What Are Stablecoins? How They Work, Main Types and Key Risks

What a stablecoin is

A stablecoin is a crypto token built to track the value of something steady, most often a national currency such as the US dollar. That target value is called the peg. If a dollar stablecoin works as intended, one coin should be worth very close to one dollar at all times.

Stablecoins live on blockchains such as Ethereum, so they can be sent anywhere in the world at any hour, held in a crypto wallet and used inside crypto apps. They aim to combine the steadiness of ordinary money with the flexibility of crypto, which explains their popularity.

The three main types

• Fiat-backed. A company holds reserves such as cash and short-term government bonds and issues tokens against them. In principle, each token can be redeemed with the issuer for one dollar. Tether's USDT and Circle's USDC are well-known examples. You are trusting the issuer to really hold those reserves.
• Crypto-backed. Users lock other cryptocurrencies in a smart contract as collateral worth more than the stablecoins they create. This extra cushion is called over-collateralisation. DAI is a well-known example. If the collateral's value falls too far, the system sells it automatically to protect the peg.
• Algorithmic. These try to hold the peg with code and incentives, often by creating and destroying a partner token, instead of holding full reserves. They have proven the most fragile of the three.

How a peg can break

A peg holds only while people believe each coin can be swapped for a dollar. If that belief cracks, holders rush to sell, the price drops below one dollar, and the fall can feed on itself. This is called losing the peg, or depegging.

The best-known failure is TerraUSD (UST), an algorithmic stablecoin. In May 2022 it lost its dollar peg, and the mechanism that created more of its partner token, LUNA, to defend the price spiralled out of control. Both tokens lost almost all their value within about a week, and many holders suffered heavy losses.

Even reserve-backed coins can wobble. In March 2023, Circle disclosed that part of the cash backing USDC was held at Silicon Valley Bank, which had just failed. USDC traded well below one dollar for a short time, then returned to its peg after US authorities said the bank's depositors would be protected.

Reserves and attestations

For fiat-backed stablecoins, the key questions are whether the reserves are really there and what they consist of. Cash and short-term government bonds are easier to sell quickly than riskier assets.

Many issuers publish regular attestations: reports in which an accounting firm checks the reserves at a specific moment. These are useful but limited. An attestation is a snapshot, not a full audit, and it may not show what happens between reports.

Regulation of stablecoins is developing in several regions, and the rules differ from country to country. Checking who issues a stablecoin, where it is regulated and how often it reports on its reserves is a sensible habit.

How beginners use stablecoins

• A parking spot. Switching into a stablecoin lets you step out of volatile coins without leaving a crypto platform.
• Trading pairs. Many exchanges price coins against dollar stablecoins, so you often need one to buy or sell.
• Sending money. Stablecoins can move across borders without waiting for bank opening hours, though network fees still apply.
• Using crypto apps. Many decentralised apps use stablecoins for lending, borrowing and payments.

When sending, always check that you and the receiver are using the same blockchain network. The same stablecoin can exist on several networks, and choosing the wrong one can mean losing the funds.

Risks to know

• Depegging. A stablecoin can fall below its target, briefly or for good.
• Issuer and banking risk. Fiat-backed coins depend on a company and the banks holding its reserves. Issuers can also freeze tokens held at certain addresses.
• Smart contract risk. Crypto-backed and algorithmic coins rely on code that can fail or be exploited.
• Yield offers. A platform paying high interest on stablecoins is taking risks with your money somewhere. High yield usually means high risk.