A stablecoin is a token designed to hold a steady value against an outside reference, usually one US dollar. It keeps that peg through two things working together: something of value backing each token, and a way to swap tokens for that backing at close to $1. When the market price drifts away, traders can profit by pushing it back, and that arbitrage is what holds the line. How strong the peg is depends on how good the backing is and how reliable that swap is.
Why stablecoins exist
Most crypto assets swing in price by several percent in a day. That makes them awkward for payments, for pricing loans, or for simply parking value between trades. Stablecoins give blockchains a unit of account that behaves like cash while still moving like a token. You can send one to any address in minutes, use it in a smart contract, or post it as collateral.
On Ethereum, most stablecoins are ERC-20 tokens, the standard interface for fungible tokens. That makes them work in wallets, exchanges and lending protocols without special integration. Many of them also exist on other chains and layer 2 networks.
The core idea: mint, redeem and arbitrage
Nearly every stablecoin design relies on the same loop:
- Minting. Someone deposits backing and receives new stablecoins, roughly $1 of backing per token (or more, for crypto-backed designs).
- Redeeming. Someone returns stablecoins and gets backing out, again at roughly $1 per token.
- Arbitrage. If the token trades at $0.99 on an exchange, a trader buys it cheaply and redeems it for $1 of backing. If it trades at $1.01, a trader mints at $1 and sells for $1.01. Each trade nudges the market price back toward $1.
The peg is only as credible as steps 1 and 2. If redemption is slow, restricted, or the backing is worth less than people thought, the arbitrage stops working and the price can fall.
The main types of stablecoin
| Type | What backs it | How the peg holds | Examples |
|---|---|---|---|
| Fiat-backed | Cash, bank deposits, short-term government bills held by a company | Issuer mints and redeems at $1 for approved customers | USDC, USDT |
| Crypto-collateralized | More crypto locked in smart contracts than the stablecoins issued | Over-collateralization, liquidations, interest rates | DAI / USDS (Sky, formerly MakerDAO) |
| Synthetic / hedged | Crypto collateral paired with an offsetting short derivatives position | Hedge cancels out price moves; mint and redeem at $1 | USDe (Ethena) |
| Algorithmic | Mainly a paired volatile token, with little outside collateral | Minting and burning the paired token | TerraUSD (UST), which collapsed in 2022 |
Fiat-backed stablecoins
A company holds reserves off-chain and issues tokens on-chain. Circle issues USDC and Tether issues USDT. Large, verified customers can send dollars to mint new tokens or send tokens back to receive dollars. Retail users usually trade on exchanges instead, relying on those large customers to arbitrage the price.
The trust sits with the issuer and its banks. You rely on the reserves existing, being liquid, and being held safely. Issuers publish attestations of their reserves, and the depth and frequency of those reports vary between issuers. The contracts also typically let the issuer freeze addresses, which helps respond to hacks and legal orders but means the token is not censorship-resistant.
This model is strong when reserves are simple and liquid. It is exposed to banking risk. In March 2023, Circle disclosed that part of USDC's reserves sat at Silicon Valley Bank, which had just failed. USDC briefly traded well below $1 until regulators confirmed depositors would be made whole, and it then returned to its peg.
Crypto-collateralized stablecoins
Here the backing lives on-chain. With DAI, a user locks collateral such as ETH in a vault and borrows newly minted DAI against it. The vault must stay over-collateralized, meaning the collateral is worth more than the debt, for example at least 150%.
If the collateral's price falls and the vault drops below its required ratio, the protocol liquidates it. Anyone can trigger this, and the collateral is sold to cover the debt, with a penalty charged to the vault owner. This keeps the system solvent as long as liquidations can happen fast enough in a falling market.
Other levers help hold the price:
- Stability fees, an interest rate on borrowing, make minting more or less attractive. Raising them discourages new supply when the price is below $1.
- Savings rates pay holders who lock their stablecoins, raising demand.
- A peg stability module lets users swap other stablecoins such as USDC for DAI at a fixed rate. It is very effective, but it also means part of DAI's backing is a fiat-backed stablecoin.
The trade-off is capital efficiency. Locking $150 of ETH to borrow $100 of stablecoins is expensive, and a sharp crash can still leave bad debt if liquidations fail.
Synthetic, hedged stablecoins
Ethena's USDe takes crypto collateral such as staked ETH and opens a matching short position in perpetual futures, a type of derivative with no expiry date. If ETH rises, the collateral gains and the short loses about the same amount, and the reverse is true if ETH falls. The combined position stays near a constant dollar value.
The risks differ from the other models. They include exchange and custody risk where the hedges are held, and funding rates, the periodic payments between longs and shorts, which can turn negative and cost the system money. It also relies on deep derivatives markets being available when needed.
Algorithmic stablecoins
Algorithmic designs try to hold a peg without full outside collateral. TerraUSD (UST) let users always swap 1 UST for $1 worth of a sister token, LUNA, and the reverse. When UST dipped, holders burned UST to mint LUNA. In May 2022, heavy withdrawals turned this into a spiral. Burning UST minted enormous amounts of LUNA, LUNA's price collapsed, and the backing that was meant to defend UST disappeared. UST lost its peg permanently.
The lesson is that a peg backed mainly by confidence in a token you print yourself can fail suddenly. It tends to fail exactly when it is needed most.
What breaks a peg
A depeg is when a stablecoin trades meaningfully away from its target. Common causes:
- Doubts about the backing. Reserves that are missing, frozen at a failed bank, or worth less than claimed.
- Redemption friction. If only a few parties can redeem, or redemptions pause, arbitrage slows down.
- Collateral crashes. For crypto-backed coins, fast price drops can outrun liquidations.
- Bank-run dynamics. If many holders rush to exit at once, the design must handle large redemptions without selling assets at a loss.
- Smart contract or oracle failures. A bug, or a wrong price feed, can mint unbacked tokens or trigger bad liquidations.
Short dips during market stress are common and usually recover. Lasting depegs almost always trace back to backing that was not really there.
Regulation
Rules for dollar stablecoins have firmed up in recent years. In the EU, the MiCA regulation's stablecoin rules have applied since mid-2024, setting reserve and licensing requirements for issuers. In the US, the GENIUS Act, signed in July 2025, created a federal framework for payment stablecoins, including requirements for high-quality liquid reserves. Details and implementation timelines continue to evolve, so check current rules before relying on them.
How to judge a stablecoin
Before holding or building on one, ask:
- What exactly backs it, and how liquid is that backing?
- Who can redeem, how fast, and at what cost?
- How transparent is it? Are reserves attested or audited, or visible on-chain?
- Who controls the contract? Can it be frozen, upgraded or paused, and by whom?
- How has it behaved under stress in past market crashes?
No stablecoin is risk-free. Each design swaps one set of risks for another: issuer and banking risk, collateral and liquidation risk, derivatives risk, or reflexive design risk.
Key takeaways
- A stablecoin is a token built to track an outside value, usually $1.
- The peg holds because minting and redeeming near $1 lets arbitrage correct price drift.
- Fiat-backed coins trust an issuer's reserves; crypto-backed coins rely on over-collateralization and liquidations.
- Hedged designs use derivatives, and algorithmic designs with little real collateral have failed badly, as TerraUSD showed.
- Depegs usually come from doubts about backing or friction in redemption.
- Judge any stablecoin by its backing, redemption rights, transparency and control.
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