Overview
An algorithmic stablecoin maintains its peg through algorithms and market incentives rather than direct asset backing. It uses supply adjustments or seigniorage to keep the token near its target price. This design removes the need for a reserve of external assets.
How It Works
When the price rises above the peg, the protocol expands supply; when it falls below, it contracts supply or creates a debt token. Arbitrageurs respond to these incentives to move the price back. The system's stability depends on market confidence and collateral design.
Why It Matters
Algorithmic stablecoins promise fully decentralized, scalable money without reserves. However, they have proven fragile, with several high-profile depegs causing large losses. Their design is a cautionary case study in the limits of incentive-based stability.
Related Concepts
Algorithmic Stablecoins contrast with Fiat-Backed and Crypto-Backed stablecoins. They involve Rebase mechanisms and are a major risk topic in DeFi.