Why Do Algorithmic Stablecoins Often Fall into a 'Death Spiral'? How Does This Process Occur?

Algorithmic StablecoinDeath SpiralCryptocurrencyFinancial Riskdecentralized financeStablecoin
Created At: 8/6/2025Updated At: 8/18/2025
Answer (1)

Hey, this is a pretty common question. Having been in the crypto space for a few years, I've seen quite a few algorithmic stablecoins rise and fall. Let me break it down for you in plain language, like we're just chatting, about why they often fall into a "death spiral" and how that process unfolds step by step.

First, what is an algorithmic stablecoin?

Simply put, a stablecoin is a cryptocurrency designed to maintain a stable value, usually pegged to the US dollar (e.g., 1 stablecoin = $1). Common ones like USDT or USDC are backed by real assets (like dollar reserves).

But algorithmic stablecoins are different. They don't rely on physical reserves. Instead, they use a set of algorithms and mechanisms to maintain price stability. For example, they might issue two tokens: one is the stablecoin (say, UST), and the other is a "sister token" (like LUNA). The system adjusts supply and demand by burning or minting these tokens to keep the stablecoin's price near $1. Sounds clever, right? But here's the problem—it relies too heavily on market confidence and automated algorithmic adjustments. Once confidence collapses, things can go south fast.

Why do they often fall into a "death spiral"?

A "death spiral" is a vicious cycle: the token price starts falling, the mechanism tries to rescue it, but instead accelerates the crash, leading to total system collapse. Why are algorithmic stablecoins prone to this? Because they lack a "real anchor." Traditional stablecoins have bank deposits or bonds as backing, but algorithmic ones rely solely on trust in the system and automated adjustments. If panic sets in and everyone rushes to sell, the algorithm can't keep up. Historically, projects like Terra's UST and Ampleforth have stumbled badly, suffering massive losses.

The key reason: they're too fragile. Small fluctuations can be managed, but when big volatility hits, it's like dominoes falling. Not all algorithmic stablecoins are doomed, but many have inherent design flaws, especially those overly reliant on leverage or sister tokens.

How does the "death spiral" happen?

Let me walk you through it step by step, using Terra's UST and LUNA as an example (a classic disaster case—its 2022 crash wiped out tens of billions). Here’s the simplified process (reality is more complex):

  1. When things are normal: UST holds steady at $1. The system uses LUNA for adjustments—to mint new UST, you must burn an equivalent value of LUNA. Conversely, if UST drops below $1, you can swap UST for LUNA; the system burns UST and gives you more LUNA. This balances supply and demand. People trust the system, so they hold or buy more.

  2. A small problem arises: Market volatility hits—maybe the broader crypto market dips, or someone dumps a large amount of UST—causing UST to slip slightly to $0.99. The algorithm kicks in: people can swap "cheap" UST for LUNA (since the LUNA received would be worth more than the UST). In theory, this reduces UST supply, pushing the price back up.

  3. Panic starts spreading: But if selling pressure is too strong (e.g., institutional dumping or a black swan event), UST keeps falling, say to $0.95 or lower. Now, more people panic: they lose faith in a quick recovery and start selling UST for LUNA or dumping LUNA for cash. This causes LUNA’s price to drop too, because suddenly there’s more LUNA in circulation (everyone is swapping).

  4. The vicious cycle begins: As LUNA falls, the cost to mint UST using LUNA drops. To absorb selling pressure, the system might mint even more LUNA. But this further dilutes LUNA’s value, causing it to crash (from tens of dollars to pennies). Now, UST’s "peg" is completely broken—since LUNA is its backing, and LUNA is worthless, no one wants UST. A mass exodus ensues, and prices plummet.

  5. Total collapse: This creates the "death spiral"—UST falls → more people swap for LUNA → LUNA supply explodes → LUNA price crashes → the system can no longer support UST → more panic selling → cycle intensifies. Eventually, UST might crash to pennies, LUNA goes to zero, and the entire ecosystem evaporates. That’s exactly what happened to Terra—it went from a star project to ruins overnight.

How to avoid it? My two cents

Not all algorithmic stablecoins are doomed, but poorly designed ones are vulnerable. Some new projects are trying to add collateral or improve mechanisms, but risks remain high. If you’re into crypto, remember: algorithmic stablecoins sound high-tech, but they’re fundamentally propped up by collective confidence. When the market panics, it’s like an avalanche. Newbies should avoid going all-in on these—diversify your risks and learn from history.

Feel free to ask if anything’s unclear. I’m no expert, but I’ve stepped on plenty of landmines over the years, haha.

Created At: 08-06 13:19:06Updated At: 08-09 22:31:24