What caused the crash of the algorithmic stablecoin and what other tokens have a similar mechanism in place? Here we take a look at the long-term algorithmic stablecoin analysis.
How algorithmic stablecoins work
Stablecoins are cryptocurrencies backed by reserve assets such as fiat currencies, most often the US dollar, or a commodity price. They aim to maintain a 1:1 peg with the currency they back.
A Goldman Sachs report on the economics of algorithmic stablecoins explained that these digital assets “are virtually identical to money market fund shares: tradable claims on low-risk and short-dated securities that are nearly equivalent to cash from an economic standpoint.”
Algorithmic stablecoins are used primarily in the US, as the President's Working Group on Financial Markets report on stablecoins, to "facilitate trading, lending, or borrowing of other digital assets, predominantly on or through digital asset trading platforms.
"Proponents believe stablecoins could become widely used by households and businesses as a means of payment. If well-designed and appropriately regulated, stablecoins could support faster, more efficient, and more inclusive payments options.”
In addition, stablecoins allow investors and traders to remain in the cryptocurrency markets without falling victim to price volatility.
Stablecoins can be classified into three different categories:
Fiat-based stablecoins, backed by reserve assets.
Crypto-backed stablecoins, backed by a pool of cryptocurrency assets.
Algorithmic stablecoins, which use maths and incentive mechanisms to maintain their fiat peg.
Fiat and crypto-baked stablecoins use a collateral mechanism to maintain their peg and are backed by different digital assets or fiat as collateral. The process allows users to lock their cryptocurrency into smart contracts in order to receive stablecoin tokens of the same value.
Algorithmic stablecoins, on the other hand, do not use other cryptocurrencies or fiat as collateral. Instead they operate via special algorithms and smart contacts that manage the supply of tokens in circulation.
This means that the algorithmic systems of these stablecoins will reduce the number of circulating tokens when the digital asset’s price falls below the price of the fiat currency it follows.
If the stablecoin's price exceeds the price of the fiat currency it follows, new digital assets are created and entered into circulation to adjust the stablecoin’s value.
Algorithmic stablecoins rely on two tokens: a stablecoin and a cryptocurrency that backs the stablecoins. Their algorithm regulates the relationship between the two.
Algorithmic stablecoins explained: Risks and opportunities
According to CoinLoan founder and CEO, Alex Faliushin, the main algorithmic stablecoin risk is that “most of them can be manipulated if there is enough capital available”.
Dr Hamed Taherdoost, e-business professor at University Canada West, told Capital.com that changes in third parties supporting the price of stablecoins can dramatically affect their value and performance.
Gabriella Kusz, CEO of Global Digital Asset and Cryptocurrency Association, agreed on the volatility aspect and added that stablecoins are “amazing instruments that offer people around the world … access to USD, and facilitate the decentralised financial (DeFi) system. In essence, they offer a gateway to a democratised financial system.”
What went wrong with UST?
On 9 May 2022, after holding its value against the US dollar, the TerraUSD (UST) stablecoin collapsed, or de-pegged.
The stablecoin’s value dropped from its $0.9964 high on 8 May 2022 to $0.154 in less than a week – an 84.5% decline. The stablecoin continued to fall in May and June.
UST’s de-pegging dragged down other cryptocurrencies, including its sister token LUNA and BTC.
According to Goldman Sachs, UST “had a relatively simple stability mechanism”.
It added: “When users create (or ‘withdraw’, ‘convert fiat into’) UST, an equivalent amount of the blockchain’s native LUNA token is “burned” (destroyed).
“When users redeem UST (or ‘pay back’, ‘convert back into fiat’), an equivalent amount of the LUNA token is ‘minted’ (issued). This creates the incentive mechanism intended to maintain UST’s peg to the US Dollar.”
Faliushin noted that this algorithm was “something that the crypto world has never seen before”.
He added: “The idea was not new, but the size of it really stood out. When something as big as UST is dependent on something as volatile as crypto, it will raise questions about its sustainability, so yes – UST’s nature contributed to its crash,” he noted, explaining that UST’s crash was something many investors were expecting would happen.
“If something as big as UST crashed, it is obviously possible that it can happen to other similar projects as well, especially algorithmic stablecoins.”
Kusz agreed, noting that UST’s design, which required users to purchase one UST in exchange for one LUNA, allowed them to do so at a discounted price, once UST became de-pegged.
Dr Taherdoost noted that other factors such as the introduction of stronger monetary policies by the US Federal Reserve and the war in Ukraine had led to a failure in the balancing of supply and demand of UST tokens, leading to its de-pegging.
Are other algorithmic stablecoins at risk?
The three top algorithmic stablecoins by market capitalization, according to CoinMarketCap, as of 8 June, are Neutrino USD (USDN), USDD and Fei USD (FEI). USDN and USDD are similar to Terra’s UST.
USDN backed by WAVES
Neutrino USD, or USDN, is an algorithmic crypto-collateralised stablecoin pegged to the US dollar. The stablecoin is backed by WAVES, its sister cryptocurrency.
All operations involving USDN are fully transparent and governed by smart contracts. When the value of WAVES against the USD rises, a reserve fund is formed to provide backing in case the WAVES price falls.
Its price was also affected by UST, falling as low as $0.8256 on 11 May. However, it managed to resurface, and is currently trading close to its peg. As of 8 June 2022, the stablecoin has a market capitalisation of over $825m.
