Algorithmic stablecoins: the hottest trend in crypto explained

Some critics warn that the new breed of crypto assets may put the whole crypto industry in danger.

Algorithmic stablecoins have recently surged in popularity after the LUNA-UST pair breakout success. Both well-known and little-known DeFi protocols started announcing their plans to launch algorithmic stablecoins in an attempt to hop on the hot trend. TRON has already launched USDD yesterday, while Cardano launched the public testnet version of its stablecoin Djed.

The difference between conventional and algorithmic stablecoins

So what exactly makes algo stables so hot compared to their less quirky siblings? “Decentralized markets need decentralized money,” algo proponents say. And they’re right since conventional stablecoins like USDC, BUSD, and USDT have several disadvantages, tightly connected to their centralized nature.

In the case of traditional stables, one company owns, mints, and manages the whole supply. The issuing institution claims to have enough assets in its reserves, primarily cash and bonds, to redeem every coin with $1. However, it’s pretty difficult to prove and requires reliance on outside auditors. Most of you should be familiar with the controversy around Tether, the largest stablecoin by market cap. So far, the company behind it hasn’t produced an audit that would prove it holds the purported reserve. Some experts speculate that if Tether melts down, it will crash the whole crypto market.

Unlike Tether, algorithmic stablecoins neither peg their value to the U.S. dollar nor even claim to do so. To maintain the $1 price, they use complex financial engineering algorithms. Additionally, they are trustless, blockchain-based, and don’t need fiat collateral.

How does algorithmic stablecoin work?

The idea behind the algorithmic stablecoin is to achieve price stability by adjusting the supply and demand of the pair of stablecoin and its collateral token. If the price of stablecoin dips below $1, arbitrageurs can burn it in exchange for $1 worth of the underlying token, reducing the circulating supply. Similarly, if the price goes above $1, new stablecoins are minted after burning the collateral, flooding the market with new tokens. The underlying token acts as a buffer, effectively absorbing the volatility.

However, to additionally secure the decentralized stablecoin, developers often build up reserves of other cryptocurrencies. For instance, Terraform Labs, a company behind UST stablecoin and its utility token LUNA, accumulated $2.3b worth of Bitcoins to ensure that the whole system won’t fall into the debt spiral when investors try to redeem both the LUNA token and UST at the same time. The newly launched USDD stablecoin by the TRON crypto ecosystem also claimed to secure $10b worth of unspecified reserves.

The risks of algorithmic stablecoins

The mechanism behind the decentralized stablecoins is simple and elegant but at the same time inherently unstable since it's built on the fragile ground of hopes for widespread acceptance, which maintains the whole system. The reliance on traders seeking to make quick arbitrage profits won’t work amidst the market panic when investors exit both stablecoin and an underlying token. As people start losing trust in the project and sell, the digital asset will enter the so-called “death spiral.” Such disaster already happened in June 2021 to a semi-algorithmic stablecoin IRON, which lost its peg and traded at $0.69, while the price of its collateral token TITAN crashed to a near-zero level. As a result, Iron Finance TVL dropped to $356m from over $2b.

In the interview with the Roll Call, Vivian Fang, professor of accounting at the University of Minnesota's Carlson School of Management, pointed out the obvious risk of algo stables. “If you have $100 to back up 100 tokens, then we know if anything goes terribly wrong then we should be able to get $100. But with the algorithmic stablecoins, you can’t be so confident.”

“Computers cannot always guarantee that the market works,” the professor added. Similar concerns were voiced by macro analyst Lyn Alden, who warned that Terra's massive accumulation of Bitcoin can disturb the entire crypto market.

“Unlike a crypto-collateralized stablecoin, there is no specific threshold where UST breaks. However, if LUNA gets small relative to UST, the probability of an algorithmic bank run increases,” Alden added.