What a Stablecoin Is, and What Keeps It Stable

A stablecoin is a token that aims to stay worth about one unit of something else, usually one US dollar. USDT and USDC are the two most used. On the chain they are ordinary token contracts, the same machinery as any other token. What makes them unusual is the promise behind them.

Three ways a token tries to hold its value

• Backed by reserves held by a company. The issuer says it holds cash and short-term government debt, and promises to redeem tokens for dollars. USDT and USDC work this way.
• Backed by other crypto, locked in a contract and overcollateralised, so the collateral can fall some way before the peg is at risk.
• Backed by nothing but a mechanism. An algorithm mints and burns a second token to push the price back to a dollar. This is the kind that has failed most spectacularly.

Why the price stays near a dollar

Large customers can redeem directly with the issuer. If the token trades below a dollar, redeeming is profitable, which buys the token back up. If it trades above, creating new tokens is profitable. The peg holds because that door is open. Everything that follows is about the door closing.

How stablecoins have failed

• TerraUSD, an algorithmic stablecoin, lost its peg in May 2022 and collapsed to near zero within days, taking its paired token LUNA with it. There were no reserves to redeem against.
• USDC fell below a dollar in March 2023, trading around 87 cents at its lowest, after Circle disclosed that part of its reserves sat at Silicon Valley Bank during that bank's failure. It returned to a dollar once US regulators guaranteed the bank's deposits. The lesson stands: a reserve-backed token is only as sound as where the reserves are kept.
• Issuers can freeze tokens. Tether