A stablecoin is a cryptocurrency designed to maintain a fixed price, usually $1. Three fundamentally different mechanisms are used to achieve this: fiat backing (actual dollars held in reserve), crypto-collateralized positions (CDP model), and algorithmic approaches (seigniorage or rebasing). Each mechanism creates a different risk profile. The UST collapse in May 2022, which wiped $40 billion in value in 72 hours, is the clearest demonstration of how algorithmic risk differs from collateral-backed risk.
How each stablecoin type works
Fiat-backed stablecoins (USDT, USDC) hold reserves (cash, treasuries, commercial paper) and issue stablecoins against them. In theory, every USDT can be redeemed for $1. The risk is custodial: you trust the issuer’s solvency, honesty, and banking relationships. Tether (USDT) was accused for years of insufficient reserves; its attestations showed substantial commercial paper holdings that were not US treasuries. USDC (Circle) has experienced brief depeg events when banking partners (SVB in March 2023) faced runs, causing USDC to trade at $0.87 before the banking situation was resolved.
Crypto-collateralized stablecoins (DAI from MakerDAO, LUSD from Liquity) are minted by locking cryptocurrency in excess of the stablecoin value. To mint $1,000 DAI, you lock at least $1,500 in ETH. If ETH falls and your collateral ratio drops below the minimum, your position is liquidated and DAI is repaid. The peg holds as long as liquidation mechanisms work correctly and collateral assets retain value. DAI maintained its peg through the 2022 and 2023 market crashes without issuer intervention.
Algorithmic stablecoins attempt to maintain a peg without full collateral, using token supply expansion and contraction mechanics. Terra’s UST used a mint-and-burn mechanism with the LUNA governance token: minting $1 of UST required burning $1 of LUNA. When UST depegged slightly, the mechanism required minting more LUNA to buy and burn UST, which diluted LUNA’s price, which required minting even more LUNA. The spiral compressed $40 billion in UST and LUNA market cap to near zero in four days.
What this means for traders
Stablecoin risk is counterparty risk in a different form. Holding USDC in a self-custody wallet still means trusting Circle’s reserves and the US banking system’s stability. Holding USDT means trusting Tether’s attestations and banking relationships. DAI’s risk is smart contract risk plus collateral concentration risk (a significant portion of DAI’s collateral is now USDC, reintroducing centralized risk). Algorithmic stablecoins have demonstrated reflexive failure modes that collateral-backed designs do not have.
For active traders, stablecoin choice matters when size is meaningful. Holding $500,000 in a single stablecoin concentrates that risk; diversifying across USDC, USDT, and DAI reduces the probability that a single failure takes the full position. For DeFi users, check which stablecoins back pools you are providing liquidity to: if the pool is 50% algorithmic stablecoins and those depeg, your LP position absorbs the loss directly. See: DeFi liquidation for how stablecoin collateral risk propagates through lending protocols.
A concrete example
May 8, 2022: UST begins depegging from $1 to $0.98. The algorithmic mechanism mints LUNA to buy and burn UST. LUNA supply increases sharply, diluting its price. Reduced LUNA price means more LUNA must be minted per $1 of UST burned. UST falls to $0.90; panic selling accelerates. By May 12, UST trades at $0.15 and LUNA has lost 99.9% of its value. Holders who understood the algorithmic design exited UST at the first depeg signal; those who held through recovered cents on the dollar. The same week, USDC experienced its own brief depeg to $0.98 due to unrelated banking concerns, recovered to $1.00 within 48 hours, and processed all redemptions normally because the reserves were collateral-backed.
Frequently asked questions
Are any algorithmic stablecoins still operating safely?
Frax (FRAX) uses a partially algorithmic model with partial collateralization, which has maintained its peg through multiple market cycles. RAI from Reflexer is a non-dollar-pegged stablecoin with algorithmic interest rate control, which has held a stable value without pegging to $1. Both are significantly smaller in market cap than fiat-backed stablecoins. The UST failure has made the market deeply skeptical of pure algorithmic designs.
What are yield-bearing stablecoins?
Yield-bearing stablecoins (sDAI, USDY, stEUR) pass through interest or yield to holders while maintaining the dollar peg. sDAI holds DAI that earns the DAI Savings Rate (currently 5% to 8% depending on on-chain governance). USDY from Ondo Finance represents short-duration US treasury exposure in tokenized form. These are technically collateral-backed stablecoins with yield distributions layered on top.
How does a stablecoin peg stay at exactly $1?
Arbitrage. If USDC trades at $0.99, you can buy USDC on the open market for $0.99 and redeem it with Circle for $1.00, profiting $0.01 per USDC. If USDC trades at $1.01, you can deposit $1.00 with Circle to mint USDC and sell it for $1.01. This arbitrage pressure keeps fiat-backed stablecoins close to $1 as long as redemptions are open and the issuer is solvent. CDP stablecoins use liquidation mechanisms and interest rate adjustments to achieve the same result.
