Algorithmic stablecoin

An algorithmic stablecoin is a type of cryptocurrency that uses algorithms and smart contracts to maintain a stable value.

What Are Algorithmic Stablecoins?

Stablecoins are a type of digital asset designed to maintain a stable price regardless of market conditions. The majority of well-known stablecoins are collateralized, meaning that they are backed by an asset or commodity with a more consistent value, typically a fiat currency or a precious metal like gold, at a 1:1 ratio. 

However, there are also non-collateralized stablecoins, known as algorithmic stablecoins, that employ alternative methods to ensure their price stability.

Also called non-collateralized stablecoins or algostables, algorithmic stablecoins stabilize their value using computer algorithms and smart contracts. These stablecoins remove the need for collateral or reserves and instead use contract codes to manage the token’s circulating supply. They typically adjust the token supply in response to market demand.

Popular examples of non-collateralized stablecoins include DAI and decentralized USD (USDD).

How Do Algorithmic Stablecoins Work?

As opposed to collateralized stablecoins that tie their value to external assets, algorithmic stablecoins leverage a dynamic mechanism to adjust their token supply based on market forces. Essentially, the algorithm triggers mechanisms that either reduce or increase the token’s circulating supply if the stablecoin’s price deviates from the target value (the value of the fiat money it is pegged to).

For instance, if the stablecoin’s value drops below the target value, the algorithm reduces its supply via a process called burning. The mechanism can also reduce the circulating supply through token buybacks and locked staking, thereby increasing scarcity and driving up the price. If the price exceeds the target value, it increases its supply by minting more tokens to reduce its value. 

At a more technical level, there are different types of non-collateralized stablecoins, such as rebasing, seigniorage, and fractional algorithmic stablecoins.

• Rebase mechanisms – Employ an oracle contract to retrieve the stablecoin’s pricing information from other exchanges, and a rebasing contract to determine whether to mint or burn tokens to adjust the supply based on the obtained information.
• Seigniorage  – The seigniorage model involves issuing and redeeming two or more types of tokens: the stablecoin and a second token representing a share or seigniorage ownership. If the value of the stablecoin deviates from the intended peg, shares are used to increase or decrease the token supply.
• Fractional – These stablecoins are partially backed by collateral and partially stabilized by algorithms. Combining the features of both can help to prevent over-collateralization while alleviating custodial risks.