Decentralized Finance (DeFi) is a complicated and quickly evolving sector that builds on the conceptual and ideological grounds of a more effective, censorship-resistant, and open, decentralized financial system.

These characteristics are best shown by algorithmic stablecoins, which combine elements of monetary economics, financial markets, mathematics, and technology. These innovative and complex technologies, which sit at the nexus of blockchain and money, provide several challenges and unsolved issues regarding how the future of DeFi will evolve.

In this article, we’ll explore what algorithmic stablecoins are, their key features, their types, and their pros & cons.

Introduction to algorithmic stablecoins

An algorithmic stablecoin is linked to a reserve asset, such as the U.S. dollar, gold, or any other foreign currency, to ensure price stability and balance the circulating supply of an asset.

In other words, an algorithmic stablecoin truly uses an underlying algorithm that can create more coins when their value rises and purchase them off the market when their value declines.

As the supply, demand, and target price are all controlled by the code, an algorithmic stablecoin is an example of what real decentralization looks like, as there are no regulatory agencies to maintain or monitor the processes.

Algorithmic stablecoins fill a requirement in the crypto ecosystem by reintroducing the seigniorage back into the coin economy where individuals can share it.

One such algorithmic stablecoin is USDD which was recently launched on the TRON blockchain. To read more about it, click here.

Key features of the algorithmic stablecoins

An algorithmic stablecoin aims to make trading more approachable for experienced and novice users. Following are some features of algorithmic stablecoins:

1. Limited Volatility = Value Addition

Due to their limited price volatility and usefulness level, stablecoins serve as reliable repositories of value. Stablecoins may therefore be readily included in cross-border transactions. Additionally, the collateral diversification demonstrated by these stablecoins creates resistance against hyperinflation and unstable markets.

2. Adaptive Responses to the Market

The algorithm’s parameters, which are hardcoded into smart contracts, guarantee an automated response to market data without requiring direct human participation. Following an analysis of the underlying market circumstances, these factors attempt to stabilize market supply and demand for these tokens.

3. Security

By utilizing a private key, stablecoins may be securely kept in online wallets. The linked funds can only be accessed by the stablecoin holder. For higher security levels, one can use advanced encryption technologies.

Types of algorithmic stablecoins & their working

There are two types of algorithmic stablecoins:

• Rebase

• Seigniorage.

Rebase stablecoins alter the stablecoin’s supply to keep a stablecoin’s peg with fiat currencies. To maintain the stable value, the protocol mints (adds) or burns (removes) coins in accordance with the stablecoin’s price fluctuation. Coins are taken out of circulation if the price of the stablecoins falls below $1, and vice versa.

Seigniorage stablecoins function similarly. To have more control over its value, they also combine stablecoin with other cryptocurrencies. The system provides incentives to market players to buy/sell the paired cryptocurrencies in addition to a mint and burn mechanism to preserve the stablecoin’s price.

A great example of a seigniorage stablecoin is TerraUSD. It keeps its valuation in relation to the USD using LUNA, the native cryptocurrency of Terra. However, this creative pegging strategy also contributed to its failure.

Pros and cons of algorithmic stablecoins

Pros

The regulations regarding the underlying financial system are defined by the code for algorithmic stablecoins, meaning no regulatory bodies are watching over user transactions. This makes algorithmic stablecoins the ultimate embodiment of decentralization. Additionally, algorithmic stablecoin minimizes the possibility of user error by not requiring a physical asset.

Seigniorage, or the ability to evaluate the profit or loss earned on the production of a currency, was once again brought to the crypto ecosystem by algorithmic stablecoins.

Cons

First, for the apparently stable cryptocurrencies to function correctly, there must be a certain level of demand. If demand falls below a certain point, the system breaks down.

Second, stablecoins are weak because they depend on self-driven, independent investors who must be eager to benefit from the mechanism that maintains TerraUSD linked to the dollar.

Finally, this kind of stablecoin may devalue during crises due to traders responding to confusing information and uncertainty. Additionally, it may encourage the selling of the underlying stablecoin, which would lead to a sharp price decline.

Curtain thoughts on the future of algorithmic stablecoins

Until now, speculative arbitrage trading and liquidity pools have made considerable use of algorithmic stablecoins. However, the recent Terra fall makes the future seems gloomy. The legislators closely monitor market trends and may impose strict rules on these stablecoins.

Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.