An accessible breakdown of how fiat-backed, crypto-backed and algorithmic stablecoins each try to hold their peg — and the real failures that show what happens when they don't.
Nadia OkoroPolicy & Consumer Editor · Regulation, tax, stablecoins and the products retail users hold
A stablecoin is a cryptoasset designed to hold a steady value against a reference, almost always the US dollar. Fiat-backed coins hold reserves and rely on redemption arbitrage; crypto-backed coins use over-collateralisation and liquidation; algorithmic designs rely on incentives and have repeatedly failed. Pegs break through reserve problems, a bank holding those reserves failing, suspended redemption, or simply thin liquidity.
Stablecoins are the least glamorous corner of crypto and, by transaction volume, one of the most important. They don't promise to make anyone rich; they promise something far more useful for a functioning market — that one unit will reliably be worth roughly one US dollar, tomorrow and next year alike. Understanding how a stablecoin actually holds that peg is essential before treating one as a safe place to park value.
A stablecoin is a cryptocurrency designed to hold a stable value, almost always pegged to a fiat currency like the US dollar. Where Bitcoin can move ten percent in a day, a well-functioning stablecoin like USDC or Tether (USDT) should trade within a fraction of a cent of $1.00, day in and day out. That stability is what makes stablecoins useful as the settlement layer of crypto trading — a place to park value between trades without cashing out to a bank account, and a unit traders use to price everything else on an exchange, since quoting every pair against volatile Bitcoin would make prices far harder to reason about.
The largest stablecoins by market capitalisation — Tether and USD Coin between them account for the bulk of stablecoin volume — work on a simple premise: for every token in circulation, the issuer claims to hold one dollar, or equivalent low-risk assets, in reserve. Users can, in principle, redeem tokens for dollars through the issuer, and that redemption right is what's supposed to anchor the price. If the token trades below a dollar on the open market, arbitrageurs buy it cheap and redeem it for a full dollar, pushing the price back up; if it trades above a dollar, they mint new tokens and sell them, pushing the price back down. This arbitrage loop, in theory, does most of the work of maintaining the peg without any central authority setting the price directly.
The catch is that this mechanism only works if the reserves are real, liquid, and verifiable. Tether spent years facing scepticism over exactly what backed its tokens before settling with the New York Attorney General in 2021 over allegations it had misrepresented its reserves, and it has since shifted toward more regular reserve disclosures, though these still fall short of a full independent audit in the strictest sense. USD Coin, issued by Circle, has generally published more detailed monthly attestations of its reserves, largely held in cash and short-term US Treasuries — though even Circle wasn't immune to stress, when USDC briefly dropped to around $0.87 in March 2023 after it disclosed exposure to the collapsed Silicon Valley Bank, before recovering its peg within days once the bank deposits were made whole by regulators.
A second model, exemplified by MakerDAO's DAI, backs the stablecoin not with dollars in a bank account but with other cryptocurrencies locked in smart contracts — and more of them than the stablecoin issued. Deposit $150 worth of Ethereum, for instance, and you might be able to mint $100 worth of DAI. That extra buffer exists because crypto collateral is volatile; if Ethereum's price falls, the system needs headroom before the collateral becomes worth less than the DAI it backs, at which point the position gets automatically liquidated by the protocol to protect the peg, selling the collateral to buy back and burn the outstanding DAI.
This model trades counterparty risk — trusting an issuer's bank reserves and its honesty about them — for smart contract and liquidation risk: trusting the code and the market to unwind positions correctly during a fast-moving crash, when liquidations can cascade faster than a network can process them. It's a genuinely different set of assumptions, and it's why DAI has held up through several periods of market stress that have, at various points, rattled fiat-backed alternatives instead, even as MakerDAO has itself gradually added real-world assets like US Treasuries to its own collateral mix.
A third approach tried to maintain a peg through code and market incentives alone, without meaningful collateral backing each token. TerraUSD (UST) was the largest example, using a companion token, Luna, that could be minted or burned to absorb price pressure and keep UST near a dollar. In May 2022, that mechanism failed under a wave of selling, and the feedback loop between the two tokens spiralled instead of stabilising — UST fell to a few cents, Luna's supply exploded from minting to absorb the sell pressure and its price collapsed to near zero, and roughly $40 billion in value was wiped out within days, taking a chunk of the broader crypto market down with it in the panic that followed.
The lesson from Terra wasn't simply "algorithmic stablecoins are bad" in the abstract — it was that a peg maintained purely by incentives and confidence, with no hard collateral floor, can unwind in a self-reinforcing spiral once that confidence cracks, and it can do so far faster than a collateralised system typically would.
A stablecoin can lose its peg for a handful of reasons: the reserves backing it turn out to be insufficient or illiquid, as briefly happened to USDC during the SVB stress; the collateral behind it crashes faster than the system can liquidate it, straining a crypto-collateralised design; or, in the algorithmic case, the incentive mechanism itself simply stops working once confidence cracks and there's no hard asset underneath to catch the fall. The practical takeaway for anyone holding stablecoins is to know which model you're holding and how transparent the issuer actually is about backing it — regular, independently audited reserve reports are a meaningfully better sign than marketing copy alone, and a total absence of disclosure is itself a signal worth weighing.
Stablecoins have grown well past their original role as a trading tool. They're used for cross-border remittances that settle in minutes instead of days at a fraction of traditional wire fees, as a dollar-denominated savings option in countries with high inflation or capital controls where holding local currency erodes value quickly, and increasingly as the settlement rail for on-chain payments and DeFi lending markets that need a stable unit of account to function at all. Their combined market capitalisation has run into the hundreds of billions of dollars, and regulators from the US to the EU have taken notice, with frameworks like the EU's Markets in Crypto-Assets regulation now explicitly setting reserve and disclosure requirements for issuers operating in the bloc.
If you're holding a stablecoin for any length of time rather than just passing through it mid-trade, it's worth treating the choice with the same seriousness as choosing a bank: check what backs it, how often that backing is disclosed and by whom, whether the issuer has weathered stress before, and what regulatory regime it operates under, if any. A stablecoin that's been tested by a real depeg event and recovered transparently often tells you more than one that's simply never been pressured yet.
None of this makes stablecoins risk-free — "stable" describes the design intent, not a guarantee, and every model carries a failure mode that has already played out at least once in the market's short history. Understanding which mechanism sits underneath a given stablecoin is the difference between treating it as digital cash and treating it, correctly, as a financial product with its own set of assumptions that can fail.
A stablecoin sitting in your wallet is doing more work than the flat number on the screen suggests — it's a claim on a specific mechanism, run by a specific issuer, with a specific history of holding up or not under pressure. Spend the ten minutes it takes to find out which one you're holding, and you'll know in advance whether a wobble in the news is background noise or a genuine reason to move funds elsewhere, rather than finding out the hard way during the depeg itself.
A side-by-side breakdown of how fiat-backed, crypto-backed and algorithmic stablecoins each maintain their peg, and the specific failure mode that has taken each category down.
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