Algorithmic Stablecoins: What They Are and How They Can Go Terribly Wrong

The stunning crash of UST stablecoin and LUNA, its sister token, has many questioning if an algorithmic stablecoin can be trusted.

Cryptocurrencies are known for volatility; they can go up and down in double digits. But one form of cryptocurrency, called stablecoins, aims to provide refuge to those who want to exit constant volatility while still staying in the crypto market.

Stablecoins are cryptocurrencies that are supposed to be pegged to fiat currencies like the US dollar. In the cases of USD-pegged stablecoins, their prices are supposed to be $1 at all times.

Each stablecoin project differs in ways they maintain the peg. The two biggest ones, tether (USDT) and Circle’s usd coin (USDC), are “over-collateralized” by fiat reserves, meaning they have cash or cash-equivalent assets in their reserves. So each UST or USDC traded in the crypto market is backed by what’s actually in the possession of the stablecoin issuers. Similarly, MakerDAO’s stablecoin DAI is decentralized but also overcollateralized – backed by ether (ETH) deposited into its smart contracts.

Over the past year, however, a new form of stablecoin has emerged that differs in its collateralization: algorithmic stablecoins, such as terraUSD (UST), magic internet money (MIM), frax (FRAX) and neutrino usd (USDN).

They’re called algorithmic because what backs them is an on-chain algorithm that facilitates a change in supply and demand between them (the stablecoin) and another cryptocurrency that props them up.

In the case of the Terra blockchain, which runs the largest algorithmic stablecoin platform, the algorithmic tango is performed by UST, a stablecoin, and terra (LUNA), Terra’s native cryptocurrency that backs the stablecoin. For the remainder of this article, we will use “LUNA” to refer to terra (LUNA) to avoid any confusion.