What Are Algorithmic Stablecoins, And Why Can They Be A Problem?

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When most people with some level of knowledge about the crypto markets think about stablecoins, they imagine cryptocurrencies with stable valuations that are pegged to a particular asset or fiat currency like the U.S. dollar. However, algorithmic stablecoins are much more complex. They rely on algorithms and a second cryptocurrency to maintain their peg, making implosions like what happened to the original Terra coin possible.

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  • Like standard stablecoins, algorithmic stablecoins are pegged to another asset like a fiat currency, precious metal or something else.
  • While standard stablecoin operators often maintain a reserve big enough to back some or all of their stablecoins in circulation, algorithmic stablecoins usually don't.
  • Algorithmic stablecoins rely on algorithms and a second cryptocurrency to maintain their pegs.
  • Standard operation involves minting and burning new stablecoins and coins of the supporting cryptocurrency as supply and demand shift with the goal of maintaining the stablecoin's peg.
  • Unfortunately, the crash of the original Terra stablecoin has highlighted some issues with algorithmic stablecoins and could lead to the eradication of all algorithmic stablecoins at some point.
  • Crypto experts now expect regulations to be imposed on stablecoins.

If you've been following the world of crypto at all, you've probably heard about the implosion of the so-called stablecoin Terra. The coin was supposed to be pegged to the U.S. dollar, but it broke its peg on May 9 and has remained de-pegged since then.

The Terra coin has since been rebranded, but for the sake of this article, we will continue to refer to the now-de-pegged stablecoin previously called Terra by its original name, ignoring the rebranding. (For those who are wondering, the UST coin originally called Terra now trades as USTC under the name TerraClassicUSD.)

What are stablecoins?

If cryptocurrencies are known for one thing, it's volatility. Due to the highly speculative nature of cryptocurrencies, it's anyone's guess where each coin will go next. Bitcoin's value has been cut in half multiple times, but it generally comes roaring back, sometimes soon but other times eventually. Other cryptocurrencies can be just as volatile as bitcoin.

However, stablecoins are an entirely different story. Some enthusiasts might see them as the bridge between fiat currencies and highly volatile cryptocurrencies. What gives stablecoins a stable price is their peg. For example, many stablecoins are pegged to the U.S. dollar, which means their value should always be right around or, ideally, at exactly $1.

The first stablecoin was BitUSD, but the first to gain widespread recognition and use was Tether, which is also pegged to the U.S. dollar. While the dollar is a common peg for stablecoins, they can also be pegged to other assets like another fiat currency, precious metals or certain other assets.

Stablecoins were created to remove the volatility associated with cryptocurrencies by pegging them to another asset that's far less volatile. Aside from the reduced volatility, stablecoins also offer reduced risk because they are pegged to an uncorrelated asset. However, they also may experience the same level of volatility and risk as the asset they are pegged to.

One of the concerns with standard stablecoins has to do with their peg. Reputable stablecoins like Tether are actually backed by the asset they are pegged to, meaning that the developer of Tether holds enough cash and equivalents to convert some or all of the stablecoin's supply into its pegged currency. Tether claims all of its coins are backed 100% by its reserves, although not all stablecoin developers do this.

What are algorithmic stablecoins?

When someone hears that a particular cryptocurrency is a stablecoin, they typically think of standard stablecoins. However, a new type has emerged, creating some confusion for those who don't follow the crypto market closely.

Algorithmic stablecoins are far more complex than standard stablecoins. While they are pegged to a particular asset, they use algorithms to try to hold the peg in place. Most algorithmic stablecoins are undercollateralized, meaning the developers don't have enough of the pegged asset in reserves to back the value of the coins. This is one of the increased risks of algorithmic stablecoins over the standard kind.

Another risk is the fact that they usually rely on a second cryptocurrency to enable them to hold their peg. The second cryptocurrency backs the stablecoin, and the algorithm regulates the relationship between the two coins using supply and demand.

How do algorithmic stablecoins work?

When the supply of the stablecoin is too small compared to the amount of demand, its price moves higher than its peg, which is often the dollar. To push the stablecoin's value back down to $1, the algorithm burns $1 worth of the other coin to create $1 worth of the stablecoin.

In the case of Terra, the protocol allowed users to trade $1 worth of the other coin for one of the stablecoins. Users could make money when the stablecoin was minted by selling it for $1.01, earning a profit of one cent. The profits added up when it was done millions of times.

On the other hand, where there's too much of the stablecoin compared to demand, the value falls below $1 in the case of Terra and other stablecoins pegged to the dollar. When the supply was too high, the Terra protocol burned one Terra coin and minted $1 worth of Luna by allowing users to buy one Terra coin for 99 cents and then trade it for $1 worth of Luna, once again resulting in a profit of one cent.

The protocol allowed Terra coins to be burned and Luna coins to be minted until Terra was again worth $1. As a result, the market could be flooded by Luna coins whenever the Terra coin fell below $1, meaning that the value of Luna could enter freefall whenever Terra's value fell below $1. Terra fell as low as 12 cents at one point, illustrating the fact that it had de-pegged from the dollar. Even after the rebranding of the coin, it hasn't regained its peg.

What will happen to stablecoins?

Regulators around the world have been discussing the need to regulate cryptocurrencies, but so far, there has been no broad-based effort to do so. However, the implosion of Terra/ Luna has led to widespread calls for regulation on stablecoins.

U.S. Treasury Secretary Janet Yellen called on lawmakers to pass legislation about stablecoins. Meanwhile, the U.K. government announced plans to regulate stablecoins earlier this year — before the Terra implosion. At the end of May, the British government unveiled a proposal to amend the existing rules to manage the failures of stablecoins that could pose a "systemic" risk.

Many experts in the crypto industry are expecting increased regulation of stablecoins, so it's probably only a matter of time. In late May, Bertrand Perez of the Web3 Foundation, a former director of the Facebook-backed Diem stablecoin, told CNBC that he expects regulators to require that stablecoins be backed by real assets. He also expects stablecoin operators to be subjected to regular audits ensuring they have the proper reserves to back their stablecoins.

There are also questions about the future of algorithmic stablecoins. Some crypto experts predict that the Terra implosion will result in the end of them, although standard stablecoins backed by the proper reserves are likely to live on.