In crypto, stability can feel impossible. Prices swing, and volatility can rock the whole market. That’s why stablecoins exist: to give you dependable value in the eye of the storm.
Not all stablecoins maintain that stability the same way, though. Some are backed by fiat currency or other assets, while others—algorithmic stablecoins—try to do it with computer algorithms and market incentives alone. Let’s figure out how these coins work, why they matter, and what you should know before putting your trust in their code.
An algorithmic stablecoin is a cryptocurrency that uses computer algorithms and smart contracts to automatically adjust its token supply so the market price stays near a target value. It’s typically pegged to a fiat currency like the US dollar, but unlike fiat-backed stablecoins, it doesn’t hold that currency or other reserve assets in storage.
This design makes algorithmic stablecoins different from fiat-backed stablecoins (like USDC) or crypto-backed stablecoins (like DAI) which rely on collateral reserves. An algorithmic model removes the tangible asset requirement, aiming for stability through code and incentives alone.
Read more: Altcoins vs. Stablecoins: What’s the Difference?
Notable examples of algorithmic stablecoins include Ampleforth (AMPL), which uses a rebase model that changes supply across all wallets daily, TerraUSD (UST), developed by Terraform Labs under co-founder Do Kwon, which used a two-token model with its sister coin Luna on the Terra Classic blockchain, before it lost its peg, and Frax (FRAX), governed by Frax Protocol and operated by Frax Finance under founder Sam Kazemian, which initially combined partial collateral with algorithmic controls using its unique Algorithmic Market Operations (AMO) model. Each project takes a different approach to reaching the same goal: a stable value without full reserves. We’ll cover these coins and their models in the following sections.
Algorithmic stablecoins work by keeping their price near a target—usually $1—using algorithms to automatically increase or decrease the token supply based on market conditions. When the stablecoin’s price exceeds its intended peg, the algorithm mints new tokens to bring it down. When the price falls, it removes tokens from the circulating supply to push it back up. These rules are enforced by smart contracts on the blockchain.
The core principle is simple: change the supply to influence price. More tokens in circulation make each one worth less; fewer tokens make each one worth more. Because these changes happen automatically, algorithmic stablecoins eliminate the need for middlemen, or fiat currency/physical assets held in reserve. For everything to function, independent investors just need to perform price-stabilizing arbitrage, buying when prices are low and selling when prices are high.
In theory, this system creates a self-correcting mechanism that can maintain price stability indefinitely. In reality, though, its success hinges on continuous market demand and user confidence, both of which can disappear quickly under stress.
Most algorithmic stablecoins fall into three design camps. Here’s how each tries to stay pegged to the dollar, with code, incentives, and the occasional safety net.
Rebase stablecoins adjust the number of tokens in circulation automatically, without user action. If the token trades above its target price, the protocol increases everyone’s balances proportionally, essentially “creating” more coins in every wallet to bring the price down. Conversely, if it trades below, balances shrink to reduce supply. This design aims to maintain the peg without collateral or manual minting. However, it can feel unpredictable for holders, since the amount of tokens in your wallet can change over time without your input.
Two-token models use a pair of digital assets: the stablecoin itself and a volatile partner token (these are sometimes also the project’s governance tokens). Traders mint stablecoins by burning the volatile token, and redeem them by swapping back. If price fluctuations cause the stablecoin’s price to rise above its peg, buying power shifts to minting more stablecoins, increasing supply until the price cools. If the price drops, the reverse happens, and stablecoins are burned in exchange for the volatile token to shrink supply. This design relies heavily on market incentives, and its stability is only as strong as demand for the paired token.
Hybrid stablecoins, or fractional algorithmic stablecoins, combine algorithmic controls with partial collateral. Part of their value is backed by reserves, while the rest is stabilized by supply-adjustment mechanics similar to rebase or two-token systems. For example, when the price drifts above the peg, the protocol can mint more tokens, either by expanding balances or allowing swaps from other digital assets, all while still keeping the collateral as a safety net. This approach aims to combine the flexibility of algorithmic models with the security of collateral, offering a middle ground between the two extremes.
Get the top 50 crypto definitions you need to know in the industry for free
Algorithmic stablecoins have a number of advantages over other types of cryptocurrency. Let’s look at each in more detail.
If you’re looking for the most obvious example of things going wrong, look no further than the collapse of TerraUSD (UST). Before the crash, UST was a leading stablecoin, but in May 2022, its peg collapsed. The stablecoin’s value plunged as low as $0.10, dragging its sister token Luna from over $100 to virtually zero. It wiped out tens of billions in value in a single week.
The collapse laid bare several fundamental vulnerabilities of algorithmic stablecoins:
Another experiment, Fei (FEI), launched by Fei Labs and governed by Tribe DAO under founder Joey Santoro, introduced the Protocol Controlled Value (PCV) concept, where the protocol itself owns and manages the reserve assets rather than holding them in user-controlled vaults. Despite this innovative design, governance disputes and market challenges led to its wind-down in 2022.
Neutrino USD (USDN), issued via the Neutrino Protocol on the Waves blockchain founded by Sasha Ivanov, also lost its peg multiple times, highlighting risks in low-liquidity markets.
