Since the crypto market cap crossed $1 trillion, we can safely conclude that a new wave of enthusiasts has come into the crypto space. The gold rush spirit is in the air, and paper valuations are going beyond people’s wildest expectations.

However, the music isn’t going to play forever, and once it stops, you’d better have your funds parked somewhere safe. That’s where stablecoins come in handy. Today, we’re going to review the ones on the bleeding edge of technology⁠—algorithmic stablecoins.

The impact of stablecoins and their presence on the market have grown tremendously over the past year. Besides fixing profits, people are using them for transferring wealth or as payment rails (something Bitcoin was previously used for).

The cumulative supply of stablecoins is now billions of dollars. The printer goes ‘brrrr’ not only in the traditional markets but in the crypto space as well.

The primary issue about the expansion in stablecoins is that it’s led by Tether, which has trouble proving that its USDT is fully backed USD. The company has been facing regulatory issues in the past and now is under scrutiny from the New York justice department.

But what if Tether proves that it has assets to back all billions of USDT it printed. Can we relax and just stick to it? Not really. Besides backing, there’s an issue of censorship. For example, during the Summer of 2020, Circle⁠—the company behind Coinbase’s USDC stablecoin⁠—froze $100,000 after receiving law enforcement requests. Tether can do this kind of thing too.

More than ten years into the crypto evolution, we still don’t have a reliable place to park our money when markets turn bearish. That’s why startups are looking for ways to create a new one.

Meet Algorithmic Stablecoins

Algorithmic stablecoins don’t rely on USD backing; instead they derive their value from various mathematical mechanisms, hence their name. The value proposition of algorithmic stablecoins is that they don’t require trust like Tether and have no censorship like Circle’s USDC.

It’s important to note that algo stablecoins, no matter how sophisticated, are more experiments rather than reliable products. There are numerous implementations of stability mechanisms, and none of them can 100% guarantee a $1 peg.

The most frequently used mechanism for maintaining stability is elastic supply. In simple terms, the protocol mints new tokens as the number of holders increases to dilute the token value to $1. Conversely, it contracts the supply if people sell tokens and leave the system, pushing the price up to $1.

Ampleforth supply expansion. When the price increases to point O on chart 1, the system mints new tokens, pushing the price back. Source: Ampleforth.

Projects like Empty Set Dollar take this mechanic further, introducing a layer of incentives for people to regulate the token supply themselves. To do so, it has Coupons and Bonds.

If ESD price goes below $1, holders can burn their ESD (contracting the supply) for Coupons, which entitles them to profits once the peg is restored. Conversely, if a user bonds their ESD to Empty Set Dollar, they will be entitled to profits once the peg goes over $1 and Coupons are burned.

There are other variations of the concept, but at this point you should get the basic idea. At their initiation, algo stables are pegged to $1, and then they are fluctuating around the peg pushed by underlying mechanisms and token holders.

How to Get Rekt With Algo Stablecoins

Like I mentioned earlier, algo stables are a giant science experiment. We can apply thought experiments and build models, but no one knows how the pegs will behave in the open market.

Let’s take a closer look at Ampleforth. Its peg hasn’t been too stable. At its lowest point, AMPL was below $0.5, while at its highest point, it almost reached $4.

It goes without saying that such wild price swings are unsuitable for a token that is supposed to give people confidence when they close trading terminals and go to sleep. But, why do they happen?

The spike to almost $4 happened to AMPL after it was introduced as a reward to liquidity providers (people who lock their tokens to help DeFi protocols) on Uniswap.

Liquidity providers needed to lock AMPL and ETH and got AMPL as rewards. The more AMPL they locked, the higher their rewards were. Hence, at the time of the program’s launch, there was a substantial uptick in demand for AMPL. The price spike attracted traders and amplified the demand.

But shouldn’t Amlpeforth react to the increasing number of users by increasing the supply of tokens? Yes, and that’s what the protocol did every day at 7:00 PM PT. But, the demand was so strong, and people weren’t psychologically distinguishing between old and new supplies (thinking that 1 AMPL today had the same value as 1AMPL yesterday) that the price skyrocketed.

Ampleforth is just an automated mechanism. It doesn’t know what’s going on on the market, so it can’t adjust properly. Hence, it doesn’t do well under adverse conditions, which brings us to the final point of this newsletter.

Algo Stables Aren’t the Future of Finance (Yet)

While the overall concept of algorithmic stablecoins is compelling, they are far from something that can be used at scale and by large players.

Reliance on automation and game theory may work in a vacuum, but the open market will always bring surprises, which algo stables aren’t ready to withstand. Hence, they largely remain speculative plays for people who understand these systems.

Take a look at the Empty Set Dollar Chart since the beginning of the year. Technically, you can bet that it will return to above $1 and make a lot of money. But, if it doesn’t happen soon enough, your Coupons will automatically burn, and you’ll go away with nothing.

For us, average Joes who want to park their money somewhere and sleep well at night shouldn’t rely on algorithmic stablecoins. As people continue experimenting with various stability mechanisms, a game-changing project may emerge. But, for now, we better stick to stables backed by something tangible.


Disclosure: The author of this newsletter holds Bitcoin and Ethereum. Read our trading policy to see how SIMETRI protects its members against insider trading.