Can Algorithmic Stablecoins Redeem Themselves On Their Own?

Algorithmic Stablecoins

As decentralized finance grew in 2020, a particular category of coins, also known as “algorithmic stablecoins,” gained popularity. Some of the famous coins in this specific category are Ampleforth (AMPL), Based, Empty Set Dollar (ESD), and Dynamic Set Dollar (DSD).

These tokens are mostly treated as algorithmic stablecoins; the teams developing them have different definitions to offer. For MakerDAO, an algorithmic stablecoin is that uses supply manipulations to maintain the peg. On the other hand, the founders of Empty set Dollar and Neutrino feel that Dai is an algorithmic stable because of its programmatic mint and burn mechanics. Ampleforth’s team, however, thinks that their token is not a stable coin.

It is quite evident that the assets which fall under MakerDAO’s supposed definition have little stability to offer. For example, ESD’s all-time high and low remain $23.88 and $0.174. Ample growth’s reading reveals a high of $4.07 and a low of $0.1588. In comparison, Dai’s trading range remains between $0.9 to $1.22.

Along with nominal price instability, the supply manipulation tactics that these tokens use complicates the process of assigning values to them. You can group these mechanisms into two categories: rebasing coins and coupon-based mint and burn.

Rebases Hold The Peg Now, But At What Cost?

The rebase system, which coins like Ampleforth and based use, is built on the periodic expansions and contractions of its entire supply. If your coin is trading above a particular band like $1.05 for Ampleforth, the supply will expand at one-tenth of its price deviation. This implies that if a coin’s value is above $1.50, then around 5% of the total supply will be added every day.

This mechanism is not concerned with the history of rebases till that point. Even if it has rebased many times before this, it will add 5% to the current supply. This process, however, gets reversed in case the coin trades below $1.

The result is that the token’s supply grows and shrinks at a slow pace hence putting pressure on its nominal price. The supply change gets distributed between the different wallets that have tokens. This means that the user’s total portfolio will not change even if the price shift is precisely by the percentage of new tokens.
In reality, this mechanism is quite successful in keeping the price around $1. The growth or reduction in supply finally overcomes any push that is outside of the cost. But the fact that every wallet follows the rebase implies that nominal price is just one aspect of the picture.

To find if the coin is “stable” means taking the supply changes into due consideration since every wallet is affected by these changes. When we analyze the total market capitalization to account for this supply and price, it means that AMPL becomes highly volatile in nature.

However, in general, Ampleforth’s price dynamics are related to the overall crypto market fortunes. Similar to other assets, the value of the same fell down in March 2020, though it boomed again in summer 2020 and early 2021.

Coupon Coins Struggle To Stay At $1

Another category of algorithmic stable coins is coupon-based coins. The difference with rebasing coins is that the holders will not get to see their token amounts change until they perform certain actions. In most of such mechanisms- for example, like in the Empty Set Dollar and Dynamic Set Dollar- new tokens will be minted when the price goes above $1, and these tokens are given to the unique holders who showed an interest in their governance. A small portion of these rewards also goes to the Uniswap liquidity providers.

In case a peg falls below the $1 level, the protocols incentivize the holders so they can burn their algorithmic dollars in exchange for a bond or coupon. The idea is that when the next phase of supply expansion happens, the coupons could be redeemed for dollars, getting a premium of close to 56%. However, for both ESD and DSD, these coupons expire after 30 days pass.

As per an ESD spokesperson, this coupon-based mechanism simplified the use and implementation of algorithmic stablecoins.

The downside remains that coupon-based coins are unstable. An episode with DSD in January end increased the difficulty in maintaining the peg. The DSD community struck a deal with the DSD whale knows as “Escobar. eth” to purchase their complete stash of 5.5 million DSD.

The whale reduced the token’s price even though there is no clarity that this was done on purpose. Community members who accepted this deal at an average price of $0.62 per DSD received $85 million in coupons which were set to expire in a few days after purchase.

Sadly, DSD’s price never returned to the $1 mark even after the deal was accomplished. Despite the pump given, the price came back to the current price level of $0.14. While this fall was attributed to a market correction, this episode reflects the level of risk involved by holding coupons.

It is evident that the price may ever come back to $1 within the time frame. The more the price deviates from $1, the more the users get demotivated to create more coupons. Moreover, the fact that there is no stable value backing the token value implies that its price may not come back to its original level ever.

A death spiral phenomenon is seen in the Based Protocol, which also uses the same mechanism as Ampleforth. Since the highs in the “summer of DeFi,” showed the price has come to $1, but market capitalization is still at an all-time low.

What Is The Sole Purpose Of An Algorithmic Stablecoin?

Seeing the difficulties that algorithmic stable coins have in maintaining their value at a stable value, we need to figure out any other benefits to these tokens.

The ESD team says that their project aims to get a decentralized, composable unit of account that they can utilize across DeFi protocols. They wanted to place the coin in the same category as Dai or USD Coin (USDC), the only difference being in the niche targeted. As an addition, the company wanted it to be able to return to peg through an incentive mechanism.

As per Rincon-Cruz, Ampleforth is just a speculative asset that gives one significant advantage: the ability to denominate stable contracts. Traditionally money is used for three purposes: a unit of account, store of value, and medium of exchange.

A unit of account is basically how we measure the prices. For example, certain exchanges and crypto services place the costs of their service in Bitcoin. This means that they would get higher value in Dollars when the BTC’s price rises.

A medium of exchange, on the other hand, is the asset that we use to deliver and represent value. Another practice seen in the cryptocurrency industry is negotiating the contract in dollars but can pay for it either in Bitcoin or Ether. This decision depends on the exchange rate at the time of delivery, making cryptocurrency a medium of exchange but not units of account.

Lastly, a store of value is an asset that may not carry losses nor gains for long periods. However, that is not true as US dollars continue to lose value over time but remain stable over the short term. On the other hand, assets like bonds and gold keep fluctuating but show growth in the long term.

For a stablecoin to fulfill all three definitions of money, the value should remain steady. Therefore, stable representations of the dollar like USD Coin and Dai meet all the parameters. Cryptocurrencies like Bitcoin and Ether are used in all three functions, though stable coins have reduced their use in business transactions.

A currency of Ampleforth type is useful as a unit of account but is volatile to match the other two uses. Coupon-based coins also are very volatile to use as money in any situation.

In practice, the algorithmic stablecoins that use supply manipulation have not been adopted in environments where US dollar use is prevalent. The Ampleforth team is trying to integrate its coin into the Aave lending protocol. This could be its first lending integration for the project ever since it was launched in 2018. ESD can be seen on the Cream lending platform, though you will hardly see any borrowers for it.


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