Stablecoins have enjoyed impressive growth in recent years. I have already covered the different types of stablecoins in a previous blog post. The focus of this piece will be on algorithmic stablecoins. Stablecoins have surpassed $100 billion of total market capitalisation. 90% of the market capitalisation is dominated by fiat collateralised stablecoins (or tokenised funds) like Tether and USD Coin. People seeking stable value often flee into stablecoins instead of fiat currencies, influenced by the surge of decentralised finance (DeFi). From all types of stable assets, algorithmic stablecoins are the most difficult type to understand since, unlike other types of stablecoins, algorithmic stablecoins are not redeemable 1:1 for fiat currency and are often too volatile. To combat price volatility, stabilisation algorithms are put in place to track a particular unit price, such as $1. One of the first instances of algorithmic stablecoins was launched by NuBits in 2014. In March 2018, NuBits lost its peg to the US dollar. Since then, the coin has never recovered its peg. The NuBits use case serves as an example of how challenging could be to design an algorithmic stablecoin.
Why are algorithmic stablecoins important for the ecosystem?
Looking at the current market leaders such as Tether (USDT) and USD Coin (USDC), we can see that these stablecoins are managed by centralized entities. Think of it as a single point of failure. The companies behind these stablecoins are even able to freeze account balances or censor transactions. As central banks are looking into Central Bank Digital Currencies (CBDCs), the future of collateralized stablecoins is uncertain. If a central bank introduces a CBDC, it might ban ownership of alternative collateralized stablecoins. Tokenised funds like Tether also need to keep reserves of fiat currency as collateral. Auditing the reserves has raised some concerns in the past because of the lack of transparency. The idea behind Bitcoin and Ethereum is to be open and permissionless without a single point of failure. As Decentralized Finance (DeFi) is gaining much attention from users and regulators, the need for a stable asset in the blockchain space is clear. Especially with the rise of Decentralized Exchanges (DEX) like Uniswap, traders will turn to stablecoins in search of stability. Stablecoins are not only crucial for trading. These new assets can enable many use cases on public blockchains like, for example, crypto loans.
Currently the most used decentralized stablecoin is Dai.
Dai is created when a user locks down ether or other accepted crypto tokens in a smart contract. The ether is used as collateral to issue Dai stablecoins. The collateral remains locked until the user pays back the amount of borrowed Dai. The mechanism for issuing Dai is called Collateralised Debt Position (CDP). The system is designed in a way that there must always be excess collateral. The recommended collateralisation for a Dai CDP is 250%. If the price of ether falls too fast, there is a risk of liquidation, where users lose their collateral and pay a penalty fee. However, they get to keep their Dai tokens.
Dai is a collateralised stablecoin backed by a basket of currencies, including ether and USDC. While innovative, Dai shows a few problems with this model. In March 2020, Dai suffered a liquidity shortage and got hit by several negative circumstances related to the Ethereum blockchain capacity to process transactions. As a preemptive measure, the MakerDAO governance body decided to add USDC as a possible asset used as collateral. USDC is a tokenised fund backed by the US dollar, just like Tether, and it is controlled by a private company which raises a few concerns. Being controlled by a private company, USDC can freeze all transactions in a Dai CDP, which would render it useless. Another concern one might have is the regulatory independence of Dai. Since the introduction of USDC, Dai incorporates a private company's product in its services, which might lead to legal questions. Dai is governed by the Maker token (MKR) holders, and its monetary decisions must always pass a vote before they get implemented. While this is a sign of good faith, holding a vote on every monetary decision might be too slow or lead to low token holder participation. Another issue we already witnessed is the Dai liquidity. Dai has suffered liquidity problems in the past, and because of its design, it might never become liquid enough to become the default DeFi stablecoin. And we all know that liquidity kills you quick. Furthermore, Dai suffers from scalability issues due to capital inefficiency.
What are algorithmic stablecoins?
Algorithmic Stablecoins use price stabilization algorithms to track a particular unit price - typically $1. Algorithmic stablecoins are not redeemable 1:1 for fiat currency or fully backed by crypto-asset collateral, and are often too volatile when compared to collateralised stablecoins.
