A stablecoin is a type of token pegged to one unit of something and, as the name implies, is meant to be stable. The most popular stablecoins at the moment are those pegged to the US Dollar. For instance, USDC, USDT, DAI all attempt to stay $1. But, you can also peg to 1 Euro or 1 Canadian Dollar if you want.
Where it gets interesting is how different organizations attempt to keep the peg of each stablecoin. The simplest type is where there is a centralized institution that guarantees each token is backed by what it represents. USDC is one example. A more decentralized attempt is something like DAI, where the protocol over-collateralizes with various cryptocurrencies, to guarantee there is enough backing so that 1 DAI can always be redeemed for the equivalent of 1 dollar.
What if you could algorithmically hold a peg without needing any collateral? That is what seigniorage stablecoins attempt to do, although recently they haven't been very successful. They are a fascinating type of algorithmic stablecoin which I will cover in this article.
The exact mechanics a project may employ can differ, but the general principles of how seigniorage works in stablecoin projects is the same. In order to attempt to maintain a peg, seigniorage stablecoins perform different actions automatically, hence the algorithmic part.
The simplest case is when the stablecoin is above peg. In this case we can print more of the stablecoin, this meets demand until the stablecoin is at a peg of one. Typically, most projects will distribute this stablecoin to users staking the stablecoin or providing liquidity in some way on the project.
The trickier bit is what do when the stablecoin is below peg. The idea in this case is to burn as much of the stablecoin as possible to reduce supply and meet demand. Most projects do this by selling bonds for the stablecoin. Bonds are sold in return for the stablecoin, and the stablecoin is then burned. These bonds can be redeemed for the stablecoin once the stablecoin is back at peg. Investors typically buy these bonds at a discount (less than 1 unit) while the stablecoin is under peg, then once back at peg they redeem for 1 unit, profiting from the bonds.
That is the idea, however there is a very real possibility that the stablecoin never goes back up to peg. It's possible that not enough of the stablecoin is burned and more investors continue to sell the stablecoin than buy.
For readers looking for more research on the topic, some projects which have taken this approach are Empty Set Dollar (ESD), Basis Cash, and Dynamic Set Dollar. They have all not been able to hold their peg, but can serve as a great learning experience so that a project in the future may be able to pull this off.
As of today (7/19/21), one project I am following in this space is Tomb.Finance. The project's stablecoin is near its peg and I am watching closely.
Seigniorage stablecoins are a fascinating type of algorithmic stablecoin which. If pulled off correctly, this kind of technology can be a huge win for decentralized finance as it could be possible to have a stablecoin without collateral.