Algorithmic Stablecoins: What are Happened & Shouldn We Trust Them?

Since 2020, algorithmic stablecoins have become popular. Stable and predictable exchange rates of these coins allow them to be used to store capital, make payments, and exchange currencies, avoiding traditional banks and other payment systems.

Market participants believed that reliable algorithms would always keep coins stable, regardless of market conditions. However, May 2022 showed the opposite. Algorithmic stablecoins began to collapse one by one. As a result, users worldwide lost tens of billions of dollars.

In this article you will learn how algorithmic stablecoins work and why this technology is not perfect. After all, the string of collapses of such coins has only just begun. More surprises may lie ahead.

What Are Algorithmic Stablecoins?

Algorithmic stablecoins are a type of cryptocurrencies that maintains a rate without the use of collateral in fiat money or valuable assets. Instead, the exchange rate is maintained solely by algorithms. The algorithmic stablecoin protocol issues additional pegged coins when the price rises and redeems or burns them when the price falls. Accordingly, each algorithmic stablecoin has an auxiliary token whose issuance regulates a stable exchange rate to the US dollar.

There are fully unsecured or partially secured algorithmic stablecoins. These can regulate centralization and dependence on certain factors.

Such technology is supposed to be an alternative to secured and centralized coins with a fixed exchange rate to the dollar.

The lack of regulation and the lack of ties to the parent company was a major advantage of the technology. But in reality, algorithmic stablecoins turned out to be unable to withstand the non-standard market conditions — more on this below.

How Do Algorithmic Stablecoins Work?

Let’s consider the principle of algorithmic stablecoins in the example of the infamous TerraUSD (UST). It was the coin that had the largest capitalization, and best reflected the essence of the whole technology.

The developers pegged the exchange rate of the token to the US dollar. To ensure the stability of UST, the project team developed a scheme that includes forced additional issuance and burning of LUNA tokens. These tokens are part of the algorithm and the entire technology.

TerraUSD is influenced by the popularity of stablecoin in the market. An increase in the number of users of the token increases its exchange rate. A decrease in the popularity of the asset, on the contrary, lowers the UST exchange rate. Additional issuance and burning of LUNA were used to balance the price to help regulate the stablecoin exchange rate.

Other algorithmic stablecoins operate on a similar principle. Their main differences from regular stablecoins include not having centralized control, automating systems, and involving users in the regulation process. It was one of the reasons for the failure.

The imbalance of supply and demand and the lack of centralization prevented USTs from regaining their dollar peg after the volatility spike of May 7–9, 2022.

The rejection of a centralized management system does not solve all of stablecoin’s problems. For example, Tether CTO Paolo Ardoino has previously stated that decentralized stablecoins can be dangerous in case of volume liquidations of positions when tokens reach high capitalization figures. As we can see, those fears have come true.

List of Top Algorithmic Stablecoins

Unfortunately, amid the collapse of some stablecoins, we cannot evaluate coins by capitalization. Therefore, we offer a list of algorithmic stablecoins, including those that have lost their peg to the dollar.

• Terra USD (UST) — lost its peg to the dollar;
• Deus Finance (DEI) — lost its peg to the dollar;
• Dai;
• Ampleforth (AMPL);
• Fei USD (FEI);
• 3Frax (FRAX);
• BAC;
• ESD.

This algorithmic stablecoins list includes partially secured and fully unsecured algorithmic stablecoins. Unfortunately, the current situation has shown that even partial collateralization does not save from collapse when the balance of demand and capital outflows is disturbed. As a result, two of the seven best-known coins have collapsed as of May 2022.

Why is Algorithmic Stablecoins Crashing?

May 2022 was a shattering year for algorithmic stablecoins. The most famous UST coin and the LUNA token collapsed, losing 99.99% of their value. This triggered a string of declines in the value of the coins that provide algorithmic stablecoins. There are likely to be several more collapses of such assets ahead.

Why have algorithmic stablecoins started to collapse? Experts cite the main reason for the loss of investor confidence and rapid capital flight. But, as you understood, algorithmic pegging technology works perfectly only in the balance of supply and demand.

Algorithmic pegging only works effectively if there is enough constant interest in the ecosystem for different coin uses. And there is enough support from the cryptocurrency reserves being created, enough trading commissions to replenish those reserves, and enough willing users to continuously provide pegging.

If the balance of demand collapses badly in an instant, it will inevitably cause the value of the token to drop. As a result, users begin to sell the stablecoin. A vicious cycle begins. As the stablecoin becomes cheaper, the coin to support it becomes cheaper because of the growing issue. If the balance of supply and demand is not maintained, everything collapses.

Why didn’t this happen before?

Top algorithmic stablecoins only became widely used in the crypto market in 2020–2021. However, at that time, the volume of supply and demand was not enough to disrupt algorithms. In the spring of 2022, demand for stablecoins increased greatly due to the instability of Bitcoin and altcoins. As it turned out, the algorithms of most coins could not withstand this kind of stress and volatility. Algorithmic coins performed well under low volatility, but during a panic and a crushing withdrawal from the blockchain, the balance could not be restored.

Up to this point, there have been no such scenarios.

However, the current situation has exposed the disadvantages of not providing stable cryptocurrencies. Therefore, future changes in technology will be needed to restore trust and make them more stable.

Algorithmic Stablecoins Perspectives and Risks

After the collapse of the LUNA Terra token and its stable UST coin, increased volatility has been observed across all Stablecoins. The situation has attracted the attention of U.S. regulators. The US Securities and Exchange Commission (SEC) is already investigating UST’s decoupling from the dollar. In addition, US Treasury Secretary Janet Yellen mentioned the TerraUSD (UST) incident at a Senate Banking Committee hearing and called for a law to regulate stablecoins by 2022. The market is also negative due to the collapse of all cryptocurrencies in the background of the fall of the US stock index futures.

Another negative factor for algorithmic stablecoins is the loss of the peg to the US dollar DEI (Deus Finance DAO project). This became known on May 16, 2022. Against the background of this incident, the DEUS token used to maintain the DEI stablecoin exchange rate has fallen in price by 40%.

It is predicted that this will trigger a wave of the collapse of many major stablecoins. In this case, the main reason is market panic and loss of user confidence in the technology. Perhaps by the end of 2022, there will be a plan to regulate stablecoins, which will bring back a bit of trust in algorithmic technology. But at this stage, it is a highly unreliable asset for storing savings.

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Conclusion

Algorithmic stablecoins are digital assets whose rate stability is regulated by an algorithm. This scheme has both advantages and disadvantages. For example, decentralized stablecoins are not subject to regulatory pressure. Therefore, we can assume that their independence became one of the reasons for the growth of demand for such assets.

However, the algorithms’ performance does not withstand the pressure of “whales” and panic in the cryptocurrency market. Against this background, any emergency can lead to algorithm malfunction and loss of the coin’s peg to fiat money or valuable assets. Shortly, algorithms will probably be redesigned, regulators’ pressure will increase, and the best algorithmic stablecoins with real collateral like Tether USD (USDT) will remain top.