Crypto — Beginner

What Are Stablecoins?

“Stable” is an aspiration, not a guarantee. This guide explains the three main types of stablecoin, how each maintains its peg, what backs it, and when pegs break.

Key concepts in this guide

What a stablecoin is and why it exists
Fiat-backed stablecoins: USDC, USDT and how reserves work
Crypto-backed stablecoins: over-collateralisation and liquidation
Algorithmic stablecoins: the UST collapse and why the model is fragile
Regulatory risk and de-pegging events

Why stablecoins exist

A stablecoin is a cryptocurrency designed to hold a steady value — almost always pegged to $1 USD. They exist to give crypto market participants a stable unit to trade against, earn yield on, or park between positions, without converting back to a bank account each time.

They bridge the speed and composability of crypto (instant settlement, 24/7, globally accessible) with the price stability that makes fiat useful for everyday transactions.

Type 1: fiat-backed

Fiat-backed stablecoins (USDC, USDT, BUSD) are issued by companies that hold reserves of cash and short-term government bonds. For every token issued, roughly one dollar sits in reserve. The issuer can redeem tokens for dollars on request, which keeps the peg stable.

The risks are counterparty and custody: you trust the issuing company to hold real reserves and not to be shut down by regulators. Both have happened in practice. Reserve composition matters — cash and T-bills are safer than commercial paper.

Type 2: crypto-backed

Crypto-backed stablecoins (DAI being the largest example) are minted by locking up more crypto than the value of stablecoins issued — over-collateralisation. If your collateral value falls below the required ratio, the protocol automatically liquidates it to cover the peg.

The advantage is decentralisation: no company controls the reserves. The risk is that a sharp, fast crypto crash can outpace liquidations, leaving the protocol undercollateralised. Smart-contract bugs add another layer of risk.

Type 3: algorithmic

Algorithmic stablecoins attempt to maintain a peg through supply manipulation rather than reserves. The most famous example, TerraUSD (UST), maintained its peg by minting and burning a paired token (LUNA). In May 2022 the mechanism broke in a bank-run dynamic: falling confidence caused the peg to slip, which required minting more LUNA, which caused hyperinflation of LUNA, which destroyed confidence further. UST lost its peg entirely and LUNA collapsed from billions in market cap to near zero within days.

Algorithmic stability that relies only on code and market confidence has proven fragile under stress. Approach any stablecoin without clear external reserves with significant scepticism.

De-pegging events

Even fiat-backed stablecoins have briefly de-pegged. USDC briefly dropped below $0.88 in March 2023 when Silicon Valley Bank — which held some of Circle’s reserves — failed. The peg recovered within days once the FDIC stepped in, but the episode showed that no stablecoin is truly risk-free.

Evaluating a stablecoin

What backs it? Cash and government bonds are safest; crypto collateral adds market risk; nothing external is highest risk.
Is the reserve audited? By whom, and how often?
What is the redemption process? Can you redeem directly with the issuer, or only through secondary markets?
What is the regulatory exposure of the issuer?