Algorithmic Stablecoin
An algorithmic stablecoin tries to keep a fixed value, usually 1 dollar, mainly through programmed rules that expand and shrink supply and reward traders for restoring the peg, rather than through full reserves of cash or collateral.
How the mechanism works
The most common design pairs the stablecoin with a second, volatile token. The protocol always lets you swap 1 stablecoin for 1 dollar's worth of the volatile token, and the other way round. If the stablecoin trades at 0.97 dollars, arbitrageurs buy it cheaply and swap it for 1 dollar of the other token, which removes stablecoins from circulation and should lift the price. If it trades above 1 dollar, they create new stablecoins and sell them.
Other designs adjust every holder's balance automatically, or mix partial reserves with algorithmic rules. The common thread is that stability depends on market behavior rather than on assets that can always be redeemed.
The Terra UST collapse
The best-known example is TerraUSD (UST), which was paired with the LUNA token. Demand for UST was boosted by a lending protocol called Anchor that offered close to 20 percent yield on deposits. In May 2022, large withdrawals and sales pushed UST below its peg. Holders rushed to swap UST for LUNA, the protocol minted enormous amounts of new LUNA, LUNA's price collapsed, and within days both tokens had lost almost all their value.
This pattern is called a death spiral: the mechanism meant to restore the peg dilutes the backing token at exactly the moment confidence is falling.
Why the design is fragile
The system works only as long as people believe the second token has value. In calm markets that belief holds, but in a panic there is nothing outside the system to absorb losses. High yields used to attract deposits can hide the fact that demand is subsidized rather than organic.
What to watch
Ask what actually backs each coin if everyone wants out at once, whether the backing is the project's own token, and where the yield comes from. Since 2022 many regulators treat unbacked stablecoins with suspicion; under the EU's MiCA rules, stablecoins must hold reserve assets.
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Frequently asked questions
Why did TerraUSD (UST) fail?
Its peg depended on swapping UST for newly minted LUNA. When confidence broke in May 2022, mass redemptions inflated LUNA's supply, its price crashed, and the peg could not be restored.
Is DAI an algorithmic stablecoin?
Not in the Terra sense. DAI is backed by collateral locked in smart contracts, worth more than the DAI issued, and uses algorithmic rules only to manage that system.
Are all algorithmic stablecoins doomed?
Not necessarily, but designs without independent reserves have repeatedly failed under stress. The key question is what absorbs losses in a panic.
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