What are algorithmic stablecoins?

Stablecoins are cryptocurrencies designed to hold a certain value relative to something else; typically a fiat currency such as the U.S. Dollar. Because stablecoins are pegged to an expected and stable value, investors or traders often use them to stay in crypto markets while protecting themselves against market price volatility.

The majority of stablecoins aim to achieve their peg using some sort of collateral mechanism. Circulating stablecoins are backed by assets whose value should guarantee the stablecoin's value. Most major stablecoins, such as USDC and Tether (USDT), are collateralized by off-chain collateral like USD that is held with a centralized entity like a bank. However, stablecoins can also be collateralized on-chain using decentralized mechanisms, as is the case with DAI.

Algorithmic stablecoins are different. Algorithmic stablecoins, in their purest form, are completely uncollateralized. Their value is not backed by any external asset. Instead, they use algorithms—specific instructions or rules to be followed (typically by a computer) to output some result. These algorithms are optimized to incentivize market participant behavior and/or to manipulate circulating supply so that any given coin's price should—in theory—stabilize around the peg.

How do algorithmic stablecoins work? The litmus test to determine if a stablecoin (algorithmic or otherwise) works is simple: how well does it maintain its peg?

Algorithmic stablecoin designers use various mechanisms to help the coin maintain its peg. Unlike most stablecoins, with algorithmic stablecoins these mechanisms are written into the protocol, publicly available on the blockchain for anyone to view. Below are two common uncollateralized algorithmic stablecoin models, illustrated assuming a peg for $1.

Rebase. Rebase algorithmic stablecoins manipulate the base supply to maintain the peg. The protocol mints (adds) or burns (removes) supply from circulation in proportion to the coin's price deviation from the $1 peg. If the coin price > $1, the protocol mints coins. If the coin price < $1, the protocol burns coins. Coins are minted into or burned from coin holders' wallets.

Seigniorage. Seigniorage algorithmic stablecoins use a multi-coin system, wherein one coin's price is designed to be stable and at least one other coin is designed to facilitate that stability. Seigniorage models typically implement a combination of protocol-based mint-and-burn mechanisms and free market mechanisms that incentive market participants to buy or sell the non-stablecoin in order to push the stablecoin's price toward its peg.

A third model, fractional-algorithmic stablecoins, is becoming increasingly popular. Part seigniorage, part collateralized, fractional algorithmic stablecoins aim to maintain their peg by combining the best mechanisms from "pure" uncollateralized stablecoins and their collateralized counterparts. Frax Finance pioneered this model.

What are some examples of algorithmic stablecoins?

1. Ampleforth (AMPL) - One of the first rebasing algorithmic stablecoins, pegged to the CPI adjusted 2019 USD.

2. Basis Cash (BAC) - Using the 3-token seigniorage system, stablecoin Basis Cash (BAC) maintains its 1 USD peg through the use of shares and bonds.

3. USDD - A decentralized stablecoin for the Tron ecosystem, launched in May 2022 by Tron founder Justin Sun.

4. UXD - An algorithmic stablecoin backed 100% by a delta neutral position, on the Solana blockchain.

5. UST - This algorithmic stablecoin made headlines in May 2022 when it lost its dollar peg amid a wider crypto market crash—precipitating a collapse in the price of Terra (LUNA), the cryptocurrency used to maintain its dollar peg.

What are algorithmic stablecoins?

Stablecoins are cryptocurrencies designed to hold a certain value relative to something else; typically a fiat currency such as the U.S. Dollar. Because stablecoins are pegged to an expected and stable value, investors or traders often use them to stay in crypto markets while protecting themselves against market price volatility.

The majority of stablecoins aim to achieve their peg using some sort of collateral mechanism. Circulating stablecoins are backed by assets whose value should guarantee the stablecoin's value. Most major stablecoins, such as USDC and Tether (USDT), are collateralized by off-chain collateral like USD that is held with a centralized entity like a bank. However, stablecoins can also be collateralized on-chain using decentralized mechanisms, as is the case with DAI.

Algorithmic stablecoins are different. Algorithmic stablecoins, in their purest form, are completely uncollateralized. Their value is not backed by any external asset. Instead, they use algorithms—specific instructions or rules to be followed (typically by a computer) to output some result. These algorithms are optimized to incentivize market participant behavior and/or to manipulate circulating supply so that any given coin's price should—in theory—stabilize around the peg.

How do algorithmic stablecoins work? The litmus test to determine if a stablecoin (algorithmic or otherwise) works is simple: how well does it maintain its peg?

Algorithmic stablecoin designers use various mechanisms to help the coin maintain its peg. Unlike most stablecoins, with algorithmic stablecoins these mechanisms are written into the protocol, publicly available on the blockchain for anyone to view. Below are two common uncollateralized algorithmic stablecoin models, illustrated assuming a peg for $1.

Rebase. Rebase algorithmic stablecoins manipulate the base supply to maintain the peg. The protocol mints (adds) or burns (removes) supply from circulation in proportion to the coin's price deviation from the $1 peg. If the coin price > $1, the protocol mints coins. If the coin price < $1, the protocol burns coins. Coins are minted into or burned from coin holders' wallets.

Seigniorage. Seigniorage algorithmic stablecoins use a multi-coin system, wherein one coin's price is designed to be stable and at least one other coin is designed to facilitate that stability. Seigniorage models typically implement a combination of protocol-based mint-and-burn mechanisms and free market mechanisms that incentive market participants to buy or sell the non-stablecoin in order to push the stablecoin's price toward its peg.

A third model, fractional-algorithmic stablecoins, is becoming increasingly popular. Part seigniorage, part collateralized, fractional algorithmic stablecoins aim to maintain their peg by combining the best mechanisms from "pure" uncollateralized stablecoins and their collateralized counterparts. Frax Finance pioneered this model.

What are some examples of algorithmic stablecoins?

1. Ampleforth (AMPL) - One of the first rebasing algorithmic stablecoins, pegged to the CPI adjusted 2019 USD.

2. Basis Cash (BAC) - Using the 3-token seigniorage system, stablecoin Basis Cash (BAC) maintains its 1 USD peg through the use of shares and bonds.

3. USDD - A decentralized stablecoin for the Tron ecosystem, launched in May 2022 by Tron founder Justin Sun.

4. UXD - An algorithmic stablecoin backed 100% by a delta neutral position, on the Solana blockchain.

5. UST - This algorithmic stablecoin made headlines in May 2022 when it lost its dollar peg amid a wider crypto market crash—precipitating a collapse in the price of Terra (LUNA), the cryptocurrency used to maintain its dollar peg.