Understanding Algorithmic Stablecoins

Cryptocurrencies are famed for their volatility, as they can go up or down in double digits in seconds. For that reason, this one form of cryptocurrency, better known as stablecoins, provides protection to those who wish to exit the world of persistent volatility while remaining a part of the crypto market.

If we want to define stablecoins, we could say they are also cryptocurrencies like Bitcoin and Ethereum. Still, instead of providing marketable features that the other coins possess, stablecoins are created to be pegged to real fiat currencies like Euros or the U.S. dollar as their prices are always supposed to be $1 or €1 at all times.

The main thing with stablecoins is that each stablecoin differs in how its developer maintains the peg. And while many of them are “over-collateralized” by fiat reserves, over the past couple of years, a new form of stablecoins has emerged that differs in their collateralization—algorithmic stablecoins.

These algorithmic stablecoins, such as the popular Haven Protocol (XHV), are called algorithmic because what backs them instead of fiat reserves is an on-chain groundbreaking algorithm that promotes automatic change in demand and supply between the stablecoin and another cryptocurrency that props them up.

These types of cryptocurrencies are usually under-collateralized as they don’t have independent assets in reserves to back their value, for which they are also known under the name of “undercollateralized stablecoins.”

In this article, we will explain what algorithmic stablecoins are, how they work, and the different types of these financial assets.

Defining Algorithmic Stablecoins

The primary step in discovering the algorithmic stablecoins that deserve your investing attention is to understand what they are and how they work. First and foremost, it’s essential to understand that algorithmic stablecoins don’t have any alliance with collateral.

Instead, algorithmic stablecoins are fully decentralized and aim to enhance the market price stability by pre-programmed supply and the automatic matching of asset demand. For that reason, most algorithmic stablecoins come with predefined stabilization measures encoded in various smart contracts on the Ethereum blockchain.

Moreover, the algorithm behind the best stablecoins of this kind (Haven Protocol, DAI, Frax, and others) always features the required programming for enhancing the supply of a given currency in deflationary scenarios. At the same time, these algorithms also work to decrease the supply of the stablecoin in scenarios that involve a significant reduction in buying power. All in all, algorithmic stablecoins can successfully respond to various market events thanks to their automated stabilization features.

How Do They Work?

In a nutshell, these algorithmic or undercollateralized stablecoins aid in stabilizing the crypto market by using the mechanisms for selling and purchasing the concerned derivative or crypto asset.

Typically, all algorithmic stablecoins utilize crypto protocols for issuing coins in case of an unexpected price surge. These protocols also respond by buying coins from the market in case of a drop.

To get a clearer impression of how these stablecoins work, here is the process in simpler steps for everyone to understand:

• The oracle contract. First, the oracle contract helps in the communication between the external channels and the smart contract beyond blockchain. This is what obtains the price of the algorithmic stablecoins on different crypto exchanges.
• The rebase contract. The rebase contract takes the algorithmic stablecoin’s price from multiple exchanges as the input. Then it helps determine if the stablecoin’s supply needs to be increased or reduced.
• Minting or burning tokens. Finally, the rebase contract estimates the number of tokens that need to be burned or minted from the wallets of users.

Different Types Of Algorithmic Stablecoins

Finally, the outline of the most popular algorithmic stablecoins should always be strongly associated with the different types of such stablecoins. After all, each one of them comes with its unique features and traits. Here is a basic outline of the different types of algorithmic coins you should know about:

• Over-collateralized algorithmic stablecoins. These stablecoins all depend on a colossal reserve of cryptocurrencies for releasing lesser stablecoins. These are the perfect choice for a buffer for the eventual price fluctuation.
• Rebasing algorithmic stablecoins. These stablecoins involve the supply to take over the regulation of value. In this scenario, the algorithm decreases the coin supply in event of a price drop and makes sure that the issuance of extra coins is in the opposite direction.   
• Fractional algorithmic stablecoins. Fractional stablecoins are a nice addition to the algorithmic stablecoins register as they are only partially collateralized. These feature the backing of cryptographic algorithms and asset collateralization.

Final Words

The adoption of algorithmic stablecoins actually showcases the importance of leveraging brand-new technologies for crypto adoption. And as the applications of algorithmic stablecoins will continue to rise, it will become more and more evident that these financial assets can bring multiple value benefits for both users and crypto exchanges.