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What Are Algorithmic Stablecoins and Why Are They So Risky?

Stablecoins often steer clear of the major price hikes and crashes we see in the majority of other cryptocurrencies. After all, that’s the point of their existence. But, there is an exception to this rule, and that is the algorithmic stablecoin.

So, what exactly is an algorithmic stablecoin, and why is it such a risky asset?

What Is an Algorithmic Stablecoin?

It is assumed that all stablecoins are backed by some kind of real-world asset, like a national currency or precious metal. This is the case for regular stablecoins, like USD Coin, Tether Gold, and Binance USD. The fact that other assets back these cryptos means that the chance of them crashing is much lower. It can also attract investors who are hesitant about putting money into regular cryptocurrencies because of their volatility.

However, some stablecoins aren’t backed by real assets at all. These are algorithmic stablecoins.

As the name suggests, this kind of stablecoin uses an algorithm to maintain a consistent value. These algorithms usually link two coins and then adjust their price depending on the supply and demand of investors. While an algorithmic stablecoin is pegged to the value of a real-world asset, it is not backed by one.

There are multiple kinds of algorithmic stablecoins, and the three main types are rebase, seigniorage, and fractional-algorithmic. Each of these coin types uses a different kind of algorithm to maintain value.

  • Rebase algorithmic stablecoins control the supply of a coin to maintain its value. Ampleforth is an example of a rebase algorithmic stablecoin.
  • Seigniorage algorithmic stablecoins use a burn-mint multi-coin structure, where one coin is minted or burned to control the value of another. Terra Lab’s Luna and UST cryptos were an example of this, which you can read more about below.
  • Fractional-algorithmic stablecoins are partly collateralized, meaning they are somewhat backed by a real-world asset. Frax is an example of a fractional-algorithmic stablecoin, as it is partially backed by USD Coin, a stablecoin that is backed by the U.S dollar.

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In some cases, algorithmic stablecoins can be very beneficial. They don’t require a third party to remain stable, and they can efficiently regulate the number of coins in circulation depending on demand. There are several algorithmic stablecoins on the market today, such as Basis Cash (BAC) and Empty Set Dollar (ESD). For many, an algorithmic stablecoin represents how blockchain and crypto should operate, with code controlling the cryptocurrency and zero human input.

Until recently, the most popular algorithmic stablecoin was TerraUSD or UST.

Let’s look at how Terra and TerraUSD work to understand algorithmic stablecoins.

The Terra Luna/UST Relationship

Terra Luna is a regular cryptocurrency, and TerraUSD (UST) is an algorithmic stablecoin. UST is backed by LUNA. However, LUNA is not a physical asset—it’s a volatile cryptocurrency.


These two coins have a close-knit relationship, wherein one’s value is affected by the other. For example, if TerraUSD’s price exceeded a dollar (as it is pegged to the U.S dollar’s value), a portion of it would be burned, which essentially means it is destroyed. On the other hand, if TerraUSD fell slightly below the dollar, a portion of LUNA would be burned. At the same time, every time one LUNA is minted, one UST is burned, and vice versa.

UST investors were also given the option to hold their funds in an account with Anchor Protocol, which promised them a 20% return on their deposited UST. This tempting rate acted as a huge incentive and boosted UST demand.

But when Anchor decided to switch this return to a variable rate that could go as low as 15%, people began selling off their UST, as holding it in this way just didn’t seem worth it anymore. This also had a knock-on effect on the demand for UST, which took a severe toll on its price. Anchor Protocol’s native token, ANC, also nosedived because of this decision, losing a huge chunk of its value in just a few days.

Both LUNA and UST crashed severely in May 2022 because of these factors, with both now holding a fraction of their previous value. In short, UST’s peg to the dollar slipped, and the algorithm linking the two then detected this, causing an increase in the printing of Luna to shore up the price. Printing more Luna forced the price of the crypto down as people rushed to dump it, causing further downward pressure on UST, and the situation spiraled.

Terra Luna’s circulation went from 350 million to 1.4 billion in a couple of days during the crash. One week after, Luna’s circulation stood at over 6 trillion, and the price is effectively irrecoverable.

The crash of LUNA and UST brought the whole concept of algorithmic stablecoins into question, and algorithmic stable coins are considered a risky investment. So, what exactly makes algorithmic stablecoins so precarious?

Why Are Algorithmic Stablecoins Risky?

Algorithmic stablecoins pose a huge risk because they’re not actually backed by any real-world asset, and so they’re not strictly stablecoins. They have no collateral, which means that the stability of their price isn’t as much of a sure thing as you’d like to think.

As is the case with many other cryptocurrencies, algorithmic stablecoins need demand to maintain value. We all know how the demand for a coin in the crypto industry can change drastically due to a range of factors, and this alone is still a huge point of weakness for algorithmic stablecoins.

Additionally, the crash in the value of one coin in an algorithmic pair can have a knock-on effect on the other depending on the type of algorithmic stablecoin in question. We saw this happen in the LUNA//UST catastrophe. So, in short, an algorithmic stablecoin can spell double trouble if things go wrong.


Algorithmic Stablecoins Are Still Something of a Gamble

While the idea of algorithmic stablecoins certainly seems to hold some merit, there are still a lot of factors that can too easily influence their value and cause huge financial loss. So, before investing in any stablecoin, be sure to check whether it is algorithmic or not first to understand what you are investing your money in.



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