An Algorithmic Stablecoin is a type of cryptocurrency that attempts to maintain a stable peg (typically $1 USD) through programmatic supply expansion and contraction, rather than relying on fiat reserves or over-collateralization. These protocols use on-chain mechanisms — often involving moving averages and oracles — to detect when the token deviates from its peg and automatically adjust supply to restore it.

How algorithmic stablecoins work

The basic mechanism follows a feedback loop:

• Price above peg: The protocol mints new tokens and distributes them, increasing supply to push the price down.
• Price below peg: The protocol contracts supply by burning tokens or incentivizing holders to remove tokens from circulation.

Many implementations use a moving average of the exchange rate rather than spot price to determine when to rebase. This smoothing prevents unnecessary supply adjustments from short-term volatility but introduces lag that can delay corrective action.

Notable examples

Ampleforth (AMPL) pioneered the rebase model, adjusting every holder's balance daily based on a 24-hour moving average of the AMPL/USD exchange rate. If the average price exceeds $1.05, all balances increase proportionally; below $0.95, they decrease.

Terra/UST used a dual-token model where LUNA was burned to mint UST and vice versa. Its May 2022 collapse — losing over $40 billion in value — demonstrated the catastrophic failure mode of algorithmic stablecoins when the stabilization mechanism enters a death spiral.

Security risks

• Death spirals: When confidence drops, selling pressure creates a negative feedback loop that overwhelms the stabilization mechanism.
• Oracle dependence: Faulty or manipulated price feeds can trigger incorrect supply adjustments.
• Moving average lag: The smoothing that prevents overreaction also delays response to genuine depegs, potentially allowing the situation to worsen.
• Governance attacks: If supply parameters are governed by token holders, attackers could manipulate governance to destabilize the peg.

Algorithmic stablecoins remain one of the most challenging designs in DeFi, with most implementations failing to maintain their peg during severe market stress.