Decentralized finance (DeFi) is a complex and rapidly developing industry, full of experimentation and innovation, and building on the philosophical and ideological foundations of a more efficient, censorship-resistant, and open decentralized financial system.
Algorithmic stablecoins exemplify these traits; part monetary economics, part financial markets, part mathematics, and part technology. Sitting at the intersection of money and blockchain technology, they are new and complex—and pose many challenges and unanswered questions over how the future of DeFi will unfold.
In this article, we’ll explore what algorithmic stablecoins are, how they work, and how they differ from conventional stablecoins.
What are algorithmic stablecoins?
Stablecoins are cryptocurrencies designed to hold a certain value relative to something else; typically a fiat currency such as the U.S. Dollar. Because stablecoins are pegged to an expected and stable value, investors or traders often use them to stay in crypto markets while protecting themselves against market price volatility.
The majority of stablecoins aim to achieve their peg using some sort of collateral mechanism. Circulating stablecoins are backed by assets whose value should guarantee the stablecoin’s value. Most major stablecoins, such as USDC and Tether (USDT), are collateralized by off-chain collateral like USD that is held with a centralized entity like a bank. However, stablecoins can also be collateralized on-chain using decentralized mechanisms, as is the case with DAI.