Celo Dollar | Demystifying the workings of algorithmic stable coins..

Inovatyv
February 9, 2024

Cryptocurrencies, like Bitcoin (BTC) and Ether (ETH), have gained significant popularity in recent years. However, their inherent volatility poses challenges when it comes to using them as a medium of exchange for everyday transactions. This is where stablecoins come into play, offering stability and reducing price volatility.

Stablecoins employ various mechanisms to maintain their stability. The most common method involves pegging their value to a specific fiat currency, such as the US dollar, or a particular commodity like gold. By pegging their value, stablecoins ensure their price remains closely tied to the underlying asset.

Let’s start with understanding the types of stable coins before we delve deeper into the working of Celo Dollar.

Types of stablecoins

1. Fiat-backed stablecoins:

  • These stablecoins are denominated in fiat currencies, such as the US dollar or euros.
  • They maintain stability by being backed by an equivalent reserve of fiat currency.
  • The use of blockchain technology enhances their stability and predictability.
  • Fiat-backed stablecoins are commonly utilized in cryptocurrency trading and as a store of value.

2. Crypto-backed stablecoins:

  • Crypto-backed stablecoins are supported by a pool of cryptocurrencies stored in a smart contract.
  • The value of these stablecoins is adjusted based on the underlying crypto assets.
  • They offer advantages like decentralization and transparency.
  • However, they can be affected by the volatility of the underlying crypto assets.
  • Examples of crypto-backed stablecoins include Dai (backed by Ethereum) and BitUSD (backed by BitShares).

3. Commodity-backed stablecoins:

  • Commodity-backed stablecoins are collateralized by commodities like gold or oil.
  • The value of these stablecoins is tied to the price of the reserve commodity.
  • They aim to provide a digital asset with low volatility for transactions and storing value.
  • Commodity-backed stablecoins aim to combine the benefits of cryptocurrencies with the stability of a tangible commodity.

4. Algorithmic stablecoins:

  • Algorithmic stablecoins are a type of cryptocurrency that doesn't rely on external assets for backing.
  • They utilize sophisticated algorithms to maintain price stability.
  • The supply of these stablecoins is adjusted automatically based on changes in demand.
  • One common design is the "Seigniorage Shares" model, where token issuance and redemption respond to market demand.
  • The algorithm ensures the stablecoin's price remains stable by adjusting its supply.

Choosing the Blockchain network

When choosing a blockchain network for launching a stablecoin, the primary consideration should be the desired supply and demand volume for the project. The choice of blockchain will have implications for the stability and flexibility of the stablecoin. There are three main approaches:

  1. Creating your own blockchain: This involves developing a new blockchain and building a stablecoin on top of it. An example of this is the Celo blockchain with its cUSD stablecoin.
  2. Creating a decentralized stablecoin: This approach involves designing a stablecoin algorithm from scratch using an existing blockchain. The issuance of coins is ensured through smart contracts. Examples include DAI based on the MakerDAO protocol or other ETH pegged coins, suitable for creating stablecoins on Ethereum.
  3. Creating a trustable centralized stablecoin: This approach is commonly used for stablecoin development, with Tether being a prominent example. It involves creating a simple ERC-20 contract on Ethereum that issues stablecoins. This approach allows for leveraging the advantages of blockchain while maintaining stability backed by fiat currencies.

Ultimately, the choice of the blockchain network depends on the specific requirements and goals of the stablecoin project, including factors like decentralization, stability, and scalability.

Celo Blockchain - Celo$ and Celo Gold

Expansion

Expansion Algorithm for Celo Dollar

It showcases the process of creating and selling Celo Dollars, which is a stablecoin designed to be pegged to the value of gold. The protocol aims to achieve stability by expanding the supply of Celo Dollars until their market price reaches $1. This expansion is accomplished by creating new Celo Dollars and offering them for sale on the open market. In exchange for these newly created Celo Dollars, individuals can purchase them using Celo Gold and other crypto assets, which are then added to Celo's reserve.

To ensure the stability of the Celo Dollar, a smart contract is employed. This contract maintains a fixed ratio between the supply of Celo Dollars and the value of Celo Gold held in the reserve. By monitoring this ratio, the protocol can adjust the supply of Celo Dollars accordingly, expanding it when the market price is below $1 and contracting it when the price rises above $1.

Contraction

Contraction mechanism of Celo Dollars

It illustrates the contraction process employed by the protocol when the market price of Celo Dollars falls below $1. To restore the value of the stablecoin, the protocol uses Celo Gold and other assets from the reserve to purchase Celo Dollars from the open market. Once acquired, these purchased Celo Dollars are "burned," meaning they are permanently removed from circulation and their value is effectively lost.

This contraction mechanism reduces the supply of Celo Dollars in circulation, helping to maintain the Stable coin's value and peg to the targeted $1 price. The protocol monitors the market price of Celo Dollars and initiates the contraction process until the price returns to the desired level.

In conclusion, stable coins play a crucial role in bridging the gap between fiat currencies and cryptocurrencies by offering stability and reducing price volatility. They serve as a reliable medium of exchange and store of value, providing stability comparable to traditional fiat currencies while leveraging the benefits of blockchain technology. At Inovatyv we help ogranisations solve business problems,  find industry opportunities using blockchain and AI as the underlying technology. If you’re thinking about building your own stable coins drop us a note here.

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