Stablecoin Mechanics

Why Stablecoins Exist

Crypto is volatile. If you sell ETH for profit, you need somewhere to park the value without converting back to a bank account. Stablecoins solve this: they are tokens designed to hold a steady $1 value, letting you stay on-chain without exposure to price swings.

Stablecoins are also the backbone of DeFi. Lending protocols, DEX liquidity pools, and yield farms all depend on stablecoins as their primary unit of account. Over $150B of stablecoins circulate across blockchains as of 2025.

There are three fundamentally different designs.

1. Fiat-Backed: USDC and USDT

How it works: A company (Circle for USDC, Tether for USDT) holds real dollars in bank accounts. For every stablecoin token they issue on-chain, they hold $1 in reserves. You can redeem tokens 1:1 for cash.

Why it holds its peg: Arbitrage. If USDC drops to $0.98 on a DEX, traders buy it cheaply and redeem it with Circle for $1, pocketing the $0.02 difference. This buying pressure pushes the price back up. If USDC trades at $1.02, traders mint new USDC from Circle at $1 and sell it on the market.

The risk: You are trusting that the reserves actually exist and that the banking system remains functional. In March 2023, USDC briefly traded at $0.87 when Silicon Valley Bank — which held $3.3B of Circle's reserves — failed. It recovered after the FDIC stepped in to guarantee deposits.

2. Crypto-Backed: DAI (MakerDAO)

How it works: Instead of holding dollars in a bank, DAI is backed by crypto locked in smart contracts. You deposit ETH (or other tokens) into a MakerDAO "Vault" and mint DAI against it. The system requires over-collateralization: you must deposit at least $150 of ETH to mint $100 of DAI.

Why it holds its peg: If your collateral ratio falls below a threshold (e.g., ETH drops in price), your position is automatically liquidated — the smart contract auctions off your ETH to buy back and burn DAI, maintaining the system's solvency.

The trade-off: DAI is decentralized and transparent. Anyone can inspect the collateral on-chain. But it is capital-inefficient. Locking up $150 to get $100 is expensive compared to USDC's 1:1 model.

3. Algorithmic: The Cautionary Tale of UST/LUNA

How it was supposed to work: TerraUSD (UST) had no collateral backing at all. Instead, it used an arbitrage mechanism with a companion token (LUNA). If UST dropped below $1, holders could burn 1 UST to mint $1 worth of LUNA, reducing UST supply and pushing the price up. If UST rose above $1, holders could burn LUNA to mint UST.

What actually happened (May 2022):

1. Large holders began selling hundreds of millions of UST.
2. The protocol minted massive amounts of LUNA to absorb the selling pressure.
3. The flood of new LUNA crashed LUNA's price.
4. A cheaper LUNA meant even more LUNA had to be minted per UST redeemed, creating hyperinflation.
5. LUNA went from $80 to $0.0001. UST went from $1 to $0.02. Over $40 billion in value was destroyed in 72 hours.

This event is the clearest demonstration of why purely algorithmic stablecoins — with no external collateral — are considered fundamentally fragile.

Key takeaways

• Fiat-backed stablecoins (USDC, USDT) are the simplest model: trust a company to hold real dollars.
• Crypto-backed stablecoins (DAI) are decentralized but require over-collateralization to absorb volatility.
• Algorithmic stablecoins attempted to maintain a peg without any collateral. The UST/LUNA collapse proved this model has a catastrophic failure mode.
• Depeg events can happen to any stablecoin. Understanding the backing mechanism tells you how likely recovery is.