Stablecoins 101

A stablecoin is a token designed to hold a steady value, almost always one US dollar. That sounds like the least interesting thing in crypto and it is arguably the most important: stablecoins are what most trading is priced against, what moves between exchanges, and what a great deal of decentralised finance is denominated in. When one fails, the damage is not contained to the people who held it.

The whole subject reduces to one question, asked of each design in turn: what is behind it, and what happens when everyone asks for their money at once?

Three designs

Fiat-collateralised: the common kind

A company takes dollars, issues tokens one for one, holds the dollars in reserve, and redeems on request. The largest stablecoins work this way. It is simple, it scales, and it puts the entire question on a single point: do the reserves exist, in the form claimed, and can they be liquidated quickly?

You cannot verify this yourself. What issuers publish are attestations — a third party confirming reserves at a moment in time — rather than full audits, and the composition matters as much as the total. Cash and short-dated government paper can be sold in a crisis at close to face value. Longer-dated or less liquid assets cannot, which is exactly when you would need them to be.

The instructive failure was not a fraud. In March 2023 one of the major fiat-backed stablecoins traded well below a dollar for a weekend, because part of its reserves sat at a bank that had just failed. The reserves were real and the peg still broke, because reachable and existing are different properties. It recovered once the deposits were guaranteed — but the lesson stands: a fiat-backed stablecoin inherits the risk of the banking system it keeps its money in, which is the system it was implicitly sold as an alternative to.

Crypto-collateralised: over-collateralised on purpose

Instead of dollars in a bank, users lock crypto in a contract and mint stablecoins against it — but only up to a fraction of the collateral's value. Deposit well over a dollar of volatile assets to issue one dollar of stablecoin. If the collateral falls toward the amount issued, the position is automatically liquidated to keep the system solvent.

The appeal is that you can check it: the collateral is on-chain and anyone can verify it exists right now, with no trust in an attestation. The weakness is that it is backed by the thing it is meant to be stable against. A fast, deep fall can outrun the liquidation machinery, and liquidations themselves push prices down further — the same reflexive spiral described on our liquidation entry. Capital efficiency is the other cost: locking two dollars to create one is a poor deal unless you specifically want leverage.

Algorithmic: the one that broke

The third design held no meaningful reserves at all. It maintained its peg through a mechanism: a paired volatile token that could always be swapped for a dollar's worth of the stablecoin and back, so arbitrageurs would profit from correcting any deviation. On paper, elegant. In practice it depended on the paired token having enough value to absorb a run.

In May 2022 the largest of these collapsed. Enough holders sold at once that the peg slipped; the mechanism responded by minting large quantities of the paired token; that supply crushed its price; and the falling price destroyed the very capacity that was supposed to defend the peg. Within days both were close to worthless and tens of billions of dollars of value had gone. The mechanism did not fail to operate — it operated exactly as designed, and the design was a feedback loop that ran the wrong way under stress.

A large share of that money was attracted by a lending product paying around twenty percent on deposits, a rate subsidised rather than earned. That is the transferable lesson, and it is not really about stablecoins: a fixed double-digit yield on something advertised as risk-free is the risk, stated in advance.

Why they matter beyond themselves

Stablecoins are the settlement layer of crypto. Most pairs are quoted against them, most decentralised lending is denominated in them, and they are how value moves between venues without touching a bank. That makes them systemically important in the plain sense: a large stablecoin failing does not just hurt its holders, it removes the unit of account a great deal of the market is priced in.

It also explains the regulatory attention. Reserve composition, disclosure and redemption rights are where supervisors in several jurisdictions have focused, because an instrument that promises redemption at par and is used as money is doing something the existing rules already have opinions about.

What to actually check

• What backs it, specifically. Cash and short-dated instruments behave very differently in a crisis from anything longer or less liquid.
• Who verifies that, and how often. An attestation is a snapshot by a third party. It is not the same as an audit, and neither is continuous.
• Whether redemption is open to you. Many issuers redeem only for large institutional clients. Everyone else exits by selling on a market — which is precisely the mechanism that breaks under stress.
• Where the yield comes from. If a stablecoin product pays you, someone is taking risk to generate that. Knowing who and how is the whole question.

None of this means avoid them; they are genuinely useful and the major fiat-backed ones have processed enormous volume for years. It means holding a stablecoin is a credit decision about an issuer or a bet on a mechanism, not the absence of a decision. The word “stable” is a design goal, not a guarantee.