Esoteric
Algorithmic Stablecoins
Holding a peg with mechanism instead of collateral — elegant on paper, reflexive in a crisis. The UST/LUNA case study.
TradFi →Unbacked currency peg defense (and its bank runs)
Prerequisites
01 · Concept — what problem does it solve?
The dream: a decentralized dollar with no costly collateral and no centralized issuer — peg held purely by an algorithm that expands and contracts supply. The reality is that an undercollateralized peg is a confidence game, and confidence is reflexive: the same feedback loop that holds the peg up in calm markets accelerates its collapse in a panic. Algorithmic designs are the most instructive failures in DeFi.
02 · Mechanics
- Seigniorage / two-token (UST ↔ LUNA): the is always redeemable for $1 of a volatile "absorber" token. Mint/burn arbitrage between them is supposed to defend the peg.
- (Ampleforth): every wallet's balance expands or contracts to push price toward target — moves the peg problem into supply rather than price.
- Fractional-algorithmic (early Frax): part collateral, part algorithmic — a hybrid that dials backing up or down with confidence.
- The reflexive loop: the absorber token only has value because the system has value; if the peg slips and the absorber falls, redemption mints more absorber, crashing it further — a death spiral.
03 · Formulas
// seigniorage redemption (UST/LUNA style)
burn $1 of UST → mint $1 of LUNA (and vice versa)
// the death spiral
UST < $1 → arb burns UST for LUNA → LUNA supply ↑ → LUNA price ↓
→ confidence ↓ → more UST sold → UST ↓↓ (self-reinforcing)
04 · Edge cases & risks
- Terra/UST collapse (May 2022) — a ~$18B stablecoin and its ~$40B absorber (LUNA) went to near-zero in days once the peg broke and the spiral engaged. The canonical algo-stable failure.
- Yield as the real peg — UST's peg was effectively propped by Anchor's unsustainable ~20% yield; when yield-seeking deposits fled, the mechanism had nothing left to hold.
- Reflexivity, not a bug — the failure mode is structural, not an exploit. The mechanism that defends the peg is the mechanism that destroys it.
- The (3,3) cousin — OlympusDAO's rebase model shares the same reflexive DNA: glorious on the way up, brutal on the way down.
Connected concepts