Algorithmic stablecoins. Their advantages, mechanism, future

Cryptoeconomics will be built at the intersection of DeFi, BTC, a dozen altcoins and algorithmic stablecoins, which are the future. Let's talk more about their phenomenon. How are current stablecoins different from the previous generation? What development awaits them in the future? Look for answers to these questions in our article

Why are algorithmic stablecoins getting attention?

Algorithmic stablecoins are an optimized version of a cryptocurrency that lacks many disadvantages. It is very easy to trace the relevance of their appearance.

At the dawn of the development of cryptocurrencies, Satoshi Nakamoto presented his vision of the optimal cryptocurrency in the technical documentation for bitcoin.

Despite this, no existing cryptocurrency has 100% ideal traits:

  • BTC has deviated from the original idea in its development.
  • ETH operates in a transactional environment, but is essentially a utility token.
  • Although CBDCs have blockchain attributes, they are not decentralized and subject to strict controls.

Any algorithmic stablecoin is more in line with the spirit of decentralization and other advantages of the blockchain. It is not very difficult to verify this.

Why not Bitcoin (BTC)

Bitcoin is not the kind of cryptocurrency Satoshi Nakamoto wanted to see. It has high transaction fees, poor scaling, the ability to track the wallet owner and a whole bunch of problems.

Because of this, Bitcoin abandoned the role of "currency" envisioned by Satoshi Nakamoto. He followed the path of digital gold and already has hedging attributes.

Bitcoin has basic qualities that make it an excellent alternative store of value:

  • Deficiency.
  • Verification and control capability.
  • There are no analogues in traditional markets.

And although at the dawn of cryptocurrencies, no one considered bitcoins as digital gold, now the opinion is somewhat different. For example, on November 9, 2020, JPMorgan Chase indicated in its report that Bitcoin is reducing the market demand for gold ETFs.

Institutional investors like family offices see bitcoin as a great digital alternative to gold, and their demand for bitcoin exceeds that of all gold ETFs.

In the future, as cross-chain technology develops, bitcoin will strengthen its position as digital gold. We think this is a fair forecast.

Why not Ethereum (ETH)

The positioning of ETH and BTC was very different from the very beginning. The Ethereum cryptocurrency token has never been designed as a bargaining chip for the ecosystem to operate.

However, ETH does act as a transaction medium in certain scenarios based on its blockchain. Ultimately, Ethereum's value depends on the application value of its underlying network.

ETH is difficult to estimate. Sharp price fluctuations make it difficult to invest with this asset. Essentially, ETH is actually more like the "fuel" for the Ethereum network, and is mostly a utility token.

It also does not match the concept of an ideal cryptocurrency introduced by Satoshi Nakamoto. Therefore, ETH is also not suitable as an ideal cryptocurrency.

Why stablecoins?

According to Nakamoto, the essence of a currency is the presence of a blockchain and an encrypted token that operates on the basis of cryptographic principles to achieve decentralization.

Many coins issued to date have strong centralization attributes. Algorithmic stablecoins lack these qualities. This is a more optimal cryptocurrency in the broadest sense of this concept:

  • First generation is USDT, which tokenizes legal currency and builds an important bridge between legal currency and cryptocurrency.
  • Second generation — DAI from MakerDAO, based on the idea of ​​collateral (ETH, USDC, wBTC, etc.).
  • Third generation — flexible stablecoins AMPL and YAM, which are governed by algorithms and mechanisms.
  • Fourth generation is encrypted coins (ESD, BASIS, FRAX, etc.). They combine the experience of liquidity mining and flexible stablecoin, therefore they have the potential for integration.

Pros and cons of 1st and 2nd generation stablecoins

These tokens have almost no close similarities, except for the peg to the dollar. The difference in price between the two types of stablecoins and the dollar remains within a small range of fluctuations. This sets them apart from the third and fourth generation stablecoins, whose dollar-pegged price does not change.

Pricing in both groups is supported through an automatic mechanism built into smart contracts rather than through the issuer. In other words, the first and second generation stablecoin is centralized. This does not correspond to the main idea of ​​decentralization, which means that these stablecoins are less promising.

Stablecoin price volatility using USDT as an example (01/01/2020 - 12/31/2020)

What are the benefits of the fourth generation stablecoin?

This generation, like the third, establishes a "monetary" system through market supply and demand. The mechanism of their work can be described as follows.

Third generation stablecoin

It is a flexible stablecoin. Take AMPL as an example to illustrate its basic working mechanism. AMPL is issued based on the Ethereum smart contract.

The most important part of its protocol is considered to be the mechanism for "updating the token base". This mechanism is capable of automatically adjusting the number of AMPL tokens in all users' wallets based on market prices.

The adjustment is based on changes in market relations between supply and demand, the reaction of investors, against the background of which AMPL finds the point of price equilibrium.

The demand for AMPL is based on the hope that the coin will grow in order to receive more tokens for profit. This is the reason for the very strong speculative atmosphere in the market.

The overall AMPL adjustment is a little rough, and as soon as panic selling kicks in, the level of systemic risk skyrockets. That is, such third generation coins are speculative and are not suitable as a stable currency.

Stablecoin of the fourth generation

It is an algorithmic stablecoin. It combines the experience of liquidity extraction and flexibility to form a better mechanism for regulating the foreign exchange market.

Unlike the third generation AMPL and YAM stablecoins, the fourth generation ESD and BASIS stablecoins are not regulated globally, using smart contracts, but at the initiative of users. To this end, they use economic incentives to drive user reactions.

Take the BASIS stablecoin, for example. There are three types of tokens in the Basis protocol:

  • BAC (Basis Cash).
  • BAS (Basis Share).
  • BAB (Basis Bond).

Among them, the BAC target price is $ 1. The main role of the other two tokens is to bring the BAC price back to $ 1. So when the price of a Basis Cash transaction is less than $ 1, users can get a certain discount on their purchase of Basis Bond.

At the same time, during the transaction, Basis Bond (BAB) is simultaneously bought and Basis Cash (BAC) is destroyed. The BAC supply decreases, the token price decreases. Until the return to the one dollar figure.

When the price of Basis Cash rises to more than $ 1, users who own Basis Bond can directly redeem Basis Cash at a 1: 1 exchange rate. When buying Basis Cash, Basis Bond will be destroyed.

It is easy to see that the fourth generation algorithmic stablecoin is more "stable" than the flexible third generation stablecoin. Therefore, its popularity will gradually grow.

What to expect from algorithmic stablecoins in the future

At the moment, these cryptocurrencies are in the early stages of development. Therefore, it is still difficult to say how they will develop in the future. But based on statistics, some considerations can be made.

Thus, analysts are of the opinion that only 1 USD can no longer be the equivalent of a stablecoin. Emin Gün Sirer, founder of Avalanche Protocol, recently tweeted about this.

He cited DSD as an example, which is trading at $ 0.38. There aren't enough DeFi members just yet to push the price up to $ 1. This phenomenon is explained by the operation of the mechanism for adjusting the price of the cryptocurrency, which is determined by market supply and demand.

This phenomenon is also observed due to the low volume of stablecoins traded in the market. As soon as there are more of them, volatility will decrease and the price will settle down. A more precise anchor point appears. That is, in fact, the maturation of the system of algorithmic stable currencies will take place. Read more...

Algorithmic stablecoins are still in the experimental stage. In order for them to ensure long-term and sustainable development, a broad and long-term consensus is needed. So there is still work to be done on this!