Stablecoins Explained: How They Hold a Peg, and When They Don't
A stablecoin is only as stable as the mechanism behind it. Three designs, three ways to fail, and a regulatory picture that is still being written.
What a stablecoin is trying to do
A stablecoin is a crypto token designed to hold a constant value against a reference, most commonly one US dollar, though euro-, sterling-, and commodity-referenced versions exist. The purpose is practical. Blockchains settle around the clock, but a trading pair or a payment denominated in a highly volatile asset is awkward to work with, so a stable unit lets people move value between platforms, settle trades, park funds between positions, or send money across borders without taking on a network coin's price swings. The word stable, though, describes a design goal rather than a guarantee. Whether that goal is met depends entirely on the mechanism underneath, and the three main mechanisms behave very differently when they are tested.
Three designs, three failure modes
Fiat-collateralised coins are the largest category. An issuer takes in dollars, holds them in reserve — typically across bank deposits, short-dated government bills, and repurchase agreements — and issues one token per dollar received. Crypto-collateralised coins are backed by other crypto assets locked in smart contracts, and because that collateral is itself volatile they are deliberately over-collateralised, with perhaps 150 dollars of crypto locked behind 100 dollars of issued stablecoin and automatic liquidations if the buffer thins. Algorithmic designs hold little or no external collateral, relying instead on a linked token and a mint-and-burn mechanism intended to expand and contract supply to defend the peg. The first two designs fail when reserves prove illiquid or when collateral falls faster than liquidations can execute. The third can fail reflexively, because the thing defending the peg is itself a crypto asset whose value depends on confidence in that peg holding.
- Fiat-collateralised: the question is what is actually in the reserve, how quickly it could be sold at face value, and who independently verifies it.
- Crypto-collateralised: the question is whether the over-collateralisation buffer and the liquidation machinery can survive a fast, correlated sell-off.
- Algorithmic: the question is whether a mechanism with no external collateral can hold when confidence in the mechanism is the very thing under attack.
Reserves, attestations, and when pegs break
For a fiat-backed coin, the phrase fully backed is less informative than the reserve breakdown sitting behind it. Cash and short-dated government bills can generally be sold quickly at close to face value under stress; commercial paper, secured loans, corporate bonds, or holdings of other crypto assets cannot necessarily. Verification matters just as much. Most large issuers publish attestations, in which a professional firm confirms reserve balances at a point in time under an agreed procedure — meaningfully weaker than a full audit of the issuer. The peg itself is maintained by arbitrage: if the token trades at 99 cents while an eligible party can redeem it for a dollar, buying and redeeming is profitable, and that buying pushes the price back towards par. The mechanism is conditional, because it works only while redemption is genuinely available, promptly honoured, and open at scale. Depegs are not hypothetical. In March 2023 a major fiat-backed coin traded well below a dollar for a weekend after part of its reserve was found to sit at a US bank that had failed; it recovered once access to those deposits was confirmed. The most severe episode came in May 2022, when a large algorithmic dollar-referenced stablecoin lost its peg and collapsed towards zero within days, dragging its linked token down with it and erasing tens of billions of dollars of nominal value as the reflexive design meant to defend the peg accelerated the fall instead. Smaller coins have broken and simply stayed broken with far less attention paid.
Where the rules are heading
Regulation has been moving, broadly and across jurisdictions, towards treating fiat-backed stablecoins more like payment instruments: prescribed reserve composition, clear redemption rights, disclosure and reporting standards, and licensing or authorisation of issuers. The European Union's markets-in-crypto-assets regime and United States federal stablecoin legislation have both advanced along those lines, with detailed rulemaking by banking regulators still working through implementation, and several Asian jurisdictions operating licensing frameworks of their own. This is a fast-moving area: timetables have shifted, requirements differ meaningfully between jurisdictions, and the treatment of algorithmic designs in particular remains unsettled. Anything specific should be checked against current official sources. The underlying point for a holder does not change: a stablecoin is a claim on a mechanism, an issuer, or both, and it is worth knowing which. Crypto assets are high-risk, stablecoins included — the label describes an intention, not a guarantee, and holders have lost money when that intention failed.
This article is educational and general in nature. It isn’t personalized investment, tax, or legal advice — always weigh your own circumstances, or talk to a licensed professional, before making financial decisions.