Be Straight With Me: What Is an Algorithmic Stablecoin?

Cryptocurrencies were created as an alternative to fiat money that’s controlled by central banks. 

And while there are enough cryptos listed on CoinMarketCap (18,000+) to boggle the mind, you can broadly split them all into two groups: pegged cryptocurrencies and non-pegged cryptocurrencies.

Non-pegged cryptocurrencies like Bitcoin and Ethereum have the potential for major price volatility. A stablecoin, on the other hand, is pegged to a reserve asset—like the U.S. dollar or gold—to provide it with price stability. The combination of the relative stability of fiat currency and the security and efficiency of cryptocurrency has led some to posit that stablecoins are the future of money.

Algorithmic stablecoins are pegged to a stable asset, just like regular old stablecoins. But instead of being backed by a reserve, they rely on smart contracts and user incentives to maintain a stable price.  

There are four main types of stablecoins, based on the mechanisms they use to maintain price stability.

Fiat-collateralized stablecoins: These are stablecoins that are backed by fiat currency, like the U.S. dollar or the euro. Examples include Tether (USDT) and USD Coin (USDC).

Commodity-collateralized stablecoins: These are stablecoins that are backed by a commodity, such as reserves of gold or precious metals. Examples include Digix Gold (DGX) and Tether Gold (XAUT).

Crypto-collateralized stablecoins: Crypto-collateralized stablecoins are backed by cryptocurrencies rather than fiat money. This does away with much of the centralization in fiat-collateralized stablecoins, but since cryptocurrencies are highly volatile (up to 50% swings), these stablecoins have to be over-collateralized. Examples include Wrapped Bitcoin (WBTC), a stablecoin that's pegged to the value of Bitcoin.

Algorithmic stablecoins: Non-collateralized (or algorithmic) stablecoins don't use fiat or crypto reserves at all. But how do they keep prices stable then? Let’s dive into how these magic internet dollars work.

Most algorithmic stablecoins use the same underlying principle of supply and demand to maintain price stability. Here’s how that works: When the stablecoin price goes above $1, the protocol issues more tokens to apply downward pressure. Conversely, when the stablecoin price goes below $1, the protocol buys/burns tokens to apply upward pressure.

True to the spirit of cryptocurrencies, algorithmic stablecoins are more decentralized and trustless. This means that no single government or company can freeze your assets. But using algorithmic stablecoins comes with its own set of risks.

Compared to collateralized stablecoins, algorithmic stablecoins have a harder time staying on peg. If they don’t have the proper balance of liquidity, incentives and automation, then the coin can enter a so-called “death loop” where it becomes impossible to restore the peg. 

But if algorithmic stablecoins use the same mechanism to stay pegged to $1, then why does it matter which one I choose? Well, it all comes down to risk. Every algorithmic stablecoin is different in terms of their:

• Longevity: how long the protocol has been running and how battle-tested it is, e.g. by surviving market crashes
• User adoption: as measured by the market cap, transaction volume and active wallets
• Incentives: how profitable it is for users to hold the stablecoin or maintain price stability
• Transparency: whether the smart contracts have been audited and how the token supply is distributed

A few popular algorithmic stablecoins include: TerraUSD (UST), Frax (FRAX), Ampleforth (AMPL) and Celo Dollar (CUSD).

But at a $14 billion market cap, TerraUSD (UST) is the most popular algorithmic stablecoin by far. It recently surpassed the crypto-backed stablecoin DAI, and is now on its way to overtaking fiat-backed stablecoins like BUSD, USDT and USDC. Here’s how TerraUSD works.

TerraUSD (UST)

The Terra (LUNA) blockchain was built with a focus on fiat-pegged stablecoins that are more decentralized than USDT and USDC, but also more scalable than DAI. To that end, TerraUSD (UST) is LUNA’s U.S. Dollar-pegged algorithmic stablecoin. 

Terra incentivizes its users to maintain the price stability of UST with its volatile native currency LUNA. If the price of UST goes above $1, this means that there is less supply than demand. To correct this, users can burn LUNA to mint UST. As a result of this, the supply grows larger and the price is pulled down until it restores its $1 peg.

Algorithmic stablecoins are stablecoins that use smart contracts and user incentives to maintain their peg to $1 (or other fiat currency). 

The main benefit of algorithmic stablecoins over fiat-backed stablecoins is that the former is decentralized, so no institution can seize your assets. But the tradeoff is that algorithmic stablecoins can lose their $1 peg if enough users abandon the protocol or its smart contract malfunction. In other words, algorithmic stablecoins aren’t necessarily the safest stablecoins you can buy.

Just keep these risks and rewards in mind as you choose which stablecoin to place your hard-earned money in.