How Stablecoins Work

What Is a Stablecoin?

A stablecoin is a cryptocurrency designed to maintain a stable value — usually pegged to the US dollar. Stablecoins solve crypto's fundamental usability problem: you cannot price goods, settle trades, or hold savings in an asset that moves 10% in a day.

The need for stable value in a decentralised network has driven more cryptographic and economic innovation than almost any other problem in crypto. How do you create a digital dollar that anyone can hold and send — without trusting a bank? The answer depends on what you are willing to sacrifice: decentralisation, capital efficiency, or stability. This tradeoff defines every stablecoin design.

Stablecoins have grown from a niche instrument to a critical piece of global financial infrastructure. USDT and USDC combined settle over $10 trillion annually — more than Visa and Mastercard combined. In emerging markets with weak currencies, USDT has become a primary savings vehicle. For DeFi, stablecoins are the settlement layer: every lending protocol, DEX, and yield strategy denominates positions in stable value.

Fiat-Backed Stablecoins

The simplest stablecoin design: a centralised issuer holds $1 in a bank account for every stablecoin in circulation. Holders can always redeem for $1. The peg is maintained by direct convertibility.

Tether (USDT) launched in 2014 and is by far the largest stablecoin with over $110 billion in supply. It is also the most controversial: Tether's reserve composition was opaque for years and it settled with the New York AG in 2021 over misrepresentation of reserves. Tether's reserves are now primarily US Treasuries and repo agreements, disclosed quarterly — but not subject to a full audit.

USD Coin (USDC), issued by Circle (a regulated US company), publishes monthly attestations from auditing firms and holds reserves in cash and short-duration US Treasuries. USDC is the preferred stablecoin for institutional DeFi and regulatory compliance. It suffered a brief depeg in March 2023 when $3.3B of reserves were held at Silicon Valley Bank (which failed), pushing USDC to $0.87 before SVB was backstopped.

Fiat-backed stablecoins carry counterparty risk — the issuer could freeze your tokens (Circle and Tether have both blacklisted addresses), the bank could fail, or the company could be shut down by regulators. They are also censorable at the smart contract level: a single transaction from the issuer can freeze any wallet globally.

Crypto-Collateralised Stablecoins

Crypto-collateralised stablecoins replace fiat bank reserves with on-chain crypto assets. They are overcollateralised to absorb price volatility, and smart contracts enforce liquidations automatically when collateral falls below safe levels.

MakerDAO's DAI is the original and largest crypto-collateralised stablecoin. Users deposit collateral (ETH, wBTC, stETH, USDC) into a Maker Vault and mint DAI against it. If the vault's collateral ratio falls below the liquidation ratio (typically 130–175% depending on asset), the vault is liquidated. The Maker protocol charges a Stability Fee (interest) on borrowed DAI, and DAI holders earn the DAI Savings Rate (DSR).

DAI has evolved significantly since 2017. Maker now accepts USDC as collateral (through PSM, the Peg Stability Module), which allows near-instant arbitrage to maintain the peg but makes DAI partially fiat-backed. MakerDAO has invested heavily in US Treasuries through RWA vaults — earning yield while maintaining the peg. The protocol rebranded as Sky in 2024, with USDS replacing DAI for new minting, though DAI remains in circulation.

Liquity Protocol offers a purer design: ETH-only collateral, 0% interest, and a minimum 110% collateral ratio. The hardest minimum ratio in DeFi means Liquity must maintain a very efficient liquidation system — the Stability Pool, where LUSD holders absorb liquidations and receive discounted ETH in return.

Algorithmic Stablecoins

Algorithmic stablecoins maintain their peg through protocol-controlled supply expansion and contraction — with no external collateral. In theory, elegant. In practice, every major experiment has failed catastrophically.

The mechanism is straightforward: when the stablecoin trades above $1, the protocol mints new supply (inflating) to push the price down. When it trades below $1, the protocol burns supply (deflating) to push the price up. The burning mechanism typically involves issuing a governance or "seigniorage" token in exchange for the stablecoin — giving holders something for burning, but diluting the governance token in the process.

The fatal flaw is the death spiral. When confidence in the peg wavers, holders rush to exit. The exit burns stablecoins and mints governance tokens — but the governance token has no floor value if the stablecoin has no collateral. As the governance token price falls, the burning mechanism becomes less attractive, accelerating the flight. Confidence collapses faster than supply can be burned.