The amount of risk involved in algorithmic stablecoins is still very high. Innovation plays a significant role in designing algorithmic stablecoins, and many projects are still experimenting. Every year new ideas arise and need to be tested. As more algorithmic stablecoins emerge, some will stand out and will become the leaders in the space. As Tether and other similar cryptocurrencies face calls for stricter regulation from governments, we will see a gradual shift of interest to algorithmic stablecoins.
Types of algorithmic stablecoins
Algorithmic stablecoins can still be labelled as an experimental technology. The space is very dynamic, and there are always new ideas emerging. As the industry matures, we can start categorising the different approaches used to stabilise the price of algorithmic stablecoins. One big category of algorithmic stablecoins is non-collateralised stablecoins. The primary mechanisms for achieving stability are rebasing and seigniorage. The second category is the fractional reserve models, where the projects introduce some on-chain collateral used to stabilise price peg.
From all algorithmic stablecoins rebase tokens are the easiest to understand. Ampleforth, BASED and Base Protocol are examples of rebase tokens. The protocol rules are encoded in smart contracts. The primary mechanism behind rebase tokens is the token supply adjustment. Each time the coin is over its price target, the smart contract will introduce more coins in circulation. Conversely, the protocol will remove coins from circulation if the coin price drops below the target price. This algorithm acts "globally" across the stablecoin network, leading to a change in all coin holders' account balances.
For all accounts that own tokens, a rebasing can either result in an increase or decrease in their coin balance.
Elastic supply protocols experience relatively high price volatility, which may exclude these from being used as means of payment or fiat currency alternatives. (see graph below).
It is worth noting that not all rebase tokens try to be stable. Ampleforth, for example, markets itself as synthetic commodity money. On the other hand, Base protocol has its price pegged to the total market cap of all cryptocurrencies at a ratio of 1: 1 trillion, which leads to a gradual token price increase in bull markets. Nevertheless, the mechanism behind the rebase tokens can be used for achieving a target price or target market cap.
Seigniorage was first introduced in 2014 by Robert Sams as "Seigniorage Shares". Seigniorage tokens consist of at least two tokens. One of them being stable and the rest trying to stabilise it by actively managing the total supply of the stablecoin. A typical characteristic of seigniorage tokens is the absence of any collateral. The term seigniorage is also used in central banking when issuing fiat currencies.
"Seigniorage is the difference between the value of money and the cost to produce and distribute it", wikipedia.org
Seigniorage coins follow simple logic. The stablecoin follows its peg while at least one or more tokens absorbs the volatility. When the stablecoin price increases, additional stable tokens are distributed to the token holders in exchange for a certain percentage of their token holdings (token supply decreases, stablecoin supply increases). When the stablecoin price decreases, new tokens are distributed to token holders in exchange for a certain percentage of their stablecoin holdings (token supply increases, stablecoin supply decreases).
Basis Cash (BAC) is the best known multi-token algorithmic stablecoin. The coin is based on the stablecoin Basis, which was shut down by the SEC (US Securities and Exchange Commission) in 2018. It relies on a three-token model to manage its price peg. BAC is monitored by smart contracts through an oracle, and when the market price differs from 1 dollar, the algorithm tries to stabilise the price by manipulating the circulating supply of BAC:
- Basis Cash (BAC) - BAC is a stablecoin pegged to the US dollar. The coin supply is elastic and adjusts based on the current price of the token. Suppose BAC trades above 1 dollar the supply of BAC shrinks. The supply expands, then the BAC price drops below 1 dollar.
- Basis Bonds (BAB) - Bonds are always on sale to BAC holders. BAB holders can exchange their bonds for Basis Cash at a rate of 1:1, thus earning them a premium on previous bond purchases. BABs do not have an expiration date.
- Basis Shares (BAS) - The Basis shares pay dividends in BAC tokens when the BAC supply expands. This mechanism is triggered when BAC trades above 1 dollar.
Unfortunately, in January 2021, BAC lost its peg to the US dollar. The Basis Cash team launched Basis Cash V2 on April 24, 2021. Improvements of the protocol include improved incentives to hold BAS tokens in contraction phases and a staking mechanism for Basis Bonds to earn BAS rewards when BAC is below its peg. After the launch of V2 Basis Cash lost again its peg and trades under 1 dollar.
