Gate.io Cryptopedia: Algorithmic Stablecoins

What are Stablecoins?

Stablecoins, as the name implies, are digital currencies with stable value. Most cryptocurrencies are prone to large price fluctuations based on market dynamics. Stablecoins are used to connect the cryptocurrency market with the fiat market with the risk of price volatility

There are Three Types of Stablecoins:

1) Fiat-collateralized stablecoins, for example, USDT that pledges US dollars to anchor the value of the US dollar;
2) Over-collateralized stablecoins in multi-asset pools, for example, DAI;
3) Crypto-native algorithmic stablecoins, representative algorithmic stablecoins, including AMPL and YAM that use the rebase mechanism, refer to flexible stablecoins mechanism ESD and Basis Cash designed by Basecoin. ESD and Basis Cash combine the mechanisms of liquidity mining and flexible stablecoins to create a new stablecoin mechanism. This type of algorithmic stablecoins is different from the first two stablecoins that achieve a stable effect through mortgage assets. They are both experimental solutions, trying to issue and operate through a completely decentralized model.

*Rebase is an economic model. Its principle can be simply understood as when the market price deviates from the target price by a specific margin, the smart contract will automatically increase or decrease the supply of tokens to drive the market price back to the target price.

*Basecoin (later renamed Basis) is an algorithmic stablecoin launched in 2018 and was a very popular project at that time. The developers were able to reduce price volatility by linking tokens to underlying securities. However, the concept was questioned by some cryptocurrency enthusiasts and economists. Later, the founders shut down the Basecoin project in December 2018 after returning funds to investors due to regulatory intervention by the SEC.

What are Algorithmic stablecoins?

Algorithmic stablecoins are a stable currency that depends on algorithms to adjust the total amount of currency in the market. When the price of the stable currency is higher than the anchor price, the algorithm will increase the total supply in the market; when the price of a stable coin is lower than the anchor price, the algorithm reduces the total supply in the market. This mechanism does not need to anchor fiat currencies, and relies entirely on the market and algorithm to regulate the supply, also known as flexible currency.

The “Unstable” Algorithmic Stablecoins

Since an algorithmic stablecoin is a “stablecoin”, how do you explain the recent boom in investing in algorithmic stablecoins? Take the algorithmic stablecoins of the rebase mechanism as an example, when the official number of tokens is increased or the supply of tokens is decreased, the tokens in the user’s wallet will increase or decrease in the same proportion, keeping the number of holdings as a percentage of the total number of tokens unchanged. Since the mechanism of adjusting the supply of algorithmic stablecoins is designed to be tradable, both gains and losses may be magnified when investing due to the total amount of tokens available in the market not being equal to the supply in the market, and hoarding behavior of token holders will directly impact the supply of tokens, thus affecting the token price.

For example, the target price of an algorithmic stablecoin is stable at $1, and a user buys 10 stablecoins for $10. A period later, an investment boom attracts more users causing the token price to rise. In order to stabilize the token price, the algorithm will increase the total supply, and tokens in the user’s wallet will increase to more than 10 tokens, and at the same time attract more people to buy, resulting in the token price rising. Alternatively, the total supply continues to increase until the token price returns to the target price. The tokens in the user’s wallet have become more than 10 at this time and the price of the tokens has risen (>1 USD), profits can be made but the consequences of losses may also be magnified. With such a hot market, the algorithm regulation mechanism could possibly fail due to the inability to digest the buying power of the market. If the price of a token is lower than $1, the depreciation of the coin price could cause panic among coin holders. This deflationary model will cause tokens in the wallets of coin holders to decrease, and the direct impact of the price drop could cause a large number of users to sell. This could further exacerbate the decline in token price.

The emergence of ESD with the bond model and Basis Cash with dual currency aims to make up for the shortcomings of the rebase mechanism.

AMPL, ESD, Basis Cash and BASE

AMPL
AMPL adopts the rebase mechanism, which will rebalance the supply according to the target price. When the price is higher than the target price, the mechanism will increase the token supply to reduce the token price; in return, and when the price is lower than the target price, this mechanism will reduce the supply of tokens to increase the price of tokens. AMPL’s supply control is carried out at 10:00 Beijing time every day.

ESD
ESD tokens realize circulation, supply and regulation through incentive measures without collateral. When it comes to the number of tokens, ESD does not use smart contracts to adjust the supply quantity, but uses an incentive mechanism to encourage users to actively complete it. This incentive mechanism is the most special part of ESD. When the price is higher than the target price, users can choose to mortgage their ESD holdings to receive more newly issued ESD rewards. Due to the increase of ESD in the market, the price of ESD is reduced. When the price is lower than the target price, ESD will issue coupons, and holders can buy discounted ESD coupons by burning ESD. The coupons can redeem for more ESD when the price is higher than the target price in the future. This will encourage token holders to burn more ESD to obtain coupons, thereby reducing the supply of tokens and increasing the price of tokens.

BASIS
Basis has three kinds of tokens: BAC (Basis Cash), BAS (Basis Share), BAB (Basis Bond). BAS is similar to “Pledged ESD” and can get newly issued BAC rewards. BAB is similar to “ESD coupons” and has the opportunity to obtain premium income. The main role of BAS and BAB is to stabilize the price of BAC at $1.

When the price of BAC is lower than US$1, holders can buy BAB to redeem BAC at a discounted price in the future. When users buy BAB with BAC, BAC will be burnt so as to reduce the amount of BAC in circulation. The difference with ESD coupons is that BAB does not have an expiration date. When the price of BAC rises above $1, BAB can be redeemed back to BAC on a 1:1 ratio, thus issuing additional BAC. If the price of BAC is still above $1 after redemption, BAC will continue to be issued and the additional BAC will be distributed to the BAS pledgers and Basis treasury. The newly added BAC will first meet the exchange needs of BAB holders and then be issued to BAS holders.

BASE
The feature of BASE is that it does not anchor $1 like other algorithmic stablecoins, but anchors the total market value of all cryptocurrencies at a ratio of 1:1 trillion. The formula is :
the total market value of the crypto market / 1 trillion = the anchor price of BASE.

The BASE mechanism is regulated at 6 a.m. Beijing time every day, and is a simultaneous regulation. Meaning that all deflationary or inflationary regulation is completed at once. In AMPL’s mechanism, prices are regulated using the average of the last 24 hours of volume and price, while BASE uses current market prices. It is this mechanism that caused the BASE to fall by over 70% in just two days on December 6–7, 2020.

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