How Do Algorithmic Stablecoins Work, And Why Does It Matter?

By July 19, 2021DeFi
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How Do Algorithmic Stablecoins Work

How can all these stablecoins be different if they are all pegged to the same US Dollar? If you’ve asked yourself this question, this article is for you.

Here’s why it matters: different stablecoins carry certain types of risk while providing some unique features. Although Tether is the top third cryptocurrency by market cap trusted by millions, it has been accused of non-transparent management. By contrast, a much less mainstream Celo protocol offers almost instant transactions for a $0.01 fee.

In this article, we will take a quick look at how stablecoins evolved over time and consider the new-generation algorithmic stablecoins more precisely. You will see how Claim’s stablecoin builds on top of that and how you can leverage it.

The evolution of stablecoins

Fiat-backed stablecoins. The quite obvious solution was implemented first: “OK, we need a cryptocurrency that will always cost $1 — let’s back it by real dollars”. This is how USDT, USDC emerged. Their centralization is often misused, however — audits are not regular and not thorough enough; some wallets get voluntarily blacklisted.

Crypto-backed. The intent to build a trustless stablecoin resulted in the creation of DAI. When users deposit their funds in the Maker smart contract, these funds are used as reserve collateral, and DAI is minted. To protect from the collateral price crashes, DAI needs to be overcollateralized: collateral is a few times bigger than the DAI supply.

Algorithmic. This type of stablecoins is both decentralized, trustless, and does not need huge collateral. It protects its peg right on the market, automatically regulating the supply. When the stablecoin price goes above the peg, the protocol issues more tokens, and when the price goes too low, it buys them off.

Many algorithmic stablecoins were created to become the inflation-proof currencies that could serve as stable collaterals in the DeFi segment. However, of Ampleforth (AMPL), Basis Cash (BAC), and Empty Set Dollar (ESD), only the former is live now. A differently focused Celo Dollar (cUSD) works for ultra-fast and cheap transactions, while the Claim stablecoin (also cUSD) represents the newly born credit-based stablecoins. Let’s take a closer look at these tokens and their use cases.

Ampleforth — inflation-free, correlation-free

Launched in 2018, Ampleforth was the first-generation algorithmic stablecoin. Its mission isn’t simply “being as close to $1 as possible” — Ampleforth is meant to be an asset not exposed to inflation and correlation with major crypto assets such as Bitcoin. The aim is to preserve its purchasing power whatever happens on the market.

Ampleforth can be used to diversify the crypto portfolio, as reserve collateral in DeFi, and ultimately, as “an alternative to central bank money that is adaptable to shocks.”

Here’s how Ampleforth works. When the protocol finds that the AMPL price goes above $1.06, it initiates a positive rebase — the number of tokens in circulation is increased. If the price is lower than $0.96, some AMPL tokens are burnt in a negative rebase.

Interestingly, all AMPL token holders don’t really own a fixed number of tokens — they possess a fixed share of Ampleforth. When a token burn happens, users see decreased number of tokens in their wallets, but their value remains the same.

ESD, Empty Set Dollar — got overincentivized?

Empty Set Dollar is a second-generation algorithmic stablecoin launched in 2020. Not very successfully, though:

Same as Ampleforth, ESD was striving to become a reserve collateral currency for DeFi. In their ambitious plan, the pseudonymous team was intending to get rid of:

  • Tether’s centralization,
  • Dai’s need for being overcollateralized,
  • Ampleforth’s “death spiral.” Remember AMPL’s thing with reduced number of tokens where the value though stays the same? ESD suggested that when some users see they “lost” their tokens, they panic sell the rest without any understanding and recommend everyone do the same. That increases the supply contraction and unbalances the token.

To overcome this, ESD made rebases voluntary. If you just need ESD as a stablecoin and that’s it, you don’t have to participate in rebases. But if you want to engage with the protocol, you lock their tokens in the DAO and then get more tokens in case of a positive rebase (when the price is higher than $1 and we need to dilute it by raising supply). If a token goes below $1, the protocol gets your ESD and burns them in exchange for coupons. You can further redeem newly minted ESD with these coupons during a positive rebase, and the bigger was the protocol’s debt, the more you will get.

This was quite a promising concept, but only in theory. In reality, the token became highly volatile and drifted away from the peg. Here’s the lesson of this example: not all stablecoin models work. They need to be tested first.

Celo — a stablecoin for mainstream adoption

Celo protocol designs financial services in crypto with the lowest possible barrier of entry. They have created a mobile-first infrastructure that allows to send their stablecoin, Celo USD (cUSD), within seconds to anywhere in the world for fees around $0.01.

The reserve collateral for cUSD is stored in the Celo Reserve, which comprises the native token Celo, Bitcoin, and Ethereum. The stablecoin is kept at $1 by expanding and contracting supply.

For this stablecoin, there is a solid use case: the public key in the Celo network gets attached to a phone number, and you can send money to someone who even hasn’t joined the network yet. Syncing with the blockchain requires minimum data which makes it very fast.

Celo is that very bridge between crypto and fiat that was once proclaimed by Tether. It’s fast, ultra cheap, and easy to use for crypto newbies.

Claim Finance — the new way to leverage collateral

Claim’s stablecoin is not algorithmic — rather, it’s a credit-based stablecoin. On our platform, users deposit DAI, then we mint cUSD (not to be confused with Celo USD!) and invest it in DeFi protocols verified by the Claim DAO (Yearn and others). The revenues are distributed among the community — CLAIM governance token holders. Users can redeem any stablecoin assets in the pool in a 1:1 ratio.

What’s unique about Claim is that we use the deposited assets as a credit leverage formed by the expected return of assets. That is, the stablecoin is balanced not only by the existing reserve, but the expected future returns of the assets will also be used as trusted collateral. The ROI in these assets will serve as the support value of Claim’s credit system. We believe this is a very promising mechanic and will let you know once it’s fully tested and yields robust results.

The mechanic is king

Stablecoins are not just tokens that strive to be valued at $1. The mechanic of how they achieve this is critical, especially in the case of algorithmic stablecoins — because it affects directly what users do and what they will ultimately receive. Keep this in mind while choosing what stablecoins to interact with, and we wish your experience will be truly stable.

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