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An algorithmic stablecoin is a cryptocurrency designed to maintain a stable price, typically pegged to $1, through automated supply adjustments driven by smart contracts rather than by holding reserves of fiat currency or other collateral. When the price rises above the peg, the protocol mints more tokens to increase supply and push the price down. When it falls below, the protocol burns tokens or creates incentives to buy and hold, reducing supply to push the price up. The mechanism relies entirely on market participants and coded incentives to maintain equilibrium.
Think of it like a thermostat: the algorithm reads the temperature and automatically adjusts to restore the set point, no human required.
Not all algorithmic stablecoins work the same way. The main variations differ in how aggressively they use algorithms versus collateral.
In May 2022, TerraUSD lost its $1 peg and never recovered. Before the collapse, UST was the fourth-largest stablecoin with an $18 billion market cap. Anchor Protocol was offering UST depositors a 19.5% annual yield, which attracted enormous inflows and inflated UST's circulating supply.
When large withdrawals from Anchor began, the market lost confidence that the mint-and-burn mechanism between UST and LUNA could hold. Selling UST triggered minting of LUNA; LUNA's price collapsed from the selling; that collapse reduced UST's backing value further; which triggered more selling. The feedback loop wiped out both assets in days. The Richmond Federal Reserve's post-mortem noted that algorithmic stablecoins with circular backing become "extremely fragile" once demand shocks hit because neither token can independently defend the other.
The evidence from 2022 onward favors hybrid models. Frax Finance maintained its peg through the Terra collapse and the subsequent bear market by combining real collateral with its Algorithmic Market Operations modules. DAI, managed by MakerDAO, has maintained its $1 peg since 2017 through a mix of crypto collateral and algorithmic governance of stability fees.
Pure algorithmic models without collateral backing remain extremely vulnerable to bank-run dynamics. The 2025 stablecoin market reflects that lesson: assets like USDT and USDC, backed by real reserves, hold the dominant market positions, while purely algorithmic coins remain niche instruments.
The collapse of Terra prompted immediate regulatory attention globally. U.S. Treasury Secretary Janet Yellen cited UST's failure in May 2022 congressional testimony as justification for urgent stablecoin legislation. Several jurisdictions have explicitly prohibited purely algorithmic stablecoins or placed them under enhanced scrutiny. The EU's Markets in Crypto-Assets regulation treats algorithmic stablecoins as high-risk instruments with specific reserve and disclosure requirements.
Sources:
https://www.richmondfed.org/publications/research/economic_brief/2022/eb_22-24
https://corpgov.law.harvard.edu/2023/05/22/anatomy-of-a-run-the-terra-luna-crash/
https://changelly.com/blog/what-are-algorithmic-stablecoins/
https://pmc.ncbi.nlm.nih.gov/articles/PMC10162904/
https://eco.com/support/en/articles/12257457-top-algorithmic-stablecoins-your-complete-2025-guide
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