What Is an Algorithmic Stablecoin?
An algorithmic stablecoin tries to hold its peg through code and incentives rather than a vault of reserves: supply expands and contracts, arbitrage games nudge price toward a dollar, and no full backing sits underneath. The model's monument is TerraUSD, whose 2022 collapse burned roughly $40 billion and taught the whole market what "undercollateralized" means under stress.
How It Actually Works
- The classic design pairs the stable with a volatile sister token: below peg, the system lets you burn the stable for a dollar's worth of newly minted sister token, shrinking stable supply; above peg, the reverse. The peg leans entirely on the sister token retaining value.
- Under selling pressure the machine mints the sister token faster than demand absorbs it, its price falls, each redemption mints more, and the spiral is self-catalyzing: the death-spiral depeg in pure form.
- Survivors and successors hybridize: partial reserves, overcollateralization, yield-bearing backing. The marketing word "algorithmic" now hides a spectrum from fully-backed-with-extra-steps to Terra-with-new-paint. The backing question, not the label, is the analysis.
Risks and Common Mistakes
- Trusting size and yield as proof: Terra was a top-ten asset paying 20 percent on deposits the morning it started dying. Yield that funds the peg is the peg.
- Assuming regulation blesses these: U.S. stablecoin law explicitly covers reserve-backed payment coins; algorithmic designs sit outside the blessed category, per my securities guide.
- Forgetting reflexivity reads calm as strength: these systems look sturdiest immediately before the one test that matters.
When It Matters
Any stable paying notably above the boring regulated ones, and any DeFi position whose collateral includes one. Ask what breaks the spiral; if the answer is "confidence," you have your answer.
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