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Stablecoins Explained: How They Hold a Dollar Peg — and When They Don't

SoloLuck Blog · 2026-06-30

What Is a Stablecoin?

A stablecoin is a cryptocurrency designed to keep its value fixed to something external — almost always the US dollar. Where Bitcoin's price moves freely with supply and demand, a stablecoin is engineered to stay as close to $1 as possible, day after day.

The appeal is straightforward: you get the speed and programmability of a blockchain token without the wild price swings. Traders use stablecoins to park value between trades. Businesses use them for cross-border payments. People in high-inflation countries use them to hold savings in dollars without a traditional bank account.

The key word in all of this is designed. A stablecoin's $1 peg is not guaranteed by any government. It is a promise backed by a mechanism — and as we'll see, some mechanisms are much more reliable than others.

Fiat-Backed Stablecoins: The Straightforward Model

The most common type of stablecoin is fiat-backed — or fiat-collateralized. The idea is simple: for every token issued on-chain, the issuer holds one real dollar (or a dollar-equivalent asset) in reserve off-chain. If you want your dollar back, you redeem the token and the issuer sends you the cash.

The two largest examples are Tether (USDT) and USD Coin (USDC). Both target a 1:1 peg to the US dollar, but they take different approaches to what sits in the reserve and how much they disclose about it.

USDC, issued by Circle, is backed primarily by cash and short-term US Treasury bills held at regulated US banks. Circle publishes monthly attestation reports reviewed by independent accountants, and its reserve composition is considered among the most transparent in the industry.
USDT, issued by Tether, is the largest stablecoin by total supply. Its reserves include US Treasuries, cash equivalents, secured loans, and other assets. Tether publishes quarterly assurance reports, but its reserve composition has historically drawn more scrutiny from regulators and analysts than USDC's has. In 2021, Tether settled with the New York Attorney General's office over past reserve misrepresentations.

The peg mechanism for both works through direct redeemability: if USDT ever trades below $1 on an exchange, arbitrage traders can buy the discounted tokens and redeem them with the issuer for a full dollar, pushing the price back up. That redemption pressure is what keeps the peg tight under normal conditions.

Crypto-Backed Stablecoins: Decentralised but Over-Collateralised

A second category replaces the fiat reserve with cryptocurrency held in a smart contract. Because crypto prices are volatile, these systems require over-collateralisation — you must lock up significantly more value in crypto than the stablecoins you receive in return.

A classic example: you might need to deposit $150 worth of Ethereum to mint $100 worth of a stablecoin. That buffer gives the system room to absorb a price drop in the collateral. If the collateral value falls below a set threshold, the smart contract automatically liquidates it to protect the peg.

The appeal is that there is no centralised issuer to trust — the collateral is visible on-chain and the rules are encoded in public smart contracts. The drawback is capital inefficiency: tying up $150 to get $100 is expensive, and severe, fast market crashes can still outrun the liquidation mechanism.

Algorithmic Stablecoins: No Reserves, Just Code

Algorithmic stablecoins are the most experimental — and most dangerous — category. They try to hold a $1 peg without holding real-world collateral at all. Instead, they use software rules to expand or contract the token supply in response to market demand.

The basic logic: if the token trades above $1, the protocol mints more tokens to increase supply and push the price down. If it trades below $1, it removes tokens from circulation to push the price back up. In theory, this self-correcting mechanism replaces the need for any reserve.

In practice, this model has a critical vulnerability: it depends entirely on confidence. There is no hard asset to fall back on if people lose faith. Without the safety net of underlying reserves, any loss of confidence can trigger rapid sell-offs — a feedback loop sometimes called a death spiral — that the algorithm cannot stop.

When the Peg Breaks: The TerraUSD Collapse

In May 2022, the crypto world got a brutal lesson in what happens when an algorithmic stablecoin loses its peg. TerraUSD (UST) was, at the time, the third-largest stablecoin by market capitalisation. It maintained its $1 peg not through reserves, but through an arbitrage mechanism involving a paired token called LUNA.

