December 1, 2022 | Jon Hautamäki

blockchain & cryptos

Algorithmic Stablecoins

This year we have covered different crypto phenomena in our 8-part article series. This article focuses on a very specific phenomenon in the crypto sphere – algorithmic stablecoins.

We think it is almost safe to say that the dust has settled after the Crash of the Year nominee (which is why we will also dive into the culprit that partly set in motion the bear market we are in today) – Terra Luna stablecoin.

Stablecoins in general

Stablecoins are crypto assets that have their value pegged to another asset (e.g. dollar or euro) to maintain a stable value.

The most prominent stablecoin in the crypto market is the USD-pegged Tether (USDT), which provides investors with a way to maintain their portfolio value when investing in cryptocurrencies by not having to switch fiat currency to other crypto assets. In other words, owners of crypto assets can trade their assets for stablecoins to lessen their exposure to risks induced by high-volatility crypto assets or unstable markets.

It is also noteworthy to point out that thus far, there have not been that many reliable stablecoins that would be pegged to the value of the euro. However, in November 2022, a fully euro-backed stablecoin, EUROe, was accepted to be launched by the Finnish Financial Supervisory Authority, whereby especially the European markets received its first reliable option to dollar-backed stablecoins.

Algorithmic stablecoins

The defining feature of algorithmic stablecoins is that their price is kept stable with the help of smart contracts that algorithmically reduce the volatility of the stablecoin. As opposed to the “traditional” 1:1 ratio, fiat-pegged stablecoins, algorithmic stablecoins are usually under-collateralised, meaning that the circulating supply of algorithmic stablecoins can be substantially higher than the amount of fiat assets backing them.

What does the “algorithmic” stand for, then?

The general principle is that an algorithmic stablecoin ecosystem has two coins – one for absorbing market volatility (“balancer”) and another for keeping the 1:1 ratio peg. For example, the Terra Luna ecosystem had LUNA and TerraUSD, of which the former was a governance token and the latter a stablecoin. If TerraUSD’s price climbed over 1 dollar, an investor could exchange LUNA tokens for TerraUSD to profit from the higher stablecoin price and vice versa. The lucrative price difference worked as a sort of invisible hand for the market that helped the TerraUSD stablecoin retain its peg to the US dollar.

Algorithmic stablecoins can further be categorised into

  • Rebasing algorithmic stablecoins;
  • Seigniorage algorithmic stablecoins; and
  • Fractional algorithmic stablecoins.

Rebasing algorithmic stablecoins, such as Ampleforth (AMPL), keep their token price pegged by modifying the stablecoin’s total supply over certain time periods. Fractional stablecoins such as Frax (FRAX) use a partial-collateral protocol and are “hybrids” between algorithmic and collateralised stablecoins. Seigniorage stablecoins, such as Basis Cash (BAS), have a stablecoin token and seigniorage ownership tokens, “shares” of sorts. When the stablecoin price rises over the peg, the issued shares are used to increase the supply of stablecoins.

Terra Luna Stablecoin Ecosystem – The Flight of Icarus

The Terra Luna ecosystem was – and to some degree, still is – revolutionary. In April 2022, LUNA's price reached its all-time high at almost 120 dollars a token. Exactly one month later, Terra Luna was subject to one the largest crashes in the history of crypto due to an unprecedented flaw in the system that ultimately led to the de-pegging of their stablecoin pair. This set in motion a bank run, and nearly all investors cashed out, which sent the price of LUNA tumbling down to the third and fourth decimals of a dollar.

The Luna smart contract was coded so that if you sold the stablecoin Terra, the smart contract guaranteed you one dollar's worth of the native token Luna. After the de-pegging of the stablecoin Terra (i.e. the price of Terra was not tied to the dollar), users could exploit this feature in the smart contract and print Luna tokens indefinitely.

Luna's ecosystem was ambitious and concrete proof of the rise of decentralised finance (or 'DeFi'). Unfortunately, that rise was short-lived, and we will have to wait for some other project that will spearhead the DeFi revolution.

As a firm specialising in web3 and DeFi-related legal issues, we are happy to help you with any questions you may have regarding your own project.

Our Associate Trainee Patrik Anthoni took part in writing this article.