A stablecoin is a cryptocurrency designed to hold a steady value — usually pegged 1:1 to a fiat currency like the US dollar. Where Bitcoin can swing 20% in a week, a stablecoin is supposed to be boring: $1.00 today, $1.00 tomorrow, $1.00 next month. That predictability turns out to be surprisingly useful inside the crypto ecosystem. It also turns out to be surprisingly hard to guarantee.
Why stablecoins exist
Crypto without stablecoins is a bit like a marketplace where the currency fluctuates wildly between breakfast and lunch. Stablecoins solve several practical problems at once:
- A stable place to park value. If you want to exit a volatile position without cashing out to a bank account, you move into a stablecoin and wait.
- Trading pairs. Most crypto exchanges use stablecoins — rather than actual dollars — as the baseline currency for buying and selling other assets.
- Cross-border transfers. Sending $500 of a stablecoin internationally takes minutes and costs cents, without the volatility risk of sending Bitcoin.
- Decentralised finance (DeFi). Lending, borrowing, and yield protocols need a stable unit of account. Stablecoins are the engine running most of DeFi.
Taken together, stablecoins represent one of the largest categories in the entire crypto market, well over $100 billion in combined value, with Tether (USDT) the single biggest.
The three types — and why the third one is trouble
Not all stablecoins work the same way. There are three main designs, and the distance between them is the distance between boring and catastrophic.
1. Fiat-collateralised
The simplest model: a company holds actual dollars (and short-term bonds) in reserve, and issues one stablecoin token per dollar held. When you redeem your token, you get a dollar back. Tether (USDT) and USD Coin (USDC) are the giants here, between them accounting for the vast majority of stablecoin volume. The risk is not the mechanism — it’s trust. You have to believe the issuer is actually holding what it claims to hold, and that the reserves are high-quality and liquid. Tether has faced long-running scrutiny over the composition of its reserves. USDC, operated by Circle, is generally considered more transparent. Neither is the same as holding cash at a regulated bank.
2. Crypto-collateralised
Instead of dollars in a vault, these stablecoins are backed by other cryptocurrencies — deliberately over-collateralised to absorb volatility. DAI, issued by the MakerDAO protocol, is the main example: to mint $100 of DAI, you might need to lock up $150 worth of Ethereum as collateral. If your collateral value drops below a threshold, it gets automatically liquidated. The design is more decentralised than the fiat-backed model, but introduces its own risk: in a severe, fast market crash, collateral can be liquidated faster than the system can handle it.
3. Algorithmic
This is where things get genuinely fragile. Algorithmic stablecoins are not fully backed by reserves. Instead, they use supply-and-demand algorithms and financial incentives to try to maintain the peg. When the price drifts above $1, the protocol creates more supply to push it back down. When it drifts below, it contracts supply. It sounds elegant in a whitepaper. In practice, it depends entirely on continued market confidence — and when that confidence breaks, there is no reserve cushion to catch the fall.
Terra’s UST was an algorithmic stablecoin linked to a sister token called LUNA. When a large sell-off began and UST briefly slipped below $1, confidence cracked. The protocol responded by minting more LUNA to buy UST and restore the peg — but this flooded the market with LUNA, crashing its price, which destroyed the mechanism meant to support UST, which collapsed further, which prompted more LUNA minting. A death spiral. Within days, UST was worth fractions of a cent and LUNA was effectively worthless. Roughly tens of billions of dollars were wiped out. The collapse helped trigger a broader crypto market crash and the eventual collapse of other major players, including the FTX exchange. It remains one of the most dramatic single failures in financial history.
Even the “safe” ones have depegged
If you’re thinking algorithmic stablecoins sound reckless and the reserve-backed ones are obviously fine — almost, but not quite. In March 2023, USDC briefly fell to around $0.87. The cause: Circle disclosed that $3.3 billion of USDC’s cash reserves were held at Silicon Valley Bank, which had just failed. Redemptions flooded in. Within days USDC recovered fully once it became clear the reserves would be made whole, but the episode demonstrated that “backed by dollars” is only as good as where those dollars are sitting and how quickly they can be accessed.
A “depeg” — losing the $1 anchor, even briefly — is the central risk for any stablecoin. For algorithmic designs the depeg can be permanent. For reserve-backed ones it is usually temporary, but “usually” is not the same as “always.”
What actually makes a stablecoin stable
Spoiler: it isn’t the name. The factors that actually matter are:
- Reserve quality and transparency. Are the reserves real, fully liquid, and independently audited? Or are they a corporate promise?
- The peg mechanism. Fiat-collateralised designs have a real-world anchor. Algorithmic designs do not. Crypto-collateralised designs sit somewhere in between depending on the collateral ratios and liquidation rules.
- Regulatory standing. A growing number of jurisdictions are bringing stablecoins under financial regulation, which adds oversight but also legal uncertainty during the transition.
- Market size and liquidity. Larger stablecoins are harder to attack or destabilise than smaller ones — but “harder” is not the same as “impossible,” as Terra demonstrated at a $40 billion market cap.
Sources & further reading
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