Algorithmic vs. Collateralized Stablecoins: A Post-Mortem Analysis
Examining the failures of Terra, Iron Finance, and Basis Cash. Why algorithmic approaches fail and what collateralized designs get right.
The Algorithmic Stablecoin Thesis
Algorithmic stablecoins emerged from a compelling premise: maintain a price peg through supply manipulation rather than collateral. When price rises above peg, mint more tokens to increase supply and push price down. When price falls below peg, contract supply to push price up. No collateral needed—just elegant game theory and arbitrage incentives.
The Fatal Flaw
Algorithmic stabilization relies on market confidence to function. When that confidence breaks—even temporarily—the mechanisms designed to restore the peg instead accelerate its collapse. The algorithm cannot distinguish between a temporary depeg and a fundamental loss of confidence, responding identically to both.
Anatomy of the Terra Collapse
Terra's UST maintained its peg through a mint/burn mechanism with LUNA. When UST dropped below $1, arbitrageurs could redeem 1 UST for $1 worth of LUNA (newly minted), creating buy pressure on UST. The mechanism worked for years—until it didn't.
On May 7, 2022, large UST redemptions triggered the mint mechanism, flooding the market with LUNA. As LUNA's price dropped, each UST redemption required minting more LUNA, further crashing its price. The reflexive doom loop was unstoppable: more UST selling → more LUNA minting → lower LUNA price → more UST selling. Within 72 hours, $40 billion evaporated.
Why Collateralization Works
Collateralized stablecoins like USDC, USDT, and GRAIN work because redemptions are backed by real assets. When a holder redeems GRAIN, they receive USDC from the reserve—not newly minted tokens from an algorithm. The reserve exists independently of market sentiment; it doesn't depend on arbitrageurs, game theory, or confidence to maintain value.
- Algorithmic: Depends on confidence → reflexive collapse risk
- Collateralized: Backed by assets → redemption always possible
- Algorithmic: Supply manipulation → hyperinflation risk
- Collateralized: Fixed/managed supply → price stability
- Algorithmic: Works until it doesn't → catastrophic failure mode
- Collateralized: Graceful degradation → orderly wind-down possible
"There is no free lunch in stablecoin design. If you're not putting up collateral, you're putting up confidence—and confidence is the first casualty of a crisis."
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