What Stablecoins Are and Why They Matter
A stablecoin is a crypto token built to hold a steady value, usually one dollar, so value can sit still on a blockchain that never closes.
Fiat-backed
Peg holdsReserves of real cash and T-bills
Crypto-collateralised
Peg holdsOver-collateralised by other crypto
Algorithmic
Peg brokePeg held by supply and demand code alone
Look at the three stablecoin types above before reading on. Each one promises the same thing, a token worth about a dollar, but keeps that promise a different way (real reserves, a crypto cushion, or code alone), and that difference is where all the risk lives. First, though, the problem they solve. Crypto prices move fast, and that becomes a problem the moment you want value to sit still. A trader who wants to step out of a falling market, or a worker who wants to hold dollars on-chain, has usually faced an ugly choice: ride the swings, or cash out to a bank and wait through banking hours, paperwork and fees. A stablecoin is the answer to that. It is a crypto token engineered to hold a steady value, almost always pegged one-for-one to a currency like the US dollar, so value can rest inside a system that never closes without ever touching a traditional bank. That one property, a stable unit that lives on a blockchain, is why stablecoins turned into core plumbing rather than a curiosity.
The problem a stablecoin solves
Think of a stablecoin as a still point in a noisy market. Everything around it is going up and down, and it stays at roughly a dollar. That is the whole appeal. You can park money there between trades, hold dollars in a country whose own currency is sliding, or send value to someone without asking a bank to open. The volatility that makes crypto exciting is exactly what a stablecoin is designed to switch off.
The peg is the promise: one token should always be worth about one dollar. The interesting question, and the one this course keeps coming back to, is how a token keeps that promise. Because the method behind the peg is where all the risk lives.
Three ways to hold a peg
Stablecoins are not all built the same way, and the design decides the risk. There are three families.
- Fiat-backed. The issuer holds real reserves (cash and short-term government debt such as US Treasury bills) at least equal to the tokens in circulation, and each token can be redeemed for roughly a dollar. USDT (Tether) and USDC (Circle) are the giants here.
- Crypto-collateralised. The token is backed by other crypto locked in smart contracts. Because that backing is itself volatile, the system is deliberately over-collateralised: you might lock $150 of crypto to mint $100 of the stablecoin, so there is a cushion. DAI (from MakerDAO) is the leading example.
- Algorithmic. There is little or no real reserve. Instead, software expands and shrinks the token supply and leans on trader incentives to nudge the price back to a dollar. This is the fragile one, for reasons the next section makes clear.
A simple way to remember it: fiat-backed leans on a bank, crypto-collateralised leans on a cushion of other crypto, and algorithmic leans on code and confidence alone.
Why the algorithmic kind kept blowing up
The most famous algorithmic stablecoin, TerraUSD (UST), collapsed in May 2022 and took more than $40 billion of value with it. Its peg had no reserves behind it. It relied on swapping back and forth with a sister token, LUNA, to push the price toward a dollar. That works while people believe in it. The moment confidence broke, holders rushed for the exit, the mechanism that was meant to defend the peg instead flooded the market with LUNA, its price crashed, and the whole thing spiralled to near zero.
The lesson is blunt and worth keeping: a peg backed only by confidence and a clever supply trick has no floor once confidence goes, because there are no real reserves to redeem against. Most purely algorithmic designs have failed for the same reason. When you hear "stablecoin", the sensible first question is always "what actually backs it?"
Two jobs, one token
It helps to see that the same stablecoin does two very different jobs.
As a trading tool, it is a place to park value. You step out of a volatile position without leaving the exchange, wait, and step back in later. Nothing about your money touches a bank in between.
As a payments tool, it is a way to move money. You send dollars to anyone with a wallet, anywhere, in minutes, around the clock. Same token, completely different use.
The rest of this course covers both, because the risks that matter (what backs it, who holds the keys, what the regulators say) apply whether you are parking or paying.
Worked example: parking value during a sell-off
A holder owns 1 BTC worth $60,000 and expects a short drop. Cashing out to a bank means a withdrawal request, banking hours, a fee, then another deposit later to buy back in.
Instead the holder swaps 1 BTC for 60,000 USDT in seconds. The value now sits still. If BTC then falls 20% to $48,000, the holder still has 60,000 USDT and can buy back 60,000 / 48,000 = 1.25 BTC, ending with more BTC than they started with, and never once touched a bank.
The stablecoin did one job here: it acted as a parking space for value inside the crypto system.
Why stablecoins move so much of the money on-chain
Stablecoins have quietly become the default unit of account for crypto. Most exchanges quote their trading pairs against USDT or USDC, on-chain apps use them as base money, and traders sit in them between positions.
The result is that stablecoins settle enormous sums (trillions of dollars a year on public blockchains) and regularly make up a large share of all on-chain transaction value. When people say crypto is actually "used", a great deal of that use is stablecoins moving from one place to another.
The TerraUSD death spiral, step by step
UST kept its dollar peg by letting people swap it with a paired token, LUNA:
- If UST traded above a dollar, users could create new UST (shrinking LUNA), pushing the price back down.
- If UST traded below a dollar, users could destroy UST to create LUNA, meant to push the price back up.
In May 2022 confidence cracked. Holders rushed to swap UST for LUNA, which hyper-inflated LUNA's supply and crushed its price. The very mechanism built to restore the peg instead fed the collapse, because there were no reserves to redeem against. This is the difference between a temporary wobble and a terminal failure: real, recoverable backing exists, or it does not.
Quick knowledge check
What problem does a stablecoin solve? It gives you a steady-value asset that lives inside a volatile crypto system, so value can sit still on-chain without cashing out to a bank.
Name the three stablecoin designs, with one example each. Fiat-backed (USDT, USDC), crypto-collateralised (DAI), and algorithmic (the failed TerraUSD).
Why did TerraUSD collapse when a fiat-backed coin usually survives a scare? Its peg relied on swapping with LUNA rather than on real reserves. When confidence broke there was nothing to redeem against, so it spiralled to near zero and wiped out more than $40 billion. A fiat-backed coin has real assets a holder can claim.
Sources
- Federal Reserve, FEDS Notes, "The stable in stablecoins" — plain definition of a stablecoin as a token pegged to a fiat value such as the US dollar.
- Moin, Sirer and Sekniqi (arXiv:1910.10098), "A Classification Framework for Stablecoin Designs" — the three design categories: fiat-collateralised, crypto-collateralised, and algorithmic.
- Uhlig, NBER Working Paper 30256, "A Luna-tic Stablecoin Crash" — how TerraUSD's mint-and-burn peg with LUNA worked and collapsed in May 2022.
- Visa Onchain Analytics — data on the very large settlement volumes stablecoins move across public blockchains.