Nubits (USNBT) consists of a two token model: one being stable and the other managing the governance of the network:
- Nubits (USNBT) - is a stablecoin pegged to the USD dollar. The total supply is inflationary.
- NuShares (NSR) - Shares have a fixed total supply and represent ownership of the network. NuShares manage the quantity of NuBits by changing the governance rules of the network. NuBits can be created when shareholders vote to do so. The system reduces the available supply of NuBits by a voting mechanism called parking. In short, parking means earning interest on term deposits. The NuShares holders determine the interest rate and the term. When NuShares holders vote to expand the Nubits supply, elected custodians receive newly minted NiBits. Custodians are expected to invest the newly minted NuBits into the further development of the protocol (e.g. software development).
In 2016 NuBits lost its peg to the US dollar. While temporarily managing to recover, Nubits lost its peg again in 2018. The stablecoin remains underpriced as of today.
Empty Set Dollar (ESD) has a two-token model to grow the money supply and is very similar to Basis Cash's three-token model. When ESD is above the one-dollar price, the protocol will print more ESD. Any coupon (bond) holders will receive the extra printouts. In place of the third token, ESD holders can 'stake' their ESD for interest:
- Empty Set Dollar (ESD) - is a stablecoin pegged to the USD dollar. ESD holders lock their tokens to gain benefits such as voting on governance proposals and rewards. When ESD goes above one dollar, the protocol will print more ESD and distribute it among ESD holders who have taken steps to lock their tokens.
- Coupons (Bonds) - Coupons reduce the total supply of ESD. If ESD falls below one dollar, ESD holders can purchase coupons at a discount with ESD. This mechanism removes ESD from circulation. Coupons are only redeemable if ESD goes above one dollar. If it doesn't go above a dollar, the coupon disappears in 90 epochs (1 epoch = 8 hours).
Empty Set Dollar has an on-chain governance infrastructure where ESD holders can vote on updates to the protocol. The ESD token model is largely identical to Basis Cash. However, only ESD tokens are locked instead of purchasing shares. ESD lost its peg in December 2020 and has not recovered ever since.
Terra protocol is a two-token model stablecoin platform with an elastic monetary policy. Terra aims to be a family of stablecoins pegged to the world's major fiat currencies. Currently, there are three stablecoins: TerraUSD (UST), TerraKRW (KRT), TerraSDT (SDT is pegged to the IMF SDR). Each of these stablecoins is part of the same stabilisation mechanism. There are two types of tokens in the Terra protocol:
- Terra Stablecoins (UST, KRT, etc.) - track the exchange rate of various fiat currencies. The total supply of each stablecoin is elastic.
- Luna - The native token of the Terra protocol. Since Terra runs on its own infrastructure, the Luna token has multiple roles. It is part of the mining rewards, protocol governance and the price stabilisation mechanism of the Terra stablecoins. Price volatility is moved from UST's price to Luna supply. Each time the value of UST rises above 1 dollar, users can swap one dollar worth of Luna for one UST. This way, arbitrageurs can make a profit on the price difference. If UST drops below 1 dollar, UST holders can swap 1 UST for one US dollar worth of Luna, leading to supply reduction of UST. This mechanism applies to all stablecoins running on top of Terra.
As of today, all Terra stable tokens have been able to keep their peg. Terra protocol has an on-chain governance mechanism where Luna holders can vote on protocol changes. As a native token, Luna is also part of the consensus algorithm of the Terra blockchain. The Terra protocol runs on Proof-of-Stake (PoS), and miners are required to stake Luna tokens in order to earn mining rewards. Higher stakes earn higher mining rewards. The miners also play a role in the price stabilisation of the Terra stablecoins as they absorb Terra contraction costs in the short term through mining power dilution. The dilution happens when the total supply of Luna gets expanded in order to absorb the drop in the price of the stablecoins. In the long run, miners get compensated with increased mining rewards. When the demand for Terra stablecoins increases, the system also burns a portion of earned Luna, making mining power scarcer.
