Algorithmic Stablecoin

An algorithmic stablecoin is a cryptocurrency designed to maintain a stable value — usually pegged to $1 — not by holding actual dollars or other valuable collateral in a vault, but purely through software-driven incentive mechanisms and automatic supply adjustments. The algorithm contracts token supply when the price is too high and expands supply when the price is too low, relying on market participants to act on these incentives and restore the peg.

Most algorithmic stablecoins use a dual-token model. There is the stablecoin itself and a separate volatile governance or seigniorage token. When the stablecoin trades above $1, the protocol mints new stablecoins and distributes them (or sells them for the governance token), increasing supply and pushing the price down. When the stablecoin trades below $1, holders are incentivized to burn stablecoins in exchange for the governance token at a favorable rate, reducing supply and pushing the price back up. The stability depends entirely on the continuous belief that the peg will hold.

The catastrophic failure of TerraUSD (UST) in May 2022, which wiped out approximately $40 billion of value in days, demonstrated the fundamental fragility of this model. Once confidence breaks and the governance token begins losing value, the burn incentive collapses, creating a “death spiral” where no one wants to destroy stablecoins because the governance token received in return is also falling rapidly. Algorithmic stablecoins remain an active area of research but are now widely understood to carry existential risk that fully-collateralized models do not.

Example: Imagine a town that creates its own currency pegged to the dollar, backed not by gold reserves but by a promise: anyone can exchange ten town-coins for one of the mayor’s special bonds at any time, and the mayor can print town-coins freely. As long as everyone believes town-coins are worth $1, they are. But if people start doubting it, they rush to exchange their town-coins for bonds, the mayor prints more bonds, those become worthless, confidence collapses, and the currency reaches zero — not because of any fraud, but because the peg was always held up only by collective belief.