An algorithmic stablecoin is a cryptocurrency that relies on two token types: a stablecoin and the cryptocurrency backing the stablecoin.
The relationship between the two is governed by a so-called algorithm or smart contract. This algorithm aims to control the supply of both tokens depending on the demand. Algorithmic stablecoins are often under-collateralized.
What is an algorithmic stablecoin?
Stablecoins are cryptocurrencies designed to hold a certain value of a tied asset (e.g., the US dollar). Most stablecoins achieve this goal by using some form of collateral.
Circulating stablecoins are backed by assets whose value should guarantee the stablecoin’s value. Most major stablecoins, such as USD Coin (USDC) or Tether USD (USDT), are backed by an asset off the blockchain such as the US dollar, which is held at a centralized entity such as a bank.
Algorithmic stablecoins work differently. They are not backed by an asset outside of the blockchain. Instead, they use an algorithm to control and manage the given rules. These algorithms are optimized to control the supply of the algorithmic stablecoin and its associated cryptocurrency in circulation and to stabilize the given stablecoin price around a so-called peg.
Algorithmic stablecoin types
There are three key categories of algorithmic stablecoins:
REBASE algorithmic stablecoins
Rebase algorithmic stablecoins manipulate the basic supply to maintain a so-called peg. The protocol mints or burns the supply in circulation to keep the coin price, for example, at the value of one USD. If the coin price is > 1 USD, the protocol mints coins. If the coin price is < 1 USD, the protocol burns coins. Both minting and burning take place in the holders' wallets.
SEIGNIORAGE algorithmic stablecoins
Seigniorage algorithmic stablecoins use a multi-coin system. Here, a particular stablecoin is set to be stable and at least one other cryptocurrency designed to facilitate that stability.
In addition to these two cryptocurrencies, the protocol usually offers a third cryptocurrency, a so-called bond, as an incentive for buyers when the stablecoin price falls below a fixed value.
The overall protocol goal is to maintain a stable stablecoin price by adjusting its circulating supply. When the stablecoin price exceeds the peg value (e.g., 1 USD), the protocol mints new coins into circulation, increasing selling pressure and lowering the price. If the stablecoin price drops below 1 USD, the protocol encourages users to burn their coins in exchange for a bond at a 1:1 ratio. Once the stablecoin price goes above 1 USD again, users can exchange their bonds back for the stablecoin.
FRACTIONAL algorithmic stablecoins
Fractional algorithmic stablecoins are a combination of the previous two and have become more and more popular recently. This stablecoin type maintains its value by being partially backed by collateral (e.g., fiat currency like USD) and has an algorithm adjusting the stablecoin supply as needed.
Are algorithmic stablecoins safe?
Algorithmic stablecoins belong to the riskier ones in their category. A typical example of why this is so can be found in the UST-LUNA incident.
TerraUSD (UST) is an algorithmic stablecoin using the minting and burning process of UST and LUNA coins. This process directly depends on the supply and demand of coins. If UST is in high demand, LUNA will be burned to mint UST. On the other hand, if the UST demand is lower, UST coins will be burned on LUNA.
However, the system has uncontrollable limitations. Some investors noticed this loophole and decided to attack LUNA and UST by selling UST coins on the Binance and Curve Finance platforms with a total value of USD 2.3 billion. The incident caused UST to de-peg on 9 May 2022.
Many investors were so worried about the UST crash that they started selling huge amounts of their UST and LUNA as well. The butterfly effect caused the entire system to lose balance, leading to massive hyperinflation and the subsequent price collapse of both the UST and LUNA coins.
The algorithmic stablecoin market is unregulated. Therefore, investing in these stablecoins involves the devaluation risk and may be vulnerable to speculative attacks in case of insufficient collateral. When the stablecoin supply is linked to the value of a so-called governance blockchain coin, the devaluation risk increases. It is necessary to carefully choose which of these stablecoins to invest in.