How do stablecoins work—and why invest in them if they’re always worth $1?
–Serena
Stablecoins are cryptocurrencies designed to maintain a stable value by being pegged to a reserve asset, most commonly a fiat currency such as the U.S. dollar. While popular crypto assets like Bitcoin and Ethereum fluctuate widely, stablecoins aim to provide the stability of traditional money while retaining the speed, programmability and borderless nature of digital assets. Prominent examples include Circle’s USDC, Tether’s USDT and MakerDAO’s DAI, and some of these stablecoins rank among the largest cryptocurrencies by market capitalization.
To understand why stablecoins are useful, it helps to think about three classic roles of money: a medium of exchange, a store of value and a unit of account. Volatile cryptocurrencies can serve as a medium of exchange and sometimes as a store of value, but their price swings make them poor units of account—prices and contracts are hard to express and enforce when the unit itself changes value dramatically. Stablecoins bridge that gap by providing a predictable unit of value that can be used within crypto ecosystems and decentralized finance (DeFi) applications.
Investors and traders use stablecoins for several practical reasons. For example, during a market downturn many crypto holders convert volatile coins like Bitcoin or Ethereum into stablecoins to preserve value without fully exiting the crypto ecosystem. When market conditions improve, they can convert those stablecoins back into volatile assets. Stablecoins are also widely used as a base pair on exchanges, for remittances, payroll in digital-native businesses and as collateral or settlement media within DeFi protocols.
What is a stablecoin peg?
The core feature that gives a stablecoin its stability is the peg—the asset or mechanism that the coin’s value is tied to. Different stablecoins use different peg mechanisms, and those mechanisms determine both how the coin maintains its value and the risks involved. The three primary peg types are fiat-collateralized, crypto-collateralized and algorithmic.
- Fiat-collateralized: These stablecoins are issued by centralized entities and backed by reserves of fiat currency, short-term government bonds or equivalent liquid assets. Issuers typically claim a 1:1 backing—for example, one unit of stablecoin represents one U.S. dollar held in reserve. This model is straightforward and easy to understand, but it depends on the issuer’s reserves and transparency practices.
- Crypto-collateralized: These stablecoins are issued in decentralized systems and backed by other cryptocurrencies using smart contracts. Because crypto collateral can be volatile, these stablecoins are often over-collateralized—meaning more value is held in reserve than the stablecoins issued (for instance, $1.50 of crypto collateral to back $1 of stablecoin). Over-collateralization helps protect the peg when collateral values fall, and protocols can liquidate collateral automatically if necessary. MakerDAO’s DAI is a widely known example of a crypto-collateralized stablecoin.
- Algorithmic: Algorithmic stablecoins do not rely primarily on collateral. Instead, they use smart-contract rules or algorithms to expand and contract supply—similar in concept to how a central bank uses monetary policy—to keep price near the peg. While this approach can be capital-efficient, it is also more experimental and has proven fragile in several high-profile cases. Algorithmic designs can fail to restore the peg during severe market stress, producing cascading losses.
Stablecoin risks
Although stablecoins reduce price volatility, they introduce other risks that investors and users should understand. Counterparty and custody risk are central for fiat-collateralized coins: users must trust that reserves exist and are managed transparently. For crypto-collateralized coins, smart contract bugs, governance attacks or rapid collateral devaluation can threaten stability. Algorithmic stablecoins face design and market-risk challenges that can lead to complete depegging.
A notable example of algorithmic failure occurred in 2022 with the collapse of TerraUSD (UST). Terra’s design attempted to maintain stability through an algorithmic relationship with its sister token, LUNA. When confidence evaporated and liquidity dried up, the peg broke and both tokens lost significant value, causing heavy losses across DeFi platforms that relied on them. That episode highlighted the systemic risk an unstable stablecoin can create when it is deeply integrated into lending, trading and yield protocols.
Because of these risks, many conservative participants prefer well-established stablecoins with clear reserve audits, transparent governance and strong regulatory compliance. Even so, no stablecoin is entirely risk-free: regulatory changes, reserve mismanagement, smart contract vulnerabilities and extreme market stress remain realistic threats. Users should evaluate transparency reports, proof-of-reserves practices, governance structures and the specific use case before relying on any particular stablecoin.
Jeremy Koven is the Chief Operating Officer and a co-founder of a Canadian cryptocurrency trading platform and shares insights on how stablecoins function within crypto markets.
Further reading on crypto
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- How the Ethereum Merge affects investors
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