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23 May 2022

What Are Algorithmic Stablecoins?

Deepan Datta

Left, right, and center, everyone’s talking about stablecoins. Yet, there is so much confusion and uncertainty in the market about them.

That is why this article on stablecoins, with a focus on the most controversial type there is: algorithmic ones.

What is an Algorithmic Stablecoin?

Algorithmic stablecoins have spooked the market right now. But what are they?

Well, in the crypto market, there are four types of stablecoins including the algorithmic, fiat-backed, asset-backed, and crypto-backed ones.

If you read the previous sentence again, you will notice that it presents a crucial fact about stablecoins: Except the algorithmic one, every other type of stablecoin has underlying collateral.

Tether and PAXG are some examples of stablecoins linked to a collateral. Tether (USDT) is a fiat-backed stablecoin. The foundation, USD, keeps the exact amount of dollars reserved to back the USDT in circulation. PAX Gold (PAXG), on the other hand, is an asset-backed stablecoin. Each PAXG token is backed by 1 fine troy ounce kept in Brink’s vaults managed by Paxos.

The algorithmic stablecoins are of a different ilk. They are not backed by any asset or crypto. Instead, they use smart contracts to keep them pegged. Simply put:

Algorithmic Stablecoins are cryptos that are governed by a set of codes. The codes help them maintain the pegged market value.

But how exactly do they work? Let’s break that down.

How Algorithmic Stablecoins Work

Algorithmic stablecoins use specialized algorithms encoded in smart contracts to maintain the intended peg (the fiat currency it tracks). This is primarily done by managing the supply of stablecoins in circulation.

The process, understandably, requires two tokens. One, the stablecoin itself, and the other, the token that backs the stablecoin.

The algorithm encoded will burn more crypto tokens to mint stablecoins when the price of a stablecoin exceeds the intended peg. And when the price falls, the stablecoin will be used to mint new crypto tokens to maintain stability—with zero human intervention.

That’s it. That’s all there is to algorithmic stablecoins.

Disclaimer : Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions. The information provided in this post is not to be considered as investment/financial advice from CoinSwitch. Any action taken upon the information shall be at user's own risk.

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Deepan Datta

Content Writer

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