Fractional Reserve Models
Fractional reserve algorithmic stablecoins are partially backed by on-chain collateral while being algorithmically stabilised. One could argue that fractional reserve stablecoins are not algorithmic but rather a hybrid between on-chain collateralised stablecoins (e.g. DAI) and algorithmic stablecoins. This category of stablecoins is relatively new. All of the listed projects are in the early stages of development.
Fei Protocol is an algorithmic stablecoin with unique characteristics. The protocol utilises a system of bonding curves and Protocol Controlled Value (PCV) to maintain its peg to the US dollar.
"A bonding curve is a mathematical curve that defines a relationship between price and token supply.", yos.
There are two types of tokens in the Fei Protocol:
- Fei Protocol (FEI) - FEI is pegged to the US dollar.
- Tribe token (TRIBE) - The governance token of Fei Protocol. The token does not directly influence the FEI stablecoin.
FEI will enter circulation via a bonding curve where the bonding curve contract will hold a balance of a reserve token. In the case of FEI, the reserve token is ether (ETH). Any ETH holder can issue FEI after depositing ETH into the curve. As the supply of the reserve token grows, the bonding curve price approaches the fixed peg to the US dollar. Once deposited, the ETH is controlled by the protocol. Users are not able to sell FEI for ETH back to the bonding curve. Fei Protocol will use the ETH supply as a liquidity reserve to backstop the price of FEI when it trades below the peg. One could say that Fei Protocol acts as an automated market maker (AMM) by influencing the market conditions. Uniswap is a decentralised exchange (DEX) on Ethereum and plays an important part in the stability mechanism of FEI. The goal of the Fei Protocol is to maintain a liquid market on Uniswap in which ETH/FEI trades close to the ETH/USD price.
FEI experienced a bumpy launch where in April 2021, the stablecoin lost its peg to the US dollar. In May 2021, the team had to freeze the bonding curve because of potential exploit vulnerabilities. After the bug fix, FEI restored its peg and has been keeping its peg to the US dollar. The Fei protocol is governed by a DAO (Decentralised Autonomous Organisation) where token holders vote on protocol changes (e.g. adjust price functions, add new bonding curves, etc.). The governance token is called TRIBE. Part of the TRIBE supply is locked in a treasury, which can be distributed by community voting.
Frax (FRAX) is a fractional reserve algorithmic stablecoin with an additional two-token model stabilisation mechanism. The protocol maintains a variable collateral reserve that can be algorithmically adjusted. When the collateral drops under 100%, the missing value is replaced by the governance token (Frax Shares). Frax could also be classified as a hybrid model between a fractional reserve algorithmic stablecoin and seigniorage shares.
- Frax (FRAX) - FRAX is an algorithmic stablecoin pegged to the US dollar. FRAX is partially backed by on-chain collateral and is algorithmically stabilised. FRAX can always be minted and redeemed from the system for $1 of value. When the collateral ratio of FRAX is below 100%, the difference is covered by the Frax Shares token.
- Frax Shares (FXS) - Frax Shares is a governance token that also accrues seigniorage revenue. When the collateral ratio of FRAX drops below 100%, the difference is covered by FXS. If a user wants to mint FRAX at a 90% collateral ratio, 10% is covered by FXS, which then gets burned. If the price of FRAX is below one dollar and the collateral ratio is 90%, a user can purchase FRAX on the free market and exchange it for 90% collateral and 10% newly minted FXS.
FRAX has managed to maintain its price peg. At launch, FRAX was 100% collateralised with the idea to switch to a fractional reserve gradually. To ensure a smooth launch, the Frax team decided to use USDC as collateral for FRAX. USDC is a tokenised fund managed by Coinbase, similar to Tether (USDT). Frax is criticised for using USDC as collateral as they expose FRAX to a single point of failure because Coinbase could freeze or censor USDC transactions at any time.
Neutrino protocol runs on top of the Waves blockchain. The Neutrino stablecoin (USDN) is a collateralised algorithmic stablecoin tied to the US dollar. USDN uses the Waves blockchain native token (WAVES) as collateral. While Neutrino does not stride toward the fractional reserve model, it is designed to maintain its price peg even when under collateralised. Therefore I will put it under this category. In addition, the protocol is capable of issuing stablecoins tied to any real-world currencies.
