Stablecoins: how they hold a peg, and how they lose it

What a stablecoin is

A stablecoin is a crypto token designed to keep a steady value, usually one US dollar. Traders use them to move between coins without cashing out, and to send dollars across borders quickly. The largest, such as USDT (Tether) and USDC, are among the most traded assets in crypto.

“Stable” describes the goal, not a guarantee. How well a stablecoin holds its peg depends on what backs it.

Three designs

Fiat-backed. A company holds reserves (cash, bank deposits, short-term government bonds) and issues one token for each dollar held. Verified customers can redeem tokens for dollars. If the token trades below $1, they can buy it and redeem it for $1, which pulls the price back. The risk is in the reserves: whether they exist, what they are, and where they are held.

Crypto-backed. Users lock up other crypto worth more than the stablecoins they create against it, as with DAI. If the collateral’s value falls too far, it is sold automatically to keep the system covered. The risk is a crash so fast that the collateral cannot be sold in time.

Algorithmic. The peg is held by rules that create or destroy a partner token, rather than by outside assets. TerraUSD (UST) was the best-known example. In May 2022 confidence broke, holders rushed to exit, and UST and its partner token LUNA collapsed within days.

Why depegs happen

A stablecoin trades on the open market like any other token. When holders doubt they will get a full dollar back, they sell, and the price slips below $1.

In March 2023, USDC fell below 90 cents after Silicon Valley Bank, which held part of its reserves, failed. It recovered once it was clear the deposits were safe. Even a well-reserved stablecoin depends on the banks and assets behind it.

Other risks worth knowing

• Issuers can freeze tokens. Centralised issuers can block addresses, for example under legal orders.
• Redemption is not open to everyone. Usually only verified customers can redeem with the issuer directly; everyone else relies on the market price.
• Regulation. Rules for stablecoins differ by country and are still changing.

Common mistakes

• Treating a stablecoin like a bank deposit. It is a claim on a private issuer’s reserves, usually without deposit insurance.
• Assuming all stablecoins are alike. Each design, and each issuer’s reserves, are different.
• Ignoring where a high yield comes from. Unusually high interest on a stablecoin means someone is taking risk with the funds. UST’s collapse came after more than a year of close to 20% interest paid through a lending protocol.