Stablecoins Explained

Stablecoins are among the most practically important and most misunderstood assets in the crypto ecosystem. They solve the most significant practical problem with cryptocurrencies for everyday use - volatility - by pegging their value to a stable reference asset, usually the US dollar. They are the bridge between the volatility of crypto markets and the stability needed for DeFi lending, trading, savings, and payments. Understanding how different stablecoins maintain their peg - and where each approach has failed - is essential for anyone interacting with crypto markets.

What Is a Stablecoin?

A Stablecoin is a cryptocurrency that attempts to maintain a constant value - usually $1.00 - rather than fluctuating freely with market supply and demand. They achieve this stability through different mechanisms: by holding reserves of the reference asset, by over-collateralising with other crypto assets, or through algorithmic mechanisms that adjust supply. Each approach has different risk profiles - and different historical track records.

Fiat-Backed Stablecoins

Fiat-backed stablecoins maintain their Peg by holding reserves of the fiat currency (or liquid equivalents) equal to the stablecoins in circulation. For every USDC in existence, Circle holds approximately one US dollar (or short-term US Treasury bills) in reserve. Holders can redeem USDC for USD at any time - which maintains the peg through arbitrage: if USDC trades below $1, arbitrageurs buy it and redeem for $1, pushing the price back up.

Crypto-Backed Stablecoins

Crypto-backed stablecoins use cryptocurrency as collateral rather than fiat. Because crypto is volatile, they require over-collateralisation - typically 150% or more - to maintain the peg even if collateral value falls. The most prominent example is DAI, issued by MakerDAO, which is primarily backed by Ethereum and other crypto assets.

To create $100 of DAI, a user might lock $150 or more of ETH as collateral. If the ETH value falls toward the liquidation threshold, the position is automatically liquidated to repay the DAI. This mechanism maintains solvency without requiring trust in a central issuer - but it does require sufficient market liquidity to liquidate collateral quickly during crashes.

Algorithmic Stablecoins

Algorithmic stablecoins attempt to maintain their peg through algorithmic supply adjustments rather than collateral reserves. When the price rises above $1, the algorithm creates more tokens to push the price down. When it falls below $1, the algorithm burns tokens to push the price up. No physical collateral is held.

In theory, this is elegant. In practice, algorithmic stablecoins have a catastrophic track record. The mechanism only works when there is sufficient market confidence - and confidence is precisely what collapses during a crisis.

The Terra/Luna Collapse

The Terra ecosystem's UST stablecoin was the most prominent algorithmic stablecoin failure in crypto history - and one of the most significant financial collapses in the asset class overall. UST maintained its $1 peg through a mechanism linked to Terra's native token LUNA: UST could always be redeemed for $1 worth of LUNA, and LUNA could always be burned to create UST.

In May 2022, large-scale UST selling began - reportedly initiated deliberately - which caused UST to trade below $1. This triggered UST redemptions for LUNA, increasing LUNA supply. More LUNA created downward pressure on LUNA's price. More LUNA selling caused more UST selling. The De-pegging death spiral accelerated over approximately 72 hours. LUNA fell from approximately $80 to effectively zero. UST lost its peg permanently. Approximately $60 billion in market value was wiped out. The collapse caused cascading failures across the crypto ecosystem - multiple large funds and lenders exposed to Terra failed subsequently.