Among the innovations of decentralized finance, algorithmic stablecoins stand out. These are crypto assets that use smart contracts to maintain a price peg to another crypto asset. A smart currency will never deviate from its peg, and participants can take advantage of its low capital lockup and reliable exchange of value. However, the stability of an algorithmic stablecoin is not yet guaranteed. This is because its designers use a variety of mechanisms to maintain the peg.
A stablecoin typically maintains a value near the dollar. It's a digital coin backed by a reserve asset, such as the US dollar, or another crypto asset. It interacts with the broader crypto and financial ecosystem, allowing users to exchange it for a bond token or another currency. However, most stablecoins are maintained through a collateralised mechanism, a method of storing value in an external asset. In this model, the protocol is updated to add or subtract collateral as the supply of the coin increases or decreases.
Algorithmic stablecoins are created on auditable code and are publicly available on the blockchain. They attempt to maintain the price of an asset by implementing market incentives and financial engineering. Algorithms are designed to make the exchange of value more equitable by balancing the circulating supply and rebasing when necessary.
Algorithmic stablecoins can be classified into three different categories: fractional, seigniorage, and fully decentralized. Fractional stablecoins are partial backed by collateralized assets, such as cash-equivalent bonds. These models are more resistant to positive feedback loop failure. However, they also have a difficult time maintaining a peg. In addition, if a coin is held by investors who suspect its reserve asset is a crypto asset, it could lead to a run on the stablecoin.
Algorithmic stablecoins can be used in speculative arbitrage trading. They are also used in financial markets with no central bank. However, they are still in the early stages of development and do not have enough liquidity to be used as a stable store of value. They have a way to go before they can be trusted as such.