Three tokens sit on your screen. Each shows $1.00. One is propped up by a bank vault full of Treasury bills. Another is propped up by a pile of ETH locked in a smart contract worth 150% of what it backs. The third is propped up by nothing but a promise and an arbitrage loop — and one of those, a few years ago, evaporated $40 billion in 72 hours.
All three call themselves stablecoins. That label hides more than it reveals. If you want to know how do stablecoins work, you need to stop thinking of them as a single product and start thinking of them as three utterly different engineering answers to the same question: how do you make a crypto token that tracks the dollar?
This is Part 5 of 8 in DeFi from First Principles. Previous parts covered what DeFi actually is, wallets and gas, AMMs, and onchain lending. Now we dissect the asset every other protocol depends on.
Why stablecoins exist at all
Crypto has a volatility problem. Bitcoin can move 10% in a day. ETH routinely swings 5%. You cannot price a loan, pay a contractor, or hold working capital in an asset that re-denominates itself every few hours. If you want to understand the broader coin-vs-token distinction first, see what is cryptocurrency.
Stablecoins are the bridge. They give you a dollar-denominated unit of account that still lives onchain — transferable in seconds, usable as collateral in lending markets, composable inside AMM pools. Without them, DeFi collapses back into a speculative trading venue. With them, it becomes something closer to a financial system.
But the bridge is only as strong as what holds it up. Let's look at the three designs.
Design 1: Fiat-backed (USDC, USDT)
The simplest mental model. A company — Circle for USDC, Tether for USDT — takes your dollar, puts it in a bank account or buys a short-dated Treasury bill, and mints you one token. You can later redeem the token for the dollar back. The peg holds because issuance and redemption are one-for-one with real dollars.
The mechanics:
- Mint: an authorised institution wires $10M to Circle, Circle mints 10M USDC to their wallet.
- Redeem: the institution burns 10M USDC, Circle wires $10M back (minus fees).
- Reserves: held in cash, overnight repos, and short-dated T-bills. Composition is published monthly as an attestation — not a full audit, a snapshot signed by an accounting firm.
The arbitrage that keeps the peg tight: if USDC trades at $0.99 on the open market, institutions buy it cheap, redeem at par with Circle, pocket the penny. If it trades at $1.01, they mint fresh USDC at par and sell it. Professional desks close the gap in minutes under normal conditions.
Risks specific to fiat-backed designs
You have replaced crypto risk with banking risk. Your $1 token is a claim on a company that holds money at banks. When Silicon Valley Bank failed in March 2023, USDC briefly depegged to around $0.82 because Circle had $3.3B stuck in the bank over a weekend. The FDIC backstop restored confidence within 48 hours, but holders who panic-sold near the lows realised a real loss.
Other concrete risks:
- Issuer solvency: reserves could be commingled, misreported, or lost. Tether has paid multiple settlements over reserve disclosures.
- Blacklisting: Circle and Tether can freeze addresses on request from law enforcement. Your USDC can be rendered non-transferable without your consent.
- Regulatory action: an issuer operating across jurisdictions can be ordered to halt redemptions.
Fiat-backed stablecoins are the most liquid and the most predictable — and they are also the design with the strongest dependency on traditional finance holding up.
Design 2: Crypto-backed (DAI, USDS, LUSD)
Now remove the bank. Instead of dollars in an account, you lock crypto in a smart contract and mint stablecoins against it. This is the same mechanism as onchain lending — a Collateralized Debt Position — except the debt you issue is a dollar-pegged token rather than borrowed funds from a pool.
The mechanics, using MakerDAO's DAI (now alongside the newer USDS after Sky's 2024 rebrand) as the canonical example:
- You deposit $15,000 of ETH into a vault.
- You mint up to $10,000 of DAI against it (150% collateralization ratio).
- If ETH drops and your vault falls below the ratio, keepers liquidate your collateral, pay off the DAI debt, and keep a penalty.
- To unlock your ETH, you repay the DAI plus a stability fee (an interest rate set by governance).
The peg holds through two mechanisms. First, the same arbitrage loop as fiat-backed coins: if DAI trades below $1, borrowers buy it cheap to close their debt, removing supply. Second, a Peg Stability Module lets approved users swap USDC for DAI 1:1, which in practice means DAI is partially backed by other stablecoins — a design choice critics argue dilutes the pure-crypto thesis.
Risks specific to crypto-backed designs
- Collateral volatility: a fast ETH crash can outpace liquidations. If a vault goes underwater before keepers act, the system eats the loss — Maker had to auction MKR tokens to cover a shortfall during the March 2020 crash.
- Oracle risk: the vault needs to know the ETH price. A manipulated or stale oracle can trigger wrong liquidations or let undercollateralised vaults survive.
