Algorithmic stablecoin
Also called: algo stablecoin · algostable
Definition
An algorithmic stablecoin is a stablecoin that tries to hold its peg mainly through code-driven supply changes and incentives rather than full reserves of cash or collateral.
This entry is shown in English.
How Algorithmic stablecoin works
Most stablecoins are backed by dollars, short-term bonds or crypto collateral. An algorithmic stablecoin relies instead on rules: when the price is above 1 USD, the protocol expands supply; when it is below, it tries to shrink supply, often by letting users burn the stablecoin in exchange for a second, volatile token.
This works while people trust the system and the companion token keeps its value. In a panic, the loop can reverse. Holders redeem the stablecoin for the companion token, flood the market with it, its price falls, and each redemption needs even more new tokens. This is often called a death spiral.
TerraUSD (UST) is the textbook case: in May 2022 it lost its peg and its companion token LUNA collapsed toward zero within days. Since then, many projects call themselves hybrid or partially collateralized, so read how much hard backing actually exists before you treat a coin as cash.
Example
Imagine an algorithmic stablecoin trades at 0.97 USD. The protocol lets you burn 1 stablecoin for 1 USD worth of its governance token, so arbitrageurs buy at 0.97, redeem, and earn about 3% if they can sell the governance token at full value. But if 50 million stablecoins are redeemed while the governance token's market cap is only 200 million USD, the new supply equals a quarter of its value, its price drops, and the next redemptions mint even more tokens.
Common mistakes
- Treating a high advertised yield on an algorithmic stablecoin as low risk because the coin is called stable.
- Ignoring the size and liquidity of the companion token that is supposed to absorb redemptions.
- Assuming a coin labelled hybrid has full backing without checking the actual reserve ratio.
Learn and practise
FAQ
Are algorithmic stablecoins safe?
They carry more risk than fully backed stablecoins because the peg depends on market confidence and incentives. The UST collapse in 2022 showed how quickly a design can fail under stress.
What is the difference between algorithmic and crypto-backed stablecoins?
A crypto-backed stablecoin holds collateral worth more than its supply. An algorithmic stablecoin relies mainly on supply rules and arbitrage incentives, with little or no hard backing.