When large holders began selling UST, the price slipped below $1. The protocol's response was to mint new LUNA tokens to absorb the selling pressure — but this flooded the market with LUNA, crashing its price. A falling LUNA price meant even more LUNA had to be minted for each redemption, crashing LUNA further. UST and LUNA entered a death spiral together.

On May 9–10, 2022, UST fell below $0.50. By May 12, it had dropped below $0.10.
Within a week, the combined UST and LUNA system wiped out roughly $45 billion in market capitalisation.
LUNA, which had traded above $80 earlier that year, fell to virtually zero.

Even an emergency deployment of Bitcoin reserves by the Luna Foundation Guard failed to restore the peg. The collapse was swift and total. Terraform Labs later declared bankruptcy, and its founder faced criminal charges including securities fraud.

Fiat-backed stablecoins are not immune either. In March 2023, USDC briefly fell to around $0.87 after it emerged that $3.3 billion of its cash reserves were held at the failing Silicon Valley Bank. USDC recovered its peg within a few days once the situation was resolved — but the episode confirmed that even well-structured fiat-backed stablecoins carry real risks tied to their banking partners and reserve composition.

The Real Risks You Should Understand

Stablecoins are useful tools, but the word "stable" can create a false sense of security. Here are the genuine risks that apply depending on the type:

Counterparty and reserve risk (fiat-backed): You are trusting the issuer to hold honest, liquid reserves and to honour redemptions. If reserves are mismanaged, illiquid, or misrepresented, the peg can slip. You are also exposed to the banks where those reserves sit.
Collateral volatility (crypto-backed): A severe, fast market crash can overwhelm the liquidation system before the collateral buffer is consumed. No collateral model is perfectly safe.
Death spiral risk (algorithmic): Once confidence is lost, there is no hard asset backstop. Collapse can be total and irreversible, as UST demonstrated.
Smart contract risk (all types): Bugs or exploits in the code governing a stablecoin can drain reserves or destroy the peg with no warning.
Regulatory risk (all types): Governments around the world are actively writing stablecoin rules. A regulatory action against an issuer could disrupt access or force changes to how a coin operates.

None of this means stablecoins have no legitimate uses. It means they deserve the same honest evaluation you would give any financial instrument. "Pegged to the dollar" and "as safe as a dollar" are not the same thing.

FAQ

Are stablecoins the same as cash?

No. A stablecoin aims to track the value of a dollar, but it is not the same as holding cash or a bank deposit. Your money is only as safe as the issuer's reserves, the soundness of the peg mechanism, and the smart contract code — all of which carry real risks that cash in an insured bank account does not.

What is the difference between USDT and USDC?

Both are fiat-backed stablecoins targeting a $1 peg. USDC (issued by Circle) is backed primarily by cash and short-term US Treasuries, with monthly attestation reports from independent accountants. USDT (issued by Tether) is larger by supply and has broader exchange liquidity, but its reserves include a wider mix of assets and it has historically faced more regulatory scrutiny over its disclosures. Neither is risk-free.

Can a stablecoin really lose its peg?

Yes, and it has happened multiple times. TerraUSD (UST) collapsed to nearly zero in May 2022, wiping out tens of billions of dollars in value. Even USDC, one of the most transparent fiat-backed stablecoins, briefly fell to around $0.87 in March 2023 due to exposure to the failing Silicon Valley Bank. The peg is a design goal, not a guarantee.

What made UST's collapse so severe?

UST had no hard collateral backing. Its $1 peg relied entirely on an arbitrage mechanism involving a paired token, LUNA. When confidence broke and selling accelerated, the protocol minted enormous quantities of LUNA to try to absorb the pressure — but that flooded the market with LUNA, crashing its price. The two tokens entered a feedback loop of mutual destruction that no intervention could stop.

Is a fiat-backed stablecoin safer than an algorithmic one?

Generally, yes — fiat-backed stablecoins have a much stronger track record. Because they hold real assets in reserve, there is a hard floor to fall back on during stress. Algorithmic stablecoins have no such floor; they depend entirely on market confidence, which can evaporate instantly. That said, fiat-backed stablecoins still carry counterparty risk, banking risk, and regulatory risk, so they are not risk-free.

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