How Do Algorithmic Stablecoins Work?

Let’s first look at USDC. Suppose USDC de-pegs and is valued at $0.95. In theory, USDC’s founder, Circle, should have enough reserves to provide the $0.05 for every coin in issuance to bring it back to peg. This is great if the reserve actually exists, but as we have seen with Tether, sometimes that can get controversial.

It works similarly with DAI except MakerDAO backs their coin with collateral used to mint it.

These types of collateral-based stables are severely limited in their capacity to scale because it relies on a reserve to be trusted. Depending on how many coins are issued by the central reserve will determine how widely adopted the coin can be.

Sounds a lot like centralization and the problem we are trying to solve with digital currencies in the first place, right?

However, UST is completely different. TerraUSD is backed by the buyer of Terra’s native coin, LUNA, and works like this (given the de-peg scenario from above):

1. Arbitrager buys 1 UST for the value of $0.95.
2. By burning 1 UST, $1 worth of LUNA is minted.
3. $1 of LUNA is then sold for $0.05 profit.

As you can see, the UST peg is held by the current LUNA buy orders. Theoretically, if there were no buy orders for LUNA, then nothing is stopping UST from losing its peg.

So, what’s keeping the LUNA buy orders flowing? Luckily, Terraform Labs thought of that while creating the algorithm. The answer is incentive.

LUNA stakers are rewarded with a fraction of the revenue that is made on any transactions over the Terra blockchain. The fraction that stakers are paid is proportionate to the amount of LUNA an investor has staked. Therefore, there are very high incentives to keep buying and staking LUNA.

And, since UST is backed by LUNA’s buy orders; and buy orders are driven by incentives; and incentives are rewarded from blockchain revenue; and revenue is derived from blockchain transactions;

You could theoretically say that UST is an algorithmic stablecoin that is backed by transactions on the Terra blockchain.

This all makes sense as the ecosystem flows in a cycle in every other aspect of its work. Why can’t the algorithmic stablecoin join the cycle?

Source: https://medium.datadriveninvestor.com/how-do-algorithmic-stablecoins-work-5309f26be1d3?source=rss——-8—————–cryptocurrency