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?
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.
To prevent the price of a stablecoin depegging – moving away from $1 – while subject to market conditions, algorithms regulate supply and demand. When there’s too much demand for an asset but little supply of it, the price of that asset goes up – and vice versa.
How is UST designed to maintain its peg?
TerraUSD (UST) maintains – or is supposed to maintain – its 1:1 parity with the U.S. dollar via an algorithmic relationship with Terra’s native cryptocurrency, LUNA. Behind the relationship is an arbitrage opportunity that presents itself every time UST loses its peg in either direction.
When the UST supply is too small and demand for it is too high, the price of UST goes above $1. To bring UST back to its peg, the Terra protocol lets users trade 1 USD of LUNA for 1 UST at the Terra station portal. This trade burns 1 USD of LUNA and mints 1 UST, which users can sell for 1.01 USD and pocket a profit of 1 cent. It doesn’t sound like a lot, but these profits add up when done in large quantities.
— 4484 (@4484) May 10, 2022
In either case, the stablecoin hasn’t withstood the pressure enough to maintain its peg, eventually falling as low as $0.29 on May 11.