Stablecoins: How They Work and How They Fail
A stablecoin is a promise. The interesting question is always who is making it and what stands behind it.
Key points
- Fiat-backed stablecoins hold reserves off-chain; you are trusting an issuer and its auditors.
- Crypto-backed stablecoins over-collateralise on-chain and are transparent but capital-inefficient.
- Algorithmic stablecoins with no real collateral have failed repeatedly, most spectacularly in 2022.
- A peg holding today says nothing about whether the reserves behind it are adequate.
Why they exist
Volatility makes cryptocurrencies poor units of account. You cannot sensibly price a loan, quote a trading pair or hold a working balance in an asset that might move 15 % overnight.
Stablecoins solve that by tracking a reference — almost always the US dollar. They now underpin most crypto trading volume, provide the settlement layer for DeFi, and serve as a dollar substitute in countries with capital controls or high inflation, which is arguably their most socially significant use.
Three designs
Fiat-backed (USDT, USDC). An issuer holds reserves — cash, short-term treasuries, commercial paper — and issues one token per unit held. Redemption by approved parties keeps the peg via arbitrage: if the token trades below a dollar, someone buys it cheaply and redeems it at par.
The risk is entirely about the issuer. Are the reserves real, liquid and unencumbered? Attestations are snapshots by an accounting firm, not full audits. Tether has been fined by regulators over past reserve disclosures; USDC briefly lost its peg in March 2023 when $3.3 billion of its reserves sat in a failing bank. Holding a fiat-backed stablecoin is an unsecured claim on a company.
Crypto-backed (DAI). Users lock crypto collateral in smart contracts and mint stablecoins against it, over-collateralised at perhaps 150–200 %. Everything is visible on-chain and liquidations are automatic. The weaknesses are capital inefficiency, exposure to collateral crashing faster than liquidations can clear, and the fact that many such systems now hold substantial fiat-backed stablecoins as collateral — reintroducing the very counterparty risk they were designed to avoid.
Algorithmic. No meaningful collateral; the peg is maintained by a mint-and-burn mechanism with a companion token. When confidence holds, arbitrage works. When it breaks, the mechanism runs in reverse: falling price triggers issuance of the companion token, diluting it, which accelerates the fall. TerraUSD collapsed from a $40 billion ecosystem to near zero in days in May 2022. Every purely algorithmic design attempted at scale has failed the same way.
What to check before holding one
Practical questions, in order of usefulness:
- What is in the reserves? Cash and short-term government debt are very different from commercial paper, corporate bonds or loans to affiliates.
- Who verifies it, and how often? A monthly attestation from a recognised firm is meaningful; a self-published statement is not.
- Who can redeem, and at what size? If redemption is limited to large institutional clients, the arbitrage that maintains the peg depends on those parties being willing and able to act.
- What jurisdiction and regulatory status? The EU's MiCA regime now imposes reserve and redemption requirements on stablecoin issuers, which is a meaningful improvement in some markets.
- Can the issuer freeze tokens? Most centralised issuers can and do blacklist addresses, sometimes at law-enforcement request. That is a feature or a risk depending on your view.
- Where is the peg trading right now? A persistent discount is the market pricing doubt.
Sensible use and its limits
Stablecoins do several things genuinely well: settling trades without touching the banking system, moving value across borders in minutes for cents, providing a dollar-denominated balance in economies with unstable currencies, and serving as the base asset for DeFi.
What they are not is a savings account. Interest offered on stablecoin deposits comes from lending them out, and the platforms offering the highest rates have a poor survival record — Celsius, BlockFi and Voyager all offered attractive stablecoin yields shortly before entering insolvency proceedings. A yield on a dollar-pegged asset is compensation for credit risk, not a free rate.
The reasonable framing: a stablecoin is a payment instrument with counterparty risk, useful for transacting and for parking value briefly. Diversifying across issuers and keeping long-term savings in regulated, insured bank deposits is not a lack of imagination — it is the correct response to what these instruments actually are.
Frequently asked questions
Are stablecoins actually stable?
Major fiat-backed ones have held close to their peg most of the time, with brief exceptions during stress. 'Stable' describes an objective, not a guarantee. Several have failed completely and the peg is only as good as what stands behind it.
Is USDT safe?
It is the largest stablecoin by volume and has operated for over a decade, but it has also faced regulatory action over historic reserve disclosures and publishes attestations rather than full audits. Many users diversify across issuers rather than concentrating in any one.
What happened to TerraUSD?
It was algorithmic, backed by a mint-and-burn mechanism with the LUNA token rather than reserves. When large withdrawals broke confidence in May 2022, the mechanism minted enormous quantities of LUNA, destroying its value and removing any support for the peg. Roughly $40 billion evaporated within a week.
Do stablecoins pay interest?
Not inherently. Platforms that offer yield are lending your tokens out, and that yield is compensation for the risk that the borrower or the platform fails. The rate should be read as a risk price rather than as a savings rate.