The Peg Mechanism

Every stablecoin's peg is ultimately maintained by arbitrage. The protocol creates profit incentives that disappear exactly when the stablecoin is at $1, and arbitrageurs enforce the peg by chasing those incentives.

The strength of the peg depends on the accessibility and size of the arbitrage opportunity. For USDC, anyone with a verified Circle account can mint or redeem in size — making the arbitrage reliable. For DAI, anyone can open a vault and mint — but only if they have collateral to post. For algorithmic stablecoins, the arbitrage relies on the seigniorage token retaining value — which is circular and fragile.

A secondary peg mechanism is the Peg Stability Module (PSM), introduced by MakerDAO. The PSM allows 1:1 swaps between DAI and USDC at zero fees (with limits), creating an instant arbitrage channel. If DAI trades at $0.99, traders can buy DAI and swap it for USDC at 1:1 for instant profit. This makes the DAI peg extremely tight — but at the cost of DAI's independence from fiat.

The Stablecoin Trilemma

Every stablecoin must trade off between three properties: peg stability, capital efficiency, and decentralisation. No design achieves all three simultaneously — this is the stablecoin trilemma.

The trilemma explains why different protocols make different choices. Circle optimises for stability and efficiency at the cost of decentralisation. Liquity optimises for decentralisation and stability at the cost of efficiency (110%+ collateral). Algorithmic designs optimise for efficiency and decentralisation — and have repeatedly failed at stability. Hybrid designs (FRAX, crvUSD, USDe) are ongoing experiments in finding the optimal compromise.

Yield-Bearing Stablecoins

The next evolution of stablecoin design: a stablecoin that accrues yield automatically, so holding it earns interest without any additional action. The yield comes from deploying the backing collateral productively.

DAI Savings Rate (DSR) was the first major example — MakerDAO pays DAI holders a yield by deploying protocol collateral into US Treasuries and other yield sources. At peak, the DSR reached 8% — higher than most traditional savings accounts.

Ethena's USDe takes a more aggressive approach: it holds stETH as collateral and opens a perpetual short on ETH to delta-hedge the position (making the net exposure USD-stable). The yield comes from staking rewards on stETH plus the funding rate paid to shorts by longs (which is historically positive in crypto bull markets). USDe has offered 20–40% APY at peak — though this depends entirely on funding rates remaining positive.

sDAI (staked DAI), sUSDC, and similar liquid staking derivatives of stablecoins allow yield to be earned without locking funds — the receipt token is itself tradeable and usable as collateral. This is the future model: a stablecoin that earns the risk-free rate by default, with holders opting in to higher-risk yield strategies through additional layers.

Regulatory Landscape

Stablecoins are the most heavily scrutinised segment of crypto regulation. Regulators view them as potential systemic risks — private money creation at scale — and have moved to bring them within existing or new frameworks.

The EU's Markets in Crypto-Assets (MiCA) regulation, effective 2024, is the most comprehensive stablecoin framework globally. It distinguishes between e-Money Tokens (EMTs, pegged to a single fiat currency) and Asset-Referenced Tokens (ARTs, pegged to a basket). Issuers of significant stablecoins must be authorised credit institutions or e-money institutions, maintain 1:1 liquid reserves, and publish regular reserve reports. Circle obtained an EMT licence; Tether initially had difficulty meeting MiCA requirements.

The US remains fragmented. The House passed the STABLE Act in 2025, which would require stablecoin issuers to be regulated depository institutions or approved non-bank issuers, with full reserve backing and redemption rights. Tether operates offshore and has faced persistent regulatory pressure from US authorities. PayPal launched PYUSD (an OCC-regulated stablecoin) in 2023, signalling traditional finance entering the space under existing frameworks.

Risks & Failure Modes

Every stablecoin type has characteristic failure modes. The history of stablecoins is a catalogue of catastrophic experiments — understanding how they fail is as important as understanding how they work.

The most important lesson from stablecoin history is that the peg is only as strong as its weakest arbitrage path. Mechanisms that work perfectly in normal conditions can fail under stress — when liquidity is thin, when redemption is slow, or when confidence evaporates faster than supply can be burned. Every stablecoin designer claims their mechanism is robust; the market has repeatedly proven otherwise.