Algorithmic stablecoins have the potential to reduce volatility — ShapeShift

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“Stablecoin experimentation is happening in real time with billions of dollars at stake in this vast permissionless lab we call DeFi,” according to a new ShapeShift research report. The author focuses on the emergence of algorithmic stablecoins and their potential applications.

According to a new ShapeShift research report, promising innovations in DeFi have given rise to a new breed of stablecoins with the potential to reduce volatility and promote greater decentralisation.

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

As follows, Barton summarises the potential value proposition of algorithmic stablecoins:

“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 how algo-based stablecoins differ from fiat-backed and crypto-collateralized counterparts, but also points out that algorithmic and crypto-collateralized variants are not necessarily mutually exclusive. According to him, these stablecoins “are collateralized to some extent, but also feature in-protocol mechanisms to manage supply and reduce volatility.”

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RAI, FRAX, and FEI have all received varying degrees of support from the crypto community, with FEI having the largest market capitalisation of the three at around $350 million. According to Coingecko data, FRAX has a total market value of $245 million, whereas RAI is valued at around $28 million.

RAI adheres to a “redemption price” protocol that focuses on secondary-market sales, allowing it to maintain stability over time in comparison to the underlying ETH-based asset. According to Barton, RAI is a better choice for traders than long-term investors.

USDC is used to back FRAX, but the total backing is always less than the supply of FRAX. As a result, it is under-collateralized, and the stability mechanism is supported by using USDC rather than ETH.

FEI is distinct from these projects in that it employs a bonding curve that allows it to sell FEI for ETH. Wealth entering the system is locked in a mechanism known as Protocol Controlled Value, which is used to keep the peg stable through liquidity management on exchanges.

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Barton concludes by stating that algorithmic stablecoins are still in their early stages, which means that their success is far from certain. Nonetheless, this emerging asset class is distinct in terms of its regulatory profile, potential impact on DeFi, and ability to facilitate niche use cases.

 

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