Algorithmic Stablecoins: Code-Based Dollar Pegs

Key Takeaways

• An algorithmic stablecoin maintains its peg through supply rules and arbitrage, not held reserves.
• TerraUSD lost its dollar peg in May 2022, with LUNA supply ballooning from 1 billion to 6 trillion tokens.
• The most common mistake is treating an uncollateralized peg as if it were as safe as cash.
• These designs carry run risk that can wipe out a position faster than any traditional asset.

What an Algorithmic Stablecoin Is

A stablecoin is a crypto token built to track a stable value, almost always the US dollar. There are three broad designs: fiat-backed (cash and Treasury bills in a bank), crypto-collateralized (excess crypto locked in a smart contract), and algorithmic.

An algorithmic stablecoin holds little or no reserve. Instead it uses an algorithm that mints and burns tokens to push the price back toward 1 dollar. The peg depends entirely on traders acting on incentives the code creates, plus continued demand for a paired volatile token.

The Intuition

The pitch is capital efficiency. A fiat-backed coin needs 1 dollar of reserves per token, and an overcollateralized coin needs more than 1 dollar of crypto per token. An algorithmic coin claims to need almost nothing, because supply and demand do the work.

The flaw is that the model only holds while people believe it. There is no hard asset to redeem against, so confidence is the collateral. When confidence breaks, the same mechanism that defended the peg can accelerate its collapse.

How It Works

Terra used a two-token mint and burn system. UST was the stablecoin, and LUNA was the volatile partner token. The protocol let anyone swap 1 UST for 1 dollar worth of LUNA, and 1 dollar worth of LUNA for 1 UST, at any time.

If UST < $1:  burn 1 UST  ->  mint $1 of LUNA   (shrinks UST supply, lifts price)
If UST > $1:  burn $1 LUNA ->  mint 1 UST        (grows UST supply, lowers price)

In theory, arbitrage keeps UST near 1 dollar. If UST trades at 98 cents, a trader buys it cheap, redeems it for 1 dollar of LUNA, and pockets 2 cents. That buying lifts UST back toward the peg. The danger is the upward direction in a crisis: redeeming UST mints fresh LUNA, and heavy redemption mints so much LUNA that its price falls, which forces even more LUNA to be minted per UST. That feedback loop is the death spiral.

The system also leaned on outside demand. The Anchor lending app paid an unusually high yield to anyone who deposited UST, which kept demand strong and the peg comfortable. That demand was not free; it was subsidized. Once the subsidy looked unsustainable and large holders began to exit, the demand that had propped up the peg vanished, and the arbitrage mechanism switched from stabilizing to destabilizing almost overnight.

Worked Example

Terra paid users to hold UST through a lending app called Anchor that offered a yield near 19.5%. That rate drove huge inflows, and by April 2022 the daily subsidy to fund it reached about 6 million dollars, which was not sustainable.

The run started on 7 May 2022, when two large holders pulled 375 million UST out of Anchor. UST slipped below 1 dollar. Holders rushed to redeem UST for LUNA, the supply of LUNA exploded from roughly 1 billion to 6 trillion tokens, and its price fell toward zero. An emergency Bitcoin reserve was spent trying to defend the peg and failed. Within about a week the project had erased tens of billions of dollars of value and helped trigger failures across crypto lenders and funds.

Common Mistakes

1. Assuming the peg equals safety. A 1 dollar quote does not mean 1 dollar of backing. With an algorithmic coin, the peg is a target the code is trying to hit, not a guarantee you can redeem.

2. Chasing the yield without asking who pays it. A 19.5% return on a dollar-stable asset is a warning, not a feature. Ask where the money comes from and how long the subsidy can last.

3. Ignoring the volatile partner token. The stablecoin and its paired token are one system. If the partner token cannot absorb redemptions, the peg cannot hold.

4. Confusing algorithmic with overcollateralized. A coin like DAI holds more than 1 dollar of crypto per token. An algorithmic coin does not. Lumping them together hides a large difference in risk.

5. Treating size as proof of safety. UST was one of the largest stablecoins by market value right before it failed. Scale did not prevent a run, and in some ways it made the unwind worse.

Frequently Asked Questions

What is an algorithmic stablecoin in simple terms? It is a crypto token that tries to stay worth 1 dollar using software rules and trader incentives, rather than holding real cash or assets in reserve. If confidence drops, it can lose the peg fast.

How does an algorithmic stablecoin affect investment decisions? It carries run risk that most assets do not. Before holding one, you should treat it as a high-risk position, not a cash substitute, and size it accordingly given the May 2022 Terra example.

What is a real-world example of an algorithmic stablecoin? TerraUSD (UST) is the clearest case. In May 2022 it depegged, its partner token LUNA inflated from about 1 billion to 6 trillion tokens, and the system lost tens of billions of dollars within a week.

How can investors avoid the death spiral risk? Favor stablecoins backed by held reserves you can verify, be skeptical of unusually high yields, and understand the redemption mechanism before committing funds. If the peg relies only on confidence, assume it can break.

How is an algorithmic stablecoin different from an overcollateralized one? An overcollateralized coin like DAI locks more crypto than the tokens it issues, so there is a real buffer if prices fall. An algorithmic coin holds little or no reserve and leans on market incentives alone.

Sources

1. Harvard Law School Forum on Corporate Governance. "Anatomy of a Run: The Terra Luna Crash." https://corpgov.law.harvard.edu/2023/05/22/anatomy-of-a-run-the-terra-luna-crash/
2. Federal Reserve. "Interconnected DeFi: Ripple Effects from the Terra Collapse." https://www.federalreserve.gov/econres/feds/files/2023044pap.pdf
3. Chainlink Education Hub. "Stablecoins." https://chain.link/education-hub/stablecoins
4. Corporate Finance Institute. "Terra: What it Was, Collapse, Stablecoin." https://corporatefinanceinstitute.com/resources/cryptocurrency/what-happened-to-terra/

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.