Stablecoins aim to be the decentralized equivalent of fiat currency — non-volatile, a medium of exchange, and a store of value.
However, one group of these tokens known as “algorithmic stablecoins” has consistently failed to live up to this promise.
Often linked to Ponzi schemes and doomed experiments, algorithmic stablecoins had a rough year in 2022 — the most notable event being Terra Luna’s crash. Luna’s subsequent domino effect on major centralized players, including FTX, and potential ties to market manipulation have raised multiple questions on the viability of these coins.
In this article, we’ll explore what algorithmic stablecoins are, how they work, and what their future holds.
What Is an Algorithmic Stablecoin?
Algorithmic stablecoins follow the core narrative of decentralized, programmatic money.
These coins use code and pre-defined “tokenomics” to maintain their peg 1:1 to a fiat currency, usually to the US dollar. Most of these projects primarily use arbitrage and balancing methods to maintain demand for their stablecoin and associated assets.
While algorithmic stablecoins started by not being backed by physical assets, new hybrid models, such as FRAX’s fractional model, use some form of collateralization.
How Do Algorithmic Stablecoins Work?
While each project typically has its custom tokenomics, algorithmic stablecoins broadly use three mechanisms to maintain their peg — rebase, seigniorage, and a hybrid fractional model.
Think of: Ampleforth
In rebase stablecoins, smart contracts manipulate the coin’s base circulation based on supply and demand. If the coin’s value falls under a dollar (or the equivalent peg), the protocol burns coins. Conversely, if the coin’s value exceeds a dollar, the protocol mints more coins.
Think of: UST
Seigniorage stablecoins use a multi-asset system: a volatile asset (collateral) and a stablecoin. The volatile asset is designed to stabilize the stablecoin through market arbitrage, minting and burning, and network demand.
Let’s take Terra as an example: Terra’s stablecoin was TerraUSD (UST), which had a built-in exchange rate with LUNA, its volatile asset. Users could directly exchange 1 UST for $1 worth of LUNA from the protocol. Anytime UST traded above this exchange rate, arbitrageurs were incentivized to exchange LUNA for UST for a profit and vice versa. Therefore, UST’s stability depended on LUNA demand.
Along with its ecosystem, Terra incentivized this demand through the Anchor protocol by offering a 20% interest on LUNA deposits.
However, in extreme market conditions, users often tend to lose faith in both assets at the same time, as we saw with its predecessor, Basis Cash. So, UST’s depeg took LUNA with it, in an unprecedented death spiral of a top-10 crypto coin.
Think of: FRAX
Part seigniorage, part collateralized, fractional algorithmic stablecoins attempt to offer the best of both worlds. Deviating from the traditional unbacked algo stablecoins, fractional tokens use a collateralization ratio to determine the right mix of collateral (such as USDC) and volatile crypto assets.
Algorithmic Stablecoins: Are They Really Stable?
Given that $40 billion of Terra coins went up in algorithmic smoke, these “stable” coins aren’t completely true to their name. Plainly put, algorithmic stablecoins have a notorious history of losing their peg.
Terra’s the prime example: the first signs of trouble started on 7th May, 2022, when UST depegged after a sell order of over $85 million UST.
This depeg resulted in $2 billion UST being unstaked from the Anchor Protocol, signaling bearish market sentiment. Risk-averse investors and institutions like Celsius proceeded to pull out user assets from Anchor Protocol and sell their UST, fueling a death spiral. LUNA crashed below $0.1, and UST to $0.3, between 10th to 12th of May.
Over the next 36 hours, LUNA’s market cap fell below UST’s market cap, after which both coins flatlined. Although the LUNA Foundation Guard deployed $3.5 billion worth of Bitcoin reserves in an attempt to control the crash, their efforts were largely futile.
Terra isn’t the only algorithmic coin that failed to maintain its peg,albeit it was the most popular one.
For instance, USDN, the Waves-backed stablecoin, depegged four times in 2022 and is currently in freefall. The founder’s revival plan? Launch another “undepeggable” stablecoin.
However, even with such large-scale failures, multiple algorithmic stablecoin experiments are still surviving, and new ones are being planned.
Which Algo Stablecoins Are Still Standing?
- USDD: USDD is Tron’s over-collateralized stablecoin backed by USDC.
- Frax: As the first fractionalized algorithmic stablecoin, Frax is partially backed by collateral and algorithmically stabilized by its governance token, FXS.
- Beanstalk: Relaunching in just 4 months after its massive hack, Beanstalk uses decentralized credit, price oracle, and governance community to maintain its $1 peg.
Which Algo Stablecoins Are Building?
- DJED: Set to go live in 2023, DJED is Cardano’s over-collateralized algorithmic stablecoin.
- GHO: GHO is Algorand’s crypto-backed algorithmic stablecoin.
The Future of Algorithmic Stablecoins
Algorithmic stablecoins have a long way to go before they can ever become a store of value.
Unchained podcast guest Tascha Che has stated that she believes algorithmic stablecoins can theoretically work because they “work in real life.” Most governments whose currencies tie their exchange value to the dollar, such as Dubai, have an undercollateralized reserve.
However, as Eric Wall, the former chief investment officer of Arcane Assets, summarizes, “[We] haven’t really synthesized a good variant of a decentralized stablecoin… [In UST] The oracle mechanism was rather primitive, and the price was tied to the demand of basically a shitcoin.”
Given the FTX collapse and its alleged Terra link, stablecoins are also likely the first target in a regulatory crossfire. And algorithmic stablecoins are the weakest link.