A stablecoin is supposed to be the most boring asset in crypto: one token, one dollar, every day. Yet some of the industry's most dramatic collapses involved coins that were meant to stay perfectly still. Stablecoins explained properly means looking past the dollar sign to the machinery underneath – who holds the backing, who can redeem it, and what happens when everybody wants out at the same time.
What is a stablecoin and why does it exist?
A stablecoin is a crypto token designed to keep a steady value against a reference asset, almost always the US dollar. It exists because traders and applications need a unit of account that lives on a blockchain but does not swing 5% in an afternoon.
In practice, stablecoins are used to:
- Park funds between trades without cashing out to a bank
- Quote prices on exchanges (many trading pairs are against a stablecoin rather than a currency)
- Move dollar value across borders quickly, at any hour
- Act as the base asset for DeFi lending and liquidity pools
All of that only works if the peg holds. There are three broad ways to try.
How fiat-backed stablecoins keep their peg
The largest stablecoins, such as Tether's USDT and Circle's USDC, are fiat-backed. The issuer holds reserve assets – cash, short-term government bills and similar instruments – and issues tokens against them.
The peg is held by mint-and-redeem arbitrage:
- If the token trades above $1 on the market, approved partners can deposit $1 with the issuer, receive a new token and sell it for more than $1. That extra supply pushes the price down.
- If the token trades below $1, those partners buy tokens cheaply on the market and redeem them with the issuer for $1 each. That buying pushes the price back up.
Note the word approved. Direct redemption is usually available only to verified institutional customers, often with minimum sizes. Ordinary holders rely on those arbitrageurs acting – which they will, as long as they trust the issuer to honour redemptions.
The quality of the peg therefore depends on the reserves: what they consist of, where they are held, how liquid they are, and how much independent verification exists. Issuers differ significantly in how much they disclose, and an attestation (a point-in-time check) is not the same thing as a full audit.
Crypto-backed and algorithmic stablecoins
Crypto-collateralised stablecoins, with MakerDAO's DAI as the classic example, are created by locking crypto in a smart contract as collateral. Because that collateral is volatile, the system requires over-collateralisation – for example, locking $150 worth of ether to borrow $100 of stablecoins. If the collateral value falls too far, the position is automatically liquidated to protect the peg. Over time, DAI's design has also come to include other stablecoins and real-world assets as backing, which trades some decentralisation for stability.
Algorithmic stablecoins try to hold the peg mainly through incentives rather than reserves, typically by minting and burning a sister token. The best-known example is TerraUSD (UST), which lost its peg in May 2022. As holders redeemed UST for its sister token LUNA, LUNA's supply ballooned and its price collapsed, which further undermined confidence in UST – a textbook death spiral. Tens of billions of dollars in value disappeared within days. The lesson most of the industry took: a peg backed only by confidence in another token you also issue is not really backed.
| Type | Backing | Main strength | Main weakness |
|---|---|---|---|
| Fiat-backed | Cash and bills held by an issuer | Simple, liquid, tight peg | Trust in the issuer, banks and regulators |
| Crypto-backed | Over-collateralised crypto in smart contracts | Transparent on-chain | Liquidation cascades, contract risk |
| Algorithmic | Incentives and a sister token | Capital efficient | History of catastrophic failure |
Stablecoin depeg risks you should understand
Even well-run stablecoins carry real risks:
- Reserve risk. If reserves are less liquid or less valuable than claimed, redemptions can fail. In March 2023, USDC briefly traded well below $1 after its issuer disclosed that part of its reserves sat at Silicon Valley Bank, which had just failed. It recovered once it became clear the deposits would be accessible – but for a weekend, a "stable" coin was not.
- Counterparty and banking risk. Reserves sit with banks and custodians, which can themselves fail or freeze accounts.
- Freezing and blacklisting. Centralised issuers can, and do, freeze tokens at specific addresses, typically in response to law enforcement or sanctions. That is a feature to some and a risk to others.
- Regulatory risk. Rules for stablecoins are being written and rewritten in many jurisdictions; a coin may be restricted on some platforms or in some regions.
- Smart-contract risk. Every stablecoin lives in code, and crypto-backed designs in particular depend on oracles and liquidation logic working under stress.
- Run risk. Any asset promising par redemption can suffer a run if enough holders lose confidence at once.
USDT vs USDC and other choices: questions to ask
Rather than ranking specific coins, which changes over time, ask these questions of any stablecoin you hold:
- What exactly backs it, and how often is that published?
- Who checks the reserves – an attestation or a full audit?
- Who can redeem directly, and on what terms?
- Which jurisdiction regulates the issuer?
- Can the issuer freeze tokens, and under what policy?
- How has it behaved under stress in the past?
- How much of your money depends on it – could you diversify across issuers?
Stable, not risk-free
Stablecoins are among the most useful things crypto has produced, and the biggest ones have held their pegs through a lot of turbulence. But "stable" describes the goal, not a guarantee. With stablecoins explained down to their mechanics, the right mental model is clear: you hold an IOU whose reliability depends on reserves, redemption rights and the people running it. Choose accordingly, and avoid treating any single one as a bank account.
This article is for education only and is not financial or investment advice.
