Algorithmic Stablecoins: Mechanisms, Risks, and Lessons from the Fall of TerraUSD

Abstract

Algorithmic stablecoins have emerged as a novel solution for achieving price stability in decentralized finance (DeFi) without reliance on traditional asset backing. By leveraging smart contracts and algorithmic mechanisms, they offer potential benefits, including enhanced capital efficiency and decentralization. However, the collapse of TerraUSD (UST) in 2022 exposed significant vulnerabilities, such as susceptibility to market volatility, inadequate risk management, and systemic risks to broader crypto and financial ecosystems. This paper critically examines the mechanics, risks, and implications of algorithmic stablecoins, highlighting lessons from past failures and evaluating emerging solutions. Innovations like hybrid collateral models and improved governance frameworks are explored as pathways to resilience. The analysis underscores the importance of balancing decentralization and stability, fostering transparency, and addressing regulatory challenges. Algorithmic stablecoins must evolve to gain user trust and contribute to a more robust DeFi ecosystem.

Keywords: Algorithmic stablecoins, decentralized finance, cryptocurrencies, smart contracts, securities regulation, stablecoin

JEL Classification: E42, E58, G23, G28, L86, O33