Algorithmic Stablecoin

An algorithmic stablecoin is a stablecoin that tries to hold its peg primarily through programmed supply adjustments and market incentives rather than through full reserves of fiat or crypto collateral. When the price rises above the target, the protocol expands supply; when it falls below, the protocol contracts supply or offers incentives designed to push the price back up.

The most famous example is TerraUSD (UST), which collapsed in May 2022. UST maintained its peg through a mint-and-burn relationship with a sister token, LUNA: one UST could always be exchanged for one dollar's worth of newly minted LUNA. When confidence broke, holders rushed to exit, LUNA's supply hyperinflated, and both tokens spiraled to near zero — a failure mode often called a death spiral. Tens of billions of dollars in market value evaporated in days.

The core weakness is that the mechanism depends on ongoing demand and confidence rather than on assets that can be sold to defend the peg; the design works until it is stressed, which is exactly when it is needed most. A common misconception is that a long track record of holding the peg proves an algorithmic design is sound — stability during calm markets says little about behavior in a panic. Since the Terra collapse, purely algorithmic designs have largely fallen out of favor, and regulators in several jurisdictions restrict them.