What are algorithmic stablecoins?

18.05.2022

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#stablecoins #Terra

Key points

Algorithmic stablecoins — are cryptocurrencies whose price stability is maintained by algorithms, smart contracts or the actions of users interacting with them.
As a result, their value depends not on collateral but on specific price‑maintenance mechanisms and holder behaviour. Prices tend to be more volatile than those of centralised or overcollateralised peers.
Algorithmic stablecoins are widely used as highly liquid trading instruments and in DeFi applications for collateralised lending, yield farming, crypto‑derivatives and other operations.

How do algorithmic stablecoins work?

Centralised stablecoins such as USDT, USDC and BUSD are usually issued by a single entity that maintains price stability with its own reserves and controls issuance.

Algorithmic stablecoins do not have full reserve backing. In other words, if 1bn such coins worth $1 each are in circulation, reserves in crypto or other assets might cover only $0.5bn.

The price is supported by mechanisms devised by the stablecoin’s developers — for example, seigniorage, rebasing or native‑token backing. Users are an active part of these mechanisms, being incentivised to take certain market actions.

What are the advantages of algorithmic stablecoins?

The issuance, circulation and burning of algorithmic stablecoins are decentralised, meaning anyone can interact with them via smart contracts. Partial collateral improves capital efficiency and allows the ecosystem to scale much faster as the holder base grows.

Decentralisation also means algorithmic stablecoins cannot be frozen in users’ wallets. By contrast, issuers of centralised stablecoins can block tokens held in user wallets — a practice seen more than once.

What types of algorithmic stablecoins exist, and how do they differ?

As of mid‑May there are about 20 algorithmic stablecoins on the market, with over 90% of total capitalisation concentrated in five projects.

There are several main price‑stabilisation mechanisms for this type of stablecoin.

Rebasing

This mechanism is used by Ampleforth (AMPL), a pioneer of algorithmic stablecoins launched in 2019 on Ethereum. The AMPL price is regulated by daily rebasing. If the token trades above the target, AMPL balances in wallets rise; if it trades below $1, they fall. The mechanism broadly works but does not solve price volatility.

Seigniorage

This mechanism is implemented, for example, in Empty Set Dollar (ESD) and Basis Share (BAS). It rewards token holders.

If the price is above target, new tokens are issued to holders, increasing supply and prompting them to sell the excess. When the price declines, issuance stops and users in the project’s DeFi application can buy special debt “coupons” by burning stablecoins. Coupons can be redeemed for profit only when the stablecoin returns to its target price.

Native‑token backing

Until recently, the most successful algorithmic stablecoins were those whose stability was supported by a network’s native token.

The best‑known example was TerraUSD (UST) on the Terra blockchain. Users could mint UST by burning the native LUNA via the Terra Station service, and vice versa. When UST deviated from $1, arbitrage opportunities arose. Users’ swaps were meant to stabilise the price.

To strengthen UST further, the Luna Foundation Guard (LFG) reserve fund was created in January 2022, effectively adding a “hybrid” stabilisation mechanism for TerraUSD.

Other stablecoins using native‑token backing include Neutrino USD (USDN) on Waves, USN (NEAR) and USDD (TRON).

Partial collateralisation

This approach is used by Frax Finance (FRAX). The stablecoin is partly backed by another stablecoin — USDC — and partly by the native Frax Shares (FXS). Collateralisation rises when FRAX trades below $1 and falls when it trades above $1. Thanks to this design, FRAX has become one of the more resilient algorithmic stablecoins.

What are the drawbacks of algorithmic stablecoins?

The history of algorithmic stablecoins shows they face the same systemic risks as the DeFi industry:

Exploitation of bugs and vulnerabilities in the smart contracts that govern issuance and the peg, enabling theft of reserves;
the potential for price manipulation if oracles malfunction;
the possibility of information attacks on a stablecoin to provoke panic selling and price manipulation.

In a crisis, a stablecoin can lose its peg, which in turn can trigger a cascade of selling of the native token that supports it, or mass liquidations of leveraged positions — culminating in panicked capital outflows by investors.

Most algorithmic stablecoins periodically lose stability. A few episodes:

FEI, launched in April 2021, almost immediately entered a period of depegging from the US dollar. The token fell below $0.7 but recovered to $1 within a month.
In late March 2022 the smart contract of Cashio Dollar (CASH) on the Solana blockchain was hacked for $28m, after which it almost completely lost its value.
On 4 April 2022 the USDN token lost its dollar peg, at one point falling to $0.7 despite overcollateralisation with WAVES. Cited causes included price manipulation and information attacks by market participants.

What happened to UST?

The systemic risks of algorithmic stablecoins fully materialised in the first half of May 2022, when TerraUSD (UST) lost its dollar peg, leading to the project’s collapse.

In 2022 UST became the most popular algorithmic stablecoin: its capitalisation grew more than 50‑fold in a year and by early May exceeded $18.6bn. About $17bn of that was locked in the Anchor DeFi protocol with a 20% annual yield.

In May the developers announced lower deposit rates to bolster UST’s resilience. The opposite happened: within two days users withdrew more than $2.2bn of UST from Anchor, causing a loss of stability. Terra’s native coin, LUNA, then plunged. The Terraform Labs team tried to lift UST via massive LUNA issuance, which only accelerated the fall. not even the reserve fund could reverse the slide.

Within a week LUNA crashed from $80 to $0.0001, and UST to roughly $0.1.

The collapse of the largest algo‑stablecoin had numerous negative effects across crypto: volatility rose in other stablecoins, including the biggest — USDT.

UST’s and Terra’s future is in doubt. The remaining LFG funds would cover only part of the losses, and the Terra Labs team has not yet found other financing. They propose a hard fork and an airdrop of new coins, but far from everyone agrees. Ethereum founder Vitalik Buterin insists that small investors should be compensated first. Binance chief Changpeng Zhao agrees.

What are the prospects for algorithmic stablecoins?

After UST’s collapse, the crypto market developed a deep distrust of algorithmic stablecoins. Project teams are responding by strengthening backing. For example, USDD creator Justin Sun has said the stablecoin’s issuance will always be below the level of reserves.

Even so, algorithmic stablecoins remain among the cheapest and simplest ways to attract liquidity to decentralised ecosystems. They also offer higher yields. They are unlikely to disappear.

At the same time, algorithmic stablecoins have drawn heightened attention from regulators and lawmakers. Tighter rules for stablecoins are likely in the near term. The US Treasury Secretary promised that a stablecoin law would be adopted by the end of 2022, and in South Korea, where Terraform Labs was headquartered, the UST situation was to be discussed at the parliamentary level.