- Neutrino stablecoin (USDN) - USDN is an algorithmic stablecoin pegged to the US dollar and backed by the WAVES token. USDN tokens are issued by a smart contract that accepts WAVES. To issue one USDN, one must send an equal amount of value in WAVES to the smart contract. The maximum possible amount of issued USDN is limited to one trillion (total supply). When USDN trades above one dollar, users can exchange WAVES for USDN at the fixed ratio and then sell USDN at exchanges for a profit. When USDN falls below its peg, traders buy USDN on the market and exchange it for WAVES via the Neutrino Protocol smart contract. When USDN gets undercollateralised, the difference is covered by the Neutrino Token (NSBT).
- Waves Token (WAVES) - WAVES is the native token of the Waves blockchain, and it is used as collateral for the stable assets issued by the Neutrino protocol. WAVES is an interest bearing asset. All WAVES deposited as USDN collateral are automatically leased by the protocol and generate an income for USDN holders who stake their coins on the platform.
- Neutrino Token (NSBT) - is the recapitalisation and governance token of the protocol. A bonding curve controls the token's issuance. NSBT acts as a bond when the collateral ratio of USDN falls below 100%. NSBT is generated and sold for WAVES.
USDN has managed to keep its price peg since its launch. Even though Neutrino looks very similar to Dai, there is one major difference between the two. Dai is a debt-collateralised stablecoin where users lock ETH tokens to issue Dai. The protocol must always stay overcollateralised; otherwise, the system would be unstable. On the other hand, Neutrino users exchange their WAVES tokens for stablecoins. The protocol aims at overcollateralisation but could also be undercollateralised for short periods if time without crashing the system.
The Future of Stablecoins
Stablecoins face a challenge from CBDCs, which would offer an alternative payment system to commercial banks. Regulators are not going to be comfortable with stablecoins co-existing with Central Bank Digital Currencies. The most vulnerable stablecoins are the centralised ones such as Tether and USDC. These could also be easily integrated into the coming regulatory frameworks as centralised entities already control them. The implications of this could even lead to banning the use of stablecoins in DeFi. On the other hand, the decentralisation of algorithmic stablecoins might leave some space for innovation and independence. Being completely decentralised and not relying on external factors for keeping their price peg, algorithmic stablecoins will be the next step in the future of stablecoins.
The next step for DeFi projects is to radically decentralise to avoid harsh treatment when new regulations get introduced. We can already witness how the ecosystem changes. The foundation behind MakerDAO will formally be dissolved in the future. The Maker token holders will make all decisions over the protocol.
The Shapeshift crypto exchange is following a similar approach. The company has begun dissolving its corporate structure and will soon switch to a DAO (Decentralised Autonomous Organisation) structure.
The future of algorithmic stablecoins, in general, is clear. Sooner or later, they will all move to a DAO structure. The regulators have just accelerated the process.
- A Note on Cryptocurrency Stabilisation: Seigniorage Shares, github.com
- Algorithmic Stablecoin Project Fei Fails To Maintain Peg To US Dollar www.dcforecasts.com
- Ampfleforth Introduction - ampleforth.org
- Basis Cash Documentation - docs.basis.cash
- Basis Cash V2 - medium.com
- Bonding Curves Explained - yos.io
- Empty Set Dollar (ESD) - emptyset.finance
- Fei Bonding Curve Bug Post Mortem, medium.com
- Fei Protocol Docs - docs.fei.money
- Frax Finance - frax.finance
- MakerDAO Has Come Full Circle, blog.makerdao.com
- Neutrino Protocol - neutrino.at
- NuBits Whatepaper - nubits.com
- Seigniorage & elastic supply. A case study on AMPL, ESD, DSD, Basis - medium.com
- Shapeshift is Decentralising, erikvoorhees.medium.com
- Stablecoin strife: crypto assets face calls for tougher oversight - ft.com
- Terra Money - docs.terra.money
- Terra Whitepaper - terra.money
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