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 USDT 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.
Read More: What Is LUNA and UST? A Guide to the Terra Ecosystem
Algorithmic stablecoins are typically undercollateralized – they don’t have independent assets in reserves to back the value of their stablecoins. In fact, “undercollateralized stablecoins” and “algorithmic stablecoins” are often used interchangeably.
What are algorithmic stablecoins?
Algorithm can be an obfuscating word. But it simply means a set of code that instructs a process. So, for example, what you get to see on your Facebook timeline is determined by Facebook’s timeline algorithms, which include things like how relevant the post is to you based on your past online behavior. In crypto, an algorithm refers to pieces of code on the blockchain, as encoded in a set of smart contracts.
Algorithmic stablecoins typically rely on two tokens – one stablecoin and another cryptocurrency that backs the stablecoins – and so the algorithm (or the smart contact) regulates the relationship between the
two.Cryptocurrencies – similar to all assets in the market, such as houses or stocks – move up and down in price depending on the market demand and the supply of the asset.