What is an algorithmic stablecoin? How it works & why it's different
An algorithmic stablecoin is a type of cryptocurrency designed to maintain a stable value (usually pegged to the US dollar) using smart contracts and algorithms instead of traditional asset backing like fiat or crypto reserves. These coins automate supply adjustments to keep prices stable, but they come with unique risks.
Unlike stablecoins like USDT (Tether) or USDC, which are backed by real assets, algorithmic stablecoins rely purely on code to control supply and demand.
How algorithmic stablecoins work
Algorithmic stablecoins use self-regulating mechanisms to balance supply and demand. Here's how:
- Price above peg ($1.02 or higher): The algorithm increases supply by minting new coins, encouraging more circulation and driving the price down.
- Price below peg ($0.98 or lower): The algorithm reduces supply, either by burning tokens or incentivizing users to buy and hold, pushing the price back up.
Some algorithmic stablecoins use a two-token system, where:
- Stablecoin token (e.g., UST in the Terra ecosystem) tries to maintain the peg.
- Volatile token (e.g., LUNA) absorbs price fluctuations by being minted or burned.
Types of algorithmic stablecoins
- Rebase stablecoins: Adjust the token supply directly (e.g., Ampleforth (AMPL)).
- Seigniorage-based stablecoins: Use multiple tokens to regulate stability (TerraUSD (UST) before its collapse).
- Overcollateralized algorithmic stablecoins: Use excess collateral in crypto but still rely on algorithms (e.g., DAI uses ETH but is managed by smart contracts).
Risks & challenges of algorithmic stablecoins
- De-pegging risks: If confidence drops and people sell quickly, the system can collapse (like Terra UST in 2022).
- Market manipulation: Vulnerable to attacks where large holders exploit supply mechanisms.
- No real asset backing: Unlike USDC or USDT, there's no reserve to redeem, making them riskier during crises.