Algorithmic stablecoins show promise of reducing volatility

“Stablecoin experimentation is happening in real-time with billions of dollars at stake in this vast permissionless lab we call DeFi,” reads a new research report from ShapeShift. The author focuses on the rise of algorithmic stablecoins and their potential use cases.

Promising innovations in DeFi have given rise to a new breed of stablecoins that have the potential to reduce volatility and promote greater decentralization, according to a new research report from ShapeShift.

In its latest New Frontiers research study, ShapeShift explores the recent growth of “algorithmic stablecoins,” which are cryptocurrencies that automatically adjust an asset’s supply and other important parameters to reduce volatility. In his analysis, author Kent Barton, who heads research and development at ShapeShift, focuses on three assets: RAI, FRAX and FEI.

Barton summarizes the potential value proposition of algorithmic stablecoins as follows:

“The basic notion here is that if a stablecoin protocol has the ability to automatically manage supply by minting and burning assets in response to market conditions, it can ensure that the asset remains close to its peg. This can lead to less reliance on governance, as well as lower collateralization requirements.”

The author explains that algo-based stablecoins differ from their fiat-backed and crypto-collateralized counterparts, but also noted that algorithmic and crypto-collateralized variants aren’t necessarily mutually exclusive. These stablecoins “are collateralized to a certain extent, but also feature in-protocol mechanisms to manage supply and reduce volatility,” he said.

RAI, FRAX and FEI have all received various levels of support from the crypto community, though FEI is the largest of the three in terms of market capitalization at roughly $350 million. By comparison, FRAX has a total market value of $245 million, whereas RAI is valued at roughly $28 million, according to Coingecko data.

RAI follows a “redemption price” protocol that targets secondary-market sales, which allows it to maintain stability over time versus the underlying ETH-based asset. Barton says RAI is a more suitable option for traders as opposed to long-term investors.

FRAX is collateralized by USDC, though its total backing is always less than the supply of FRAX. That makes it under-collateralized and the stability mechanism is supported by using USDC as opposed to ETH.

FEI differs markedly from these projects by using a bonding curve that sells FEI for ETH. Wealth entering the system is locked in something called Protocol Controlled Value, which is used to maintain the peg through liquidity management on exchanges.

Barton concludes by stating that algorithmic stablecoins are still in their early stages, which means their success is far from guaranteed. Nevertheless, this emerging asset class is unique for its regulatory profile, potentially positive impact on DeFi and ability to facilitate niche use cases.