What Are Stablecoins and How Do They Actually Stay Stable?

A stablecoin is a cryptocurrency designed to hold a steady value — most commonly one US dollar. They function as the cash layer of crypto markets, letting people move in and out of volatile positions without leaving the blockchain, and increasingly as a settlement rail in their own right.

But stable is a design goal, not a property. How a stablecoin maintains its peg determines how much you should trust it, and the three main designs fail in completely different ways.

Model one: fiat-backed

The issuer holds real assets — dollars, short-dated government bills, cash equivalents — and issues one token per unit held. Each token is redeemable for one dollar from the issuer.

This is the simplest design and the dominant one by volume. The peg holds through arbitrage: if the token trades at 99 cents, someone buys it, redeems it with the issuer for a dollar, and pockets the difference. That buying pressure pushes the price back up.

What has to be true for it to work:

• The reserves genuinely exist, in the quantity claimed.
• They are liquid enough to meet redemptions quickly.
• Redemption is actually available, in practice and not merely on paper.
• The banks and custodians holding the reserves are themselves sound.

How it fails. Every historical stress in this category has come from one of those four. Doubts about reserve composition trigger redemptions; redemptions require selling assets; if assets are illiquid or trapped at a failing bank, the issuer cannot meet them, and the peg breaks under the queue rather than under the arithmetic.

The dependency on the traditional banking system is easy to overlook. A dollar-backed stablecoin is only as strong as the bank where those dollars sit.

Model two: crypto-backed and overcollateralised

Instead of dollars, the backing is other cryptocurrency locked in smart contracts. Because that collateral is volatile, the system requires more collateral than the value issued — perhaps 150 units of crypto locked to mint 100 units of stablecoin.

If the collateral value falls toward the threshold, the position is automatically liquidated: the collateral is sold and the stablecoin repurchased and burned.

Strengths. Everything is verifiable on-chain. There is no bank, no custodian and no requirement to trust an issuer's word about reserves.

How it fails. In a sharp, fast market decline, many positions hit their liquidation thresholds simultaneously. The system tries to sell a large quantity of collateral into a market that is already falling and short of buyers. Liquidations cascade, each one pushing the collateral price lower and triggering the next. If liquidation cannot keep pace with the fall, the system ends up undercollateralised.

Capital efficiency is the other cost: locking 150 to create 100 is expensive.

Model three: algorithmic

The peg is maintained by protocol rules and incentives rather than by hard collateral — typically by expanding and contracting supply, often through a paired volatile token that absorbs the adjustment.

The appeal. No reserves are required, so it scales without capital.

How it fails. The mechanism relies on people being willing to buy the absorbing token during stress. That willingness is exactly what disappears during stress. When confidence goes, the protocol issues more of the absorbing token, its price falls, which reduces confidence further, which requires more issuance. This is the death spiral, and it has destroyed multi-billion-dollar systems within days.

The category has a poor record, and regulators have been explicit about it.

Comparison

	Fiat-backed	Crypto-backed	Algorithmic
Backed by	Cash and short-term bonds	Overcollateralised crypto	Code and incentives
Verifiability	Attestation or audit	On-chain, direct	On-chain, but reflexive
Main risk	Issuer, custodian, banking	Liquidation cascade	Confidence collapse
Capital efficiency	1:1	Poor, over 1:1	High
Track record	Generally held, with episodes	Generally held	Multiple total failures

What a depeg actually means

A depeg is when the token trades away from its target — 97 cents instead of a dollar.

Brief depegs are more consequential than they appear. In decentralised finance, stablecoins are widely used as collateral. A drop to 97 cents can push leveraged positions below their liquidation thresholds, triggering forced selling in assets entirely unrelated to the stablecoin. The contagion path runs through collateral, not through sentiment.

This is why a two-hour depeg can produce losses that persist long after the peg is restored.

What to check before trusting one

1. What backs it. Cash and Treasury bills are not the same as commercial paper, corporate debt or other crypto. Read the composition, not the headline.
2. Who verifies it. A monthly attestation by a recognised accounting firm is meaningful. A self-published dashboard is not.
3. Whether you can redeem. Many holders cannot redeem directly with the issuer at all, only sell on an exchange. That difference matters most precisely when it matters.
4. Where the reserves sit. Concentration at a single bank is a single point of failure.
5. Regulatory standing. Authorisation under a framework such as MiCA imposes reserve and redemption requirements that a self-regulated issuer does not face.
6. Behaviour under past stress. Did it hold during previous market dislocations, and how quickly did it recover?

The yield question

Stablecoins do not generate yield by holding them. The issuer earns the return on the reserves.

Where a platform offers a return on stablecoin deposits, that return comes from lending your tokens to a borrower. You are no longer holding a stablecoin; you are an unsecured creditor of whoever the platform lent to. Several large failures in this sector were exactly this: people believed they held dollars, and in fact held a claim on a lender who could not pay.

If a platform offers a yield on a stablecoin, the correct question is not how much. It is who is borrowing, against what collateral, and what happens when they cannot repay.

Where this is going

Stablecoins have moved beyond trading infrastructure. They now settle cross-border payments faster and more cheaply than correspondent banking, and they are the natural cash leg for tokenized real-world assets. That has drawn regulators in seriously, with frameworks now in force or being written across major jurisdictions.

The direction is consistent: full reserving in high-quality liquid assets, segregation of those assets, a legal right to redeem at par, and supervision of issuers. That is, essentially, a requirement that a stablecoin be what most users already assumed it was.

The bottom line

Stablecoins are infrastructure, not investments. Their value proposition is reliability, so choose on transparency and backing rather than on convenience or yield.

And hold onto the underlying point: a stablecoin is only ever as strong as whatever stands behind it. When you cannot identify what that is, you have identified the risk.

This article is educational and is not financial advice.