Other projects, like Empty Set Dollar (ESD) and Basis Cash, have also failed to hold their pegs, showing that total disaster isn’t exactly uncommon for this asset class.
Here’s a quick look at key algorithmic stablecoins, and where they’re at today in the broader stablecoin market:
Trust in this case does not mean guaranteed stability—here’s no design yet that has proven immune to market stress. But that doesn’t mean all algorithmic stablecoins are doomed from the start. Some, like Ampleforth (AMPL), still operate as designed, and Frax (FRAX) has shifted toward full collateralization to reduce risk, while USDD has added heavy over-collateralization to boost market confidence.
These adaptations show that trust can improve when protocols mix strong collateral with transparent governance. Still, given the history of high-profile failures, traders and investors treat them as higher-risk assets, often using them for short-term purposes rather than long-term stability. These coins rely on code, incentives, and liquidity conditions rather than holding equivalent reserves in a bank or blockchain wallets. As we’ve seen, when those incentives fail or liquidity dries up, the peg can collapse quickly, with no chance of recovery.
The legality varies widely by country. In most places, there’s no single law targeting them specifically, but they fall under existing rules for digital assets, securities, or payment instruments. For example, in the United States, regulators like the SEC may classify algorithmic stablecoins as securities or commodities depending on their structure, and other governing bodies have their own designations. This means projects can often face multiple compliance requirements at once, even without an explicit law aimed at them.
In the European Union, the upcoming MiCA regulation will cover all stablecoins, including algorithmic designs, setting rules for transparency, reserves, and governance. Some countries, like South Korea, have openly stated they’ll scrutinize or ban high-risk designs after the TerraUSD collapse. In contrast, others—like Singapore—let them operate under licensing frameworks that require strong disclosure and safeguards. This patchwork means a project can be legal in one place, but restricted in another, making global adoption a regulatory balancing act for developers and issuers.
Only partially. While they aim to keep a stable value, algorithmic stablecoins usually have less or no collateral to make that happen, and rely instead on incentives and code, both of which can fail under stress. You can definitely use them, but they’re better suited for trading strategies or experimental DeFi than as a long-term “safe” store of value. Even well-designed systems are vulnerable to extreme market volatility, smart contract bugs, or poor governance.
Read more: What Is Volatility in Crypto?
History has shown that large-scale depegs can happen fast, wiping out vast sums in days, or even hours. Other projects, like Ampleforth, have maintained operations but still experience significant short-term swings that make them risky for everyday payments.
Algorithmic stablecoins are unlikely to disappear. Developers continue to experiment with new designs aimed at solving the weaknesses that caused past failures, such as better collateral models, dynamic supply controls, and more transparent governance.
That said, the future depends heavily on regulation and public trust. Despite innovation in algorithmic models, the market still prefers fiat-backed stablecoins for their perceived reliability. But if algorithmic stablecoins can demonstrate consistent peg stability over time and comply with evolving legal frameworks, they could carve out a niche in DeFi and cross-border payments. Without clear safeguards, though, many will remain experimental assets rather than mainstream money.
Their future will come down to design resilience, community confidence, and the ability to learn from past mistakes.
Algorithmic stablecoins offer innovation and potential scalability but carry not insignificant risk. As we’ve seen, design flaws, low liquidity, and market sentiment can quickly unravel even the largest projects. They may be worth exploring in small amounts if you know what you’re doing, and use them in contexts like DeFi experiments. But if your priority is preserving value, collateral-backed stablecoins remain the more reliable choice.
Approach them with caution, and as always: never risk more than you can afford to lose.
Regular stablecoins like USDT or USDC maintain their value by holding reserves—usually fiat currency or equivalent assets—equal to the number of coins issued. Algorithmic stablecoins don’t hold equivalent reserves. Instead, they rely on algorithms to automatically expand or shrink the supply based on current price, aiming to keep the token near its peg.
Sometimes, but not always. If market demand and the underlying mechanism remain balanced, the peg can hold for long periods. However, history shows that loss of confidence or extreme price volatility can cause the peg to break—often permanently—because there’s no hard collateral backing it.
They’re better suited for short-term trading or specific DeFi strategies rather than long-term holding. The higher risk of depegging means investors should be prepared for potential losses and avoid relying on them for stability over months or years.
It depends on the project. Some are fully decentralized, with all supply adjustments handled by open-source smart contracts. Others are run or influenced by a core development team or company, which can introduce centralization in decision-making and governance.
Disclaimer: Please note that the contents of this article are not financial or investing advice. The information provided in this article is the author’s opinion only and should not be considered as offering trading or investing recommendations. We do not make any warranties about the completeness, reliability and accuracy of this information. The cryptocurrency market suffers from high volatility and occasional arbitrary movements. Any investor, trader, or regular crypto users should research multiple viewpoints and be familiar with all local regulations before committing to an investment.
The post Algorithmic Stablecoins Explained for Beginners appeared first on Cryptocurrency News & Trading Tips – Crypto Blog by Changelly.
Also read: BlockchainFX vs. Unstaked: Why BlockchainFX is the Top Crypto to Invest in Today
