What is Algorithmic Stablecoin? How does it work?
Although stablecoins try to protect the value of the asset on which they are based as their main purpose, they can use different methods to do this within themselves. While some stablecoins hold fiat in reserve equal to their supply, some stablecoins operate completely unsecured. Algorithmic stablecoins, as a member of them, work with another supporting asset to index their value to the dollar. Ironically, central banks also typically maintain the stability and supply of fiat currencies through similar mechanisms. The main working principle of algorithmic stablecoins is as follows:
First, algorithmic stablecoins require a level of support for the entire ecosystem to work. The algorithmic stablecoin mechanism uses a variety of mechanisms to help keep the asset stable against the dollar. Unlike most stablecoins, in algorithmic stablecoins, these mechanisms are written into the protocol and are publicly available on the blockchain network for everyone to see. We can exemplify the working mechanism of the system as follows (we will use the Seigniorage algorithmic stablecoins LUNA and UST in the example);
Seigniorage algorithmic stablecoins (UST-LUNA, for example) use a multi-cryptocurrency system in which the price of one stablecoin is designed to be fixed and another cryptocurrency is designed to facilitate that stability. Seigniorage models typically work with protocol-based minting and burning mechanisms that encourage market participants to buy and sell supporting cryptoassets to push the price of stablecoins towards stablecoins. The system here applies a combination of free market mechanisms. In fact, this is the simplest answer to the question of what is an algorithmic stablecoin.
If we need to explain this with the example of UST LUNA; TerraUSD (UST) maintains a 1:1 parity with the US dollar through an algorithmic relationship with Terra's native cryptocurrency LUNA. Behind the relationship is an arbitrage system that manifests itself when the UST loses its constant in both directions.
When the supply of UST is too small and demand is too high, the price of UST rises above $1. To restore UST's stability, the Terra protocol allows users to exchange 1 USD LUNA for 1 UST from the Terra protocol. This trade is an indirect burn, where users can sell for 1.01 USD and earn a profit of 1 cent. It may sound small, but when these profits are made in large quantities, they can be quite large.
Users can press the UST from the burned LUNA as many times as needed until the UST is pegged at $1 again. Thus, supply increases, and as supply increases, prices eventually fall.
When the supply is too great and the demand too low, the reverse happens: the price of UST drops below $1. Thus, the protocol allows users to do the opposite as above: Users can buy 1 UST for 0.99 USD and then trade 1 UST for 1 USD LUNA. The trade burns 1 UST and prints 1 USD LUNA, and the arbitrageur makes a profit of 0.01 UST.
Again, the Terra protocol allows users to continuously burn UST and receive LUNA until UST reaches $1.
However, this system has some flaws. Let's take a look at these flaws together with the example of UST and LUNA.
Why Did UST and LUNA Drop?
Although it may seem flawless at first, algorithmic stablecoins have a major problem. So much so that if the “tokenomic” incentive structure in any algorithmic stablecoin ecosystem is broken, the entire ecosystem will fail if there is no return or deposit insurance safety net.
On May 7, this is exactly what happened. UST is starting to become unstable as large-volume withdrawals from Anchor, Terra's largest decentralized finance (DeFi) protocol, begin in earnest. These have had a domino effect on the UST pool on Ethereum's Curve Protocol, the main hub of stablecoin liquidity in all of DeFi, which has seen high volumes of withdrawals. Subsequently, large-scale LUNA printing and sales were carried out to offset the UST.
So much so that trying to maintain the value of the UST means sacrificing the price of the LUNA as it increases the supply of the LUNA, and more supply means selling pressure on the price of the LUNA. As a result, LUNA fell heavily on the night of May 11, dropping more than 99 percent to as low as $0.01.