With the swift and public destruction of UST, algorithmic stablecoins are getting more attention than they used to. Stablecoins are an important part of your crypto portfolio regardless of market conditions. So today we are going to focus on algorithmic stablecoins. We will show you one quality project moving forward in this direction despite the issues that brought down UST.
Types of Stablecoins
First, we need to understand the difference between algorithmic stablecoins and other stablecoins. All other stablecoins are collateral-backed in some way. The 3 most common types of asset backing are:
- US Dollars or USD cash equivalents: money market accounts (backed by USD), or T Bills like how USDC is backed
- Crypto. One crypto backs another like using $100 of ETH to back issuing $70 of DAI.
- Commodities. Gold is the most common here but any scarce liquid commodity like silver could serve as the backing for a stablecoin. Pax Gold’s PAXG coin is a gold-backed stablecoin, for example.
The idea is that a stablecoin must be fully backed by liquid assets to hold its peg during its toughest times.
Algorithmic coins work differently. They are not fully asset-backed like the other three types of stablecoins. With these coins, the algorithm does the work of helping to manage the peg to the US Dollar (usually) or other assets.
The way it works is the algorithm works together with a smart contract to manage the peg. In the LUNA-UST example, if the price went over $1 then arbitrageurs would step in and burn $1 of LUNA to mint $1 of UST. Then, sell at over $1 for a profit. And the reverse if under $1 to create more LUNA and burn UST. This helps regulate the price to the peg and the supply of the stablecoin at any given time. LUNA even had a Bitcoin reserve to sell in case UST failed to hold the peg AND LUNA declined in price at the same time. We see now that this was not enough to solve the main problem UST had, which was a lack of liquidity.
Can Any Algorithmic Stablecoin Be Successful?
This is a question many in the industry are asking. So far, none have been successful but most don’t get as big or fail as spectacularly as UST did.
And it’s an important question. Many believe that you can’t really have decentralized finance unless you have a decentralized stablecoin as part of the system.
Bitcoin is decentralized. And at the time of writing, it’s a $580 billion market cap project. Less than 2% of that, only $8.3 billion according to CoinGecko, is currently in DeFi markets as Wrapped Bitcoin (WBTC). That’s $8.3 billion out of $107 billion in TVL in DeFi right now.
So Bitcoin’s use as DeFi’s decentralized money is less than 10% of the market. And it’s not price-stable like stablecoins are. So while we like Bitcoin for many reasons, as the decentralized medium of exchange for DeFi markets, it’s not doing much.
Vitalik Weighs In
Even ETH Co-founder Vitalik Buterin had something to say on this subject in a recent post on his blog. He believes that there are algorithmic stablecoins with good design and those with a flawed design like UST.
Buterin calls them automated stablecoins because they:
- Have a ‘targeting mechanism’. Like the mint/burn relationship between the stable and another coin (UST and LUNA) AND
- Have a completely decentralized mechanism: no custodians, protocol-level support, or any other centralized human decision-makers. Completely means completely. So that excludes USDC, USDT and BUSD. These three largest stablecoins all have single issuers and custodians.
Buterin argues that RAI is probably the closest and best-designed algorithmic stablecoin in the market today. Then he proposes two different ideas on the operation and management of a stablecoin. It’s an interesting read that we recommend when you finish reading this article.
The Leading Algorithmic Stablecoins Today
Here are the top ten stablecoins by market value.
We know the top three are not algorithmic. DAI and MIM are overcollateralized crypto- and debt-backed algorithmic stablecoins respectively.
And that leads us to Coin #6 on this list with a market value of $1.49 billion, Frax.
What is Frax and Why Is It Different?
Frax calls itself the ‘first fractional algorithmic stablecoin’.
What does that mean?
Frax is backed 90% by non-Frax collateral (USDC) and 10% by endogenous, algorithmically-backed collateral (the market capitalization of the FXS governance token). In the first paragraph of their own whitepaper, Frax mentions the extremes and design flaws of stablecoins, just as Vitalik did. In this case, Frax means the extremes of stablecoins backed solely by crypto collateral, and stablecoins backed solely by reflexive, endogenous collateral.
Frax is trying to thread the needle by doing both.
The fractional part means there is some backing by collateral. The algorithmic part means there’s an algorithm used as the targeting mechanism. And that mechanism is decentralized.
Like LUNA and UST, there’s a mint/burn relationship between the stablecoin FRAX and the governance token Frax Shares (FXS).
But that’s where the similarities end.
Frax has done a couple really smart things in their design. The first smart thing they did was when they launched and $FRAX value was small and vulnerable, it was backed 100% by collateral. Frax uses USDC as its backing coin. Now the collateral less but steady and phasing up the use of the algorithm.
Today, the collateral ratio is unlike any other stablecoin. It’s not zero like pure algo coins or 100% or more like fully collateralized or over-collateralized coins. The ratio is currently 89.5%.
You can see in this chart that when the coin launched in January 2021 its collateral ratio was 100%. Smart. Now it hovers between 80-90% most days. The collateral ratio determines how much $FRAX you can mint too. At 90% (if we round up), for your $100 of FXS or combination of FXS and USDC, you can mint $90 worth of FRAX. So it’s not 1:1. The collateral ratio determines this automatically. This is smart too as it helps keep FRAX tighter to its peg. That’s instead of keeping it at 1:1 when collateral levels drop creating more risk for all $FRAX holders. Managing this ratio is one way $FRAX manages its peg. The ratio drops if $FRAX is trading above $1 and increases if it goes below to incentivize more minting or redeeming to keep the peg.
There’s another ratio in this image called the Decentralization Ratio. This ratio tells us how fractional $FRAX is right now. It’s the ratio of decentralized assets over the total collateralized stablecoin supply. If we got to full decentralization with no collateral backing then Frax would be at 100%. It’s at 23.78% today. So a ways to go but the stability in the price and maintenance of its peg speaks to the success of this strategy so far. Especially in these terrible market conditions we have right now.
The other really smart thing Frax did when they decided to go collateralized in the beginning is that $FRAX is always mintable and redeemable for USDC. To have a coin outside the Frax system for this adds to its stability. It’s something LUNA did not have when both LUNA and UST started declining at the same time as people lost faith in the Terra ecosystem. USDC provides an escape hatch that’s completely outside the Frax ecosystem if the same type of death spiral that killed UST tries to kill off $FRAX too. Attempts to short both $FRAX and $FXS would be less effective since neither influences the price and issuance of USDC. This is an important feature that Vitalik likes about RAI. You can go outside the RAI system and redeem it for ETH. Frax did the same with USDC. And Frax is much larger and more established than RAI.
So far, no algorithmic stablecoin has yet been sustainable. Yet, we have reason to believe that improving the stablecoin design and target mechanisms can make one successful in the future. Project teams think this and so does Vitalik in his own analysis. And of those trying it, the largest, most successful, and best designed of these algorithmic stablecoins is the Frax Finance $FRAX coin. We will be following it to see if we can get that decentralized medium of exchange the DeFi sector needs.