Algorithmic Stablecoins are quite something to wrap your head around.
But with up to 40% APY to make in their ecosystems, it’s worth it.
Let me give you a head start 🧵👇
1| Stablecoins (SCs) can be divided in three categories:
1️⃣ Off-Chain Collaterized
2️⃣ On-Chain Collaterized
3️⃣ Algorithmic
2| 1️⃣ Off-Chain Collaterized means for each $ of the coin, there is one $ of the reserve (the collateral) in a bank.
The security that there will always be a $ to get in return for your SC, provides the necessary market stability.
3| 2️⃣ On-Chain Collaterized means for each $ of the coin, there are some $ of another crypto asset as a reserve locked in a Smart Contract.
It is usually more than the same amount, to account for the volatility of the reserve.
4| But this thread is about 3️⃣!
If you need a refresher Stablecoins, continue here👇
twitter.com/CordtMinzer/status/1486851533954109440
5| Algorithmic Stablecoins (ASCs) usually don’t have collateral.
They maintain the peg to the reference asset (e.g. USD) using Algorithms running on the Blockchain.
I say usually, because there are some Protocols that work differently.
I will come back to that 🙂
6| The design goal of ASCs is to overcome the shortcomings of its older brothers:
Off-Chain collateral means potential for censorship and market entrance-barriers.
On-Chain collateral means high volatility that needs to be handled.
7| With that out of the way, let’s look at the simplest form of an algorithm providing stability:
It’s called rebasing.
Here is how it works:
8| Let's say you have 1SC (Stablecoin) worth 1$.
Over night, the price of SC rises and 1SC is now worth 2$.
To stabilise it, the algorithm adjusts all amounts of SC in all Wallets (DeX, MetaMask, all)!
You wake up and own 0.5SC, worth 1$.
9| You might think you got scammed, since now you have only half the amount of SC as before.
But the key is to understand that the value you own, compared to the reference asset (i.e. USD), remained the same.
All the algorithm is doing, is attempting to maintain the peg.
10| This process is called expanding/ contracting and can be thought of as money printing (and burning).
It basically artificially creates inflation/ deflation.
The caveat: This step alone won’t change anything about the price 😱
11| To make the whole piece play-out, the market needs to respond to the change in supply and thereby adjust the price.
This is where you can make a profit by arbitraging - which is exactly what happens.
An example of this is @AmpleforthOrg
12| Btw, Smart Contracts can only use data from the Blockchain, right?
How do they know the market price?
Oracles. But I’ll write about them another time ;)
13| Let’s get back to this statement:
ASCs usually don’t have collateral.
Except some of them do. They are called Fractional-Algorithmic Stablecoins 🤯
14| These exotic products actually have collateral, but it gets even weirder.
Let’s look at FRAX: The collateral is USDC, a fiat-backed Stablecoin.
The collateral-ratio is adjusted by the algorithm, depending on the FRAX price.
15| The idea is to gradually reduce the amount of collateral to eventually become fully algorithmic.
How does it work?
For this you need to understand multi-token models:
16| SCs like FRAX have a secondary Token that serves two purposes:
1️⃣ It can be used for arbitrage, helping to maintain the peg of the SC itself
2️⃣ They give access to an ecosystem and hold value themselves - making them desirable to buy and earn
17| I will explore this in more detail in the next Thread, using the example of FRAX :)
Until then, let’s see what could possibly go wrong.
18| $IRON is another example of a Fractional-Algorithmic Stablecoin.
Actually, its a clone of $FRAX!
But its design and execution were flawed, leading to its complete failure in a matter of hours.
19| The project witnessed a “bank-run”, where, kicked-off by some whales pulling their funds, the secondary token $TITAN ended in a death-spiral, rendering it virtually worthless.
Its value went from 40$ to 0$ within a few hours.
20| Here is a great write-up of that incident:
stablerates.substack.com/p/looking-at-iron-finances-failure
21| That’s it for now.
For the next threads I’ll try to pick topics that are easier to digest 😅
22| If this helped you to understand something better or different, re-tweeting or liking the f i r s t tweet would mean a lot to me ❤️
If I got something wrong or you have a question, please let me know 💬
23| If you want to read more of this, my goal is to write 1 Thread every week of 2022.
In simple language that anyone (in particular, me) can understand.
twitter.com/CordtMinzer/status/1477305115254177796?s=20