What a stablecoin is trying to do
A stablecoin is a crypto token designed to keep a steady value, most often one US dollar per token. Most of the price of other coins moves with supply and demand, and a stablecoin tries to cancel that movement out. People use them as a place to park value between trades, as a unit for quoting other assets, and as a way to move dollar-like value across blockchains without touching a bank.
The target price is called the peg. A token “holds its peg” when it trades close to that target on exchanges. No stablecoin is guaranteed to do so. The word “stable” describes an intention, not a promise, and the differences between designs are mostly differences in what stands behind that intention.
Three broad designs
Stablecoins are usually grouped by what supports the peg.
| Design | What supports the peg | Main dependency |
|---|---|---|
| Fiat-backed | Cash and short-term assets held by an issuer | Trust in the issuer and its custodians |
| Crypto-backed | Other crypto locked in smart contracts | Collateral value and contract code |
| Algorithmic | Rules and incentives, with little or no hard backing | Continued market confidence |
Real products often mix features, so treat these as categories, not strict boxes.
Fiat-backed stablecoins
The simplest design is a company that accepts dollars, issues tokens, and promises to redeem each token for a dollar. The issuer holds assets, often cash and short-term government debt, as a reserve. If the reserve is at least as large as the tokens outstanding, and holders can actually redeem, the token should trade near one dollar.
An illustration with round numbers: an issuer has 1,000,000 tokens in circulation and holds 1,000,000 dollars of assets against them. Every token is covered. If it holds only 950,000 dollars, then each token is covered by about 95 cents, and that shortfall is what worries holders during stress.
The weak points are not in the code but in the real world. Holders must trust that the reserve exists, that it is liquid, that it is held at institutions that stay solvent, and that the issuer will honour redemptions. Often only larger customers can redeem directly with the issuer, while everyone else sells on an exchange. How to read what these companies publish is covered in the article on stablecoin reserves. Because a company sits in the middle, this model also carries the kind of counterparty risk that applies to any institution holding your funds, and it is exposed to regulators in the places where it operates.
Crypto-backed stablecoins
A crypto-backed stablecoin replaces the company with a smart contract. Users lock crypto in the contract and borrow newly created stablecoins against it. Because crypto prices swing widely, these systems are usually overcollateralized: the locked value is worth more than the tokens issued.
Illustration: someone locks 150 dollars of collateral and mints 100 tokens. If the collateral falls 30 percent, it is worth 105 dollars, still above the 100 tokens. If it falls 40 percent, it is worth 90 dollars, and the position no longer covers its debt. To prevent that, the system lets anyone liquidate positions that fall below a set ratio, selling the collateral to repay the debt.
This is transparent, since the collateral can be inspected on a blockchain, but it has its own risks. A sharp fall in collateral prices can trigger many forced sales at once, a dynamic similar to a liquidation cascade in leveraged trading. Smart contract bugs, faulty price feeds and heavy network congestion can also hurt, and congestion makes high gas fees a practical problem for people trying to add collateral in time. Some such systems accept other stablecoins as collateral, which can quietly bring fiat-backed risks back in.
Algorithmic stablecoins
Algorithmic designs try to hold the peg mainly through rules. A typical approach pairs the stablecoin with a second, freely floating token. When the stablecoin trades below one dollar, the rules let users swap it for a set amount of the companion token, which is meant to reduce supply and lift the price. When it trades above, the rules create new stablecoins.
The weakness is circular. The mechanism works only while the companion token has value, and that value depends on people believing the system works. If confidence falls, the companion token drops, redeeming becomes less rewarding, and more selling follows. This feedback loop is sometimes called a death spiral. The best-known failure of this kind was TerraUSD in May 2022, covered in more detail in the article on depegging events. Because of such failures, some jurisdictions have looked at tighter rules for this category, and jurisdiction differences matter a great deal for what issuers may offer.
How a peg is held day to day
Whatever the design, pegs are mostly held by arbitrage. Suppose a token that can be redeemed one for one trades at 98 cents. A trader with redemption access can buy at 98 cents, redeem for a dollar, and keep the difference, minus fees and delays. That buying pressure pushes the price back up. The mirror case works when the token trades above a dollar: new tokens are issued and sold.
This only works if redemption is credible and fast enough. Fees, minimum amounts, banking hours and doubts about the reserve all weaken it, and when trust is shaken the gap can widen rather than close. Liquidity on exchanges also matters. A token with deep order books can absorb large sales with little movement, while thin markets amplify swings.
Comparing the risks
None of the three designs removes risk. It only moves it.
- Fiat-backed: issuer, custodian, banking and regulatory risk.
- Crypto-backed: collateral volatility, liquidation mechanics and software risk.
- Algorithmic: confidence risk, with no hard asset to fall back on.
A token that has held its peg for years may still be vulnerable, because pegs are tested mainly in rare stress events. Consider how it is backed, how redemption works, who can use it, and what disclosures exist before relying on one.
Why this matters for prices
Stablecoins are the main dollar-like unit inside crypto markets, and many displayed prices are quoted against them. That connects them to topics such as why prices are quoted against dollar tokens and whether growth in supply says anything about market liquidity. If the unit itself wobbles, so does every price measured in it.
Crypto assets are volatile, past behaviour does not predict future results, and people can lose everything they put in, stablecoins included. This article is educational and is not financial, tax or legal advice.