What are algorithmic stablecoins?

Imagine a thermostat that tries to keep the temperature steady, but instead of controlling the heater, it gives the tenants incentives to open and close the windows. That’s roughly the logic of algorithmic stablecoins: the mechanism also needs people who are willing to take part.

Usually, the target is a peg such as one token to one dollar. Smart contracts apply rules that affect the supply or allow swaps with another token. Some models also use collateral, so not all of them fall into the category of fully unbacked coins.

In a hypothetical system, when the price rises above one dollar, users can mint new stablecoins by handing over one dollar’s worth of a second token. By selling them at the higher price, they have an incentive to increase the supply. Below one dollar, the reverse process can reduce the supply. Profiting from these price differences is called arbitrage. The exact rules vary from system to system.

Why it matters

In decentralized finance (DeFi), stablecoins are used in swaps, loans and liquidity pools. If you hold such a coin, what matters to you is how its price is supported, not just its name or ticker.

The appealing idea is less dependence on bank reserves and central issuers. The hard part is that code doesn’t create demand or value on its own. We consider it crucial to separate the intended goal of stability from the actual ability to maintain it.

What to watch out for

If confidence is lost, the incentives may stop working. Losing the intended peg is called a depeg. In systems with a second token, minting more of it to absorb selling can push its price down, triggering a vicious circle. The collapse of TerraUSD, known as UST, showed this risk in practice.

Check whether there’s collateral, what it consists of and on what terms redemption works. High deposit yields don’t prove stability, and a security audit of the code doesn’t guarantee that the economic model can withstand mass withdrawals.