Algorithmic stablecoins have been gaining a lot of traction lately, especially due to the DeFi boom and the resultant popularity of automated money markets and financial protocols built on blockchain technology.
However, as we discussed in our latest in-depth analysis of the stablecoin space, the current solutions are far from ideal — and even though algorithmic models may look solid on paper, they are yet to be proven in practice.
In this market commentary, we will be taking a closer look at the recent performances of several such stablecoins and comment on their success, or lack thereof, in bringing price stability to the cryptosphere.
Stablecoins using the rebase model
As explained in our in-depth feature referenced above, by adjusting token balances in user wallets, rebase stablecoins ensure that holders always retain the same percentage share of the entire market capitalization.
Ampleforth (AMPL) is a good example of such a stablecoin, especially since there are no other notable projects using this model. YAM Finance, a DeFi project that was once extremely popular, also recently disabled its rebase feature.
Following the rebase model, AMPL’s supply is adjusted once every 24 hours in accordance with the volume weighted average price, or VWAP — and by doing so, the protocol attempts to keep the token at a stable price of $1.
However, a review of AMPL’s price performance over the last 90 days shows fluctuations between $0.75 and $1.70. These fluctuations, though not ideal, do show an improvement in AMPL’s stability when compared with its performance in July 2020, when it was briefly trading above $2.
While users holding AMPL are still subjected to changes in the value of their balances, they can further reduce this volatility by paying attention to the supply changes at various stages, such as deflation, inflation and event-driven surges in demand.
That being said, AMPL is one of the more stable algorithmic stablecoins on the market today and still uses the rebase model.
Stablecoins using a multi-token model
In a multi-token model, also known as Seigniorage Shares, the number of actual tokens in a user’s wallet doesn’t change in response to price changes. Instead, the price stability mechanism is passed on to secondary tokens, which incentivize liquidity providers and lenders to support the price.
Basis Cash is a stablecoin using this model and has been operating for about two months. It has three types of tokens in its protocol: a stablecoin (BAC),a dividend token (BAS) and a bond token (BAB). When the price of BAC is lower than $1, BAB is obtained by destroying BAC at a discount, and when the price of BAC is higher than $1, BAB is exchanged for BAC at a one-to-one ratio. In addition, if all bonds are redeemed, then BAS holders can receive additional BAC when the price of BAC is higher than $1.
Despite the fact that Basis Cash is built on such a complex mechanism, when reviewing BAC’s price performance over the last 30 days, we see that it lost its $1 price peg for more than 10 days. BAC is now running below $0.60 and is not showing signs of a strong rebound.
The reason for this situation may be the large debt issuance that resulted after the BAC price ran under $1. A large issuance of bonds means longer waiting times for redemptions, which further leads to excessive deflation of the stablecoin.
Ultimately, this becomes a cycle in which the low price of BAC means more BAB needs to be exchanged at a discount, which puts further pressure on the price of BAC.
Basis Cash has not yet gone through a full cycle, and it needs more time to show the resilience of its mechanism. While it is possible for it to re-enter the inflationary phase at some point in the future, it seems difficult at the moment.
Basis Coin, the copycat of Basis Cash, is collapsing even faster. The stablecoin in this protocol, BCC, is running at $0.11, as of Jan. 20, and it has never stabilized at around $1 for more than 24 hours. BCC has clearly failed at providing price stability and remains under pressure from huge bond redemptions, making it unlikely that it will return to the $1 peg anytime soon.
Empty Set Dollar (ESD), another algorithmic stablecoin protocol, uses a “coupon” mechanism in order to finance protocol debt. Coupons are purchased by burning ESD, which results in a contracting supply. Coupons can then be redeemed for ESD once the protocol enters an inflationary phase.
ESD considers an eight-hour cycle as an “epoch,” which means that the total circulating number of tokens is adjusted in a shorter cycle. Debt is created when an “epoch” ends and the volume-weighted average, or VWAP, price falls below $1. Thus, if the ESD price falls below the anchor for multiple “epochs,” the debt becomes larger and, meanwhile, the “coupon” discount becomes greater in order to attract people to purchase. In addition, ESD adds a maturity period to the debt, where coupons will expire in 90 “epochs,” which is equivalent to 30 days.
Although ESD has made many improvements, on paper, over AMPL and BAS, looking back at its price over the past 30 days, we can clearly see that its current price of $0.51 is far off from the $1 peg. Theoretically, whether ESD prices will rebound or not will depend on the point at which a large number of bonds expire. For now, ESD also needs time to prove itself.
Dynamic Set Dollar (DSD), a ESD copy, differs in some ways, including extending the maturity of coupons and reducing the number of token expansions and contractions. DSD has also entered a deflationary phase over the past two weeks, but the current price of $0.65 appears to be firmer than ESD.
Stablecoins using a partially collateralized model
FRAX, launched around a month ago, is a partially collateralized stablecoin and the world’s first fractional-algorithmic stablecoin. Anyone can create FRAX by providing two tokens: a collateral token (USDT and USDC supported at genesis) and a governance token, FXS. The current collateral ratio is 82.25%, which means 1 FRAX can be minted with $0.8225 worth of USDT or USDC and $0.1775 worth of FXS.
Theoretically, when 1 FRAX is below $1, arbitrageurs will buy FRAX and use it to redeem USDC and FXS, and profit from the sale of FXS. The demand for FRAX purchases will allow the exchange rate to reach $1 again. When 1 FRAX is over $1, the arbitrageurs will mint FRAX with USDC and FXS, and then sell FRAX at a profit. This selling pressure will drive the exchange rate back to $1.
FRAX is, however, still in the very early stages, and the bonds used to mitigate the deflationary phase, when large amounts of FXS tokens are being sold, have still not been launched. That being said, the protocol has been very stable for the past month, and FRAX’s price is firmly anchored at $1. In addition, the market size of FRAX is growing slowly, and the total issuance of FRAX has not exceeded 26 million. We still need to see if FRAX remains anchored when the collateral ratio is further reduced and if its total issuance expands further.
Algorithmic stablecoins have much to prove
After reviewing all the above-mentioned algorithmic stablecoins, we can see that the use of bonds and dividends as incentives appears to work to some extent. However, there is definitely a speculative, high-risk element involved in these models.
While algorithmic stablecoins aim to be more scalable than collateral-back stablecoins, recent market performances suggests that they don’t always work well in practice and need more time and market maturity to remain firmly anchored to the $1 soft peg.
Regardless, it is evident that the DeFi boom and a general shift toward blockchain-powered financial solutions are encouraging innovation and experimentation, which are likely to yield positive results and better, more robust protocols in the future. Until then, fiat-collateralized stablecoins are likely to remain popular.
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