- Governance risk: MKR (now SKY) holders vote on stability fees, collateral types, and emergency shutdown. A hostile or incompetent vote can break the system.
- Smart contract risk: one bug in the vault logic and the entire backing can be drained.
The trade-off: you eliminate the bank, but you replace it with code, oracles, and a governance token whose holders may not share your interests.
Design 3: Algorithmic (the UST cautionary tale)
The purest form. No dollars, no overcollateralisation — just two tokens and a market maker that promises to swap between them at a fixed ratio.
TerraUSD (UST) worked like this: 1 UST could always be redeemed for $1 worth of LUNA, a sister token whose supply floated freely. If UST traded above $1, arbitrageurs burned $1 of LUNA to mint 1 UST and sold it for profit. If UST traded below $1, arbitrageurs bought cheap UST, redeemed it for $1 of LUNA, and sold the LUNA for profit. The peg was supposed to be self-correcting.
It wasn't.
In May 2022, a coordinated sell-off pushed UST below peg. The protocol started minting massive amounts of LUNA to absorb redemptions. LUNA supply went from hundreds of millions into the trillions within days. LUNA's price collapsed to fractions of a cent, which meant redeeming 1 UST no longer gave you $1 of LUNA — it gave you dust. The peg mechanism failed completely. Roughly $40 billion evaporated. An entire Layer 1 ecosystem went to zero. Terraform Labs founder Do Kwon was sentenced to 15 years in US federal prison in December 2025 for wire fraud and conspiracy tied to the collapse.
Why purely algorithmic designs are structurally fragile
- Reflexivity: the backing asset's value depends on confidence in the peg. When the peg breaks, the backing breaks faster, accelerating the break. This is a positive feedback loop in the wrong direction.
- No external anchor: nothing outside the system forces the backing token to have value. Fiat-backed coins anchor to Treasuries. Crypto-backed coins anchor to ETH or BTC. Pure algorithmic coins anchor to themselves.
- Bank-run geometry: every depegging event rewards early exiters and punishes latecomers, so the rational move is to exit first at any sign of stress.
A small number of hybrid designs survive (FRAX, partially collateralised and partially algorithmic), but the pure algorithmic category is essentially empty now. Anyone claiming a new pure-algorithmic design will work this time is asking you to ignore the history.
How to evaluate any stablecoin in 60 seconds
Before holding or using any stablecoin, ask:
- What backs it? Fiat in a bank, crypto in a contract, or just another token? If the answer is vague, the answer is "nothing good."
- Who can freeze or blacklist you? Centralised issuers can. Permissionless designs generally cannot. This matters differently depending on your threat model.
- What is the redemption path? Can anyone redeem for the backing, or only whitelisted institutions? Retail-only markets with no direct redemption rely entirely on arbitrageurs showing up.
- Has it been stress-tested? USDC survived SVB. DAI survived March 2020. UST did not survive May 2022. Track record matters.
- Where does it trade? Deep liquidity in AMM pools and on centralised venues means the peg self-heals faster during stress.
Risks to understand before you participate
Consolidating across all three designs, these are the exposures you inherit when you hold a stablecoin:
- Issuer risk (fiat-backed): the company custodying reserves can fail, misreport, or be forced to halt redemptions.
- Banking risk (fiat-backed): the banks holding the reserves can fail, as SVB demonstrated.
- Smart contract risk (crypto-backed, algorithmic): a bug drains the backing or breaks the peg mechanism.
- Collateral risk (crypto-backed): a fast crash in backing assets outruns liquidation keepers.
- Oracle risk (crypto-backed, algorithmic): bad price data triggers wrong liquidations or masks insolvency.
- Governance risk (crypto-backed): token-holder votes can change stability fees, collateral types, or pause the system.
- Reflexivity risk (algorithmic): confidence loss accelerates backing loss, creating a self-reinforcing collapse.
- Censorship risk (fiat-backed, some hybrids): issuer-level blacklists can freeze your holdings.
- Regulatory risk (all designs): jurisdictional action against issuers, protocols, or specific tokens.
The phrase "stablecoin" hides this entire matrix behind a $1.00 price tag. Every time you use one, you are accepting a specific combination of these risks.
Key takeaways
- Stablecoins are three distinct designs solving the same peg problem, not one product.
- Fiat-backed (USDC, USDT): simplest and most liquid, but introduces banking risk, issuer risk, and censorship.
- Crypto-backed (DAI/USDS): removes the bank, but introduces smart contract risk, collateral volatility, and governance exposure.
- Algorithmic (UST): has no external anchor and is reflexively fragile. The historical track record is catastrophic.
- Evaluate any stablecoin by asking what backs it, who controls it, how redemption works, and whether it has survived real stress.
- Every stablecoin trades short-term stability for a specific bundle of long-term risks. You are always picking which risks you prefer, never escaping them.
