoin is a swimming pool, and the water level in it is a token price. As the demand for UST grows, the value of the digital asset (water level) begins to rise. You can return the price to the original $1 value by increasing the pool area. To do this, additional UST is issued. By redistribution of "water" taking into account the increase in the number of tokens, the rate is again lowered to $1. In reverse, the UST stablecoins are bought back, thereby reducing the pool area, reducing supply.

Points to ponder

The technical director of Tether, Paolo Ardoino, thinks that decentralized stablecoins can be dangerous in case of cascading liquidations when tokens achieve high capitalization.

Also, decentralized stablecoins were criticized by Vivian Fang, a professor of accounting at the Carlson School of Management at the University of Minnesota. According to the professor, it is dangerous for market participants to blindly trust algorithms. She also believes that the developers' rejection of the classical system of providing tokens with reserves should be a concern.

Furthermore, Dr. Ryan Clements emphasized the problems of the algorithmic stablecoins — decentralized stablecoins depend on the demand level. The systems of such tokens rely on independent projects with no legal obligation.

The stability of the algorithmic stablecoin course is controlled by a rebalancing algorithm. This scheme has its own pros and cons. Decentralized stablecoins are not subject of pressure from centralized regulatory authorities. There is the opinion that decentralization has been one of the reasons for the popularity of algorithmic tokens. The security of algorithmic stablecoins is questionable now as there are some precedents for $-binding loss. A striking example is the Terra project and the UST stablecoin. It seems that algorithmic stablecoins still have to prove their value on the market and build a reliable image. Anyway, the topic remains a fluttering one for crypto enthusiasts, so let's stay tuned and watch the development together!

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