“USDN is not dissimilar to UST in its peg mechanism, and itself also lost the $1 mark amid the Terra death spiral mayhem last month,” said Invezz data analyst Dan Ashmore.
“For the same reasons as Terra, I believe a crash is possible here too, and am not bullish long-term. I would not hold any USDN,” Ashmore told Capital.com
USDD backed by TRON DAO
USDD was built and is managed by the TRON DAO (decentralised autonomous organisation) Reserve. The token is pegged to 1:1 with the US dollar.
The stablecoin is over-collateralised by a number of mainstream tokens, including TRX, BTC and USDT. Following TerraUSD’s collapse, Tron boosted its transparency and added collateral in order to avoid a dip similar to that faced by UST.
The stablecoin was slightly affected by UST’s collapse, losing nearly 2% of its value, falling to $0.9852 on 12 May. As of the time of writing (8 May), USDD has a market capitalisation surpassing $703m.
“USDD was launched by Tron last month, ironically around the same period that Terra descended into its death spiral,” Ashmore said.
“It is different in that it is overcollaterised, with a ratio of 130% placing it even above DAI’s 120%. This is intriguing as it makes the possibility of a Terra-esque crash significantly less likely.
“While one month is too early yet to judge and the system has yet to be tested, it’s an interesting experiment as part of the “new age” of stables, and hopefully will bring more credibility to the sector.”
FEI backed by TRIBE
The last on our algorithmic stablecoins list is FEI, a stablecoin that intends to be more capital efficient and fully decentralised.
The FEI Protocol aims to create a liquid market where ETH/FEI and ETH/USD exchanges are closely traded. The protocol also has its own governance token, TRIBE. It releases TRIBE to bonded FEI/TRIBE Uniswap liquidity provider tokens.
Unlike previous algorithmic stablecoin examples that fell in line with the UST’s collapse, FEI was not significantly affected, continuing to trade in line with its peg value. As of 8 June, the stablecoin has a market capitalisation amounting to $422m.
Asmore explained that FEI is a different type of an algorithmic stablecoin as it uses ETH as a reserve currency.
“While this is an improvement on Terra’s mechanism, it still leaves open the possibility of a crash if ETH suffers a large dip in value,” he said.
“Other algorithmic stablecoins can be manipulated in a similar manner as was done to UST. Of course, after the crash the safety measures have been readjusted, but they are definitely not unhackable,” Faliushin added.
Future of algorithmic stablecoins
Following UST’s collapse, a number of lawmakers were vocal about imposing stricter rules around stablecoin regulations, which could eventually point to a bearish algorithmic stablecoins outlook.
“The future of algorithmic stablecoins is under the radar of lawmakers, so it really depends on what kind of regulations the stablecoins in general will see in the near future. Hopefully, the UST crash will prevent this kind of event from ever happening again,” said Faliushin.
The chairman of the Senate Banking Committee, Sherrod Brown, was quoted by Politico as being supportive of strong stablecoin regulation.
“Not being collateral makes algorithmic stablecoins inherently fragile since their basic functional assumptions are not certainly guaranteed and may fluctuate in times of crisis in the market. Thus, under-collateralized stablecoins are expected to be safer investments in future,” said Dr Taherdoost.
“However, algorithmic stablecoins can be an interesting topic for future development projects in cryptocurrencies without the use of collateral or lending support.”
Ashmore agreed, saying that stablecoins will need to be collaterised for them to work.
“The uncollaterised algo-stable experiment went down the tubes with the collapse of UST; with that debacle so public, confidence in the mechanism is gone and they will fail to capture the public’s trust again.
“This is why general long-term sentiment is so low right now, coupled with the wider macro bear environment derived from the inflation situation, hawkish Fed and tenuous geopolitical situation,” he told Capital.com.
Kusz gave a positive algorithmic stablecoins outlook, pointing out that algorithmic stablecoins will “continue to innovate, develop and mature in the marketplace.”
“This is such a new area and there will be evolutions of various coins, products and services. As such, I believe that the industry will continue to study, reflect and build upon the lessons learned from TerraLUNA,” she added.
Note that analyst predictions can be wrong. Forecasts shouldn’t be used as a substitute for your own research. Always conduct your own diligence and remember that your decision to trade or invest should depend on your risk tolerance, expertise in the market, portfolio size and goals.
Keep in mind that past performance doesn’t guarantee future returns. And never invest or trade money you cannot afford to lose.
What are the risks of algorithmic stablecoins?
CoinLoan’s CEO Alex Faliushin told Capital.com that possibly the biggest algorithm stablecoin risk is that most of their algorithms can be manipulated if there is enough capital available. E-business professor at University Canada West, Dr Hamed Taherdoost, added that changes in third parties supporting the price of stablecoins can also dramatically affect their value and performance.
Are algorithmic stablecoins safe?
Just like any cryptocurrency, investing in algorithmic stablecoins comes with risks. Because algorithmic stablecoins lack collateral, they are considered to be a risky investment. Cryptocurrencies, stablecoins included, are high-risk assets. You should do your own research and evaluate the level of risk you are prepared to accept before investing. Never invest or trade money you cannot afford to lose.
Are algorithmic stablecoins collateralized?
Unlike fiat or crypto-based stablecoins, algorithmic stablecoins lack collateral. Instead, they use an algorithm to maintain their peg at a consistent value.
How many algorithmic stablecoins are there?
According to data provided by CoinMarketCap, there are currently 20 different algorithmic stablecoins in circulation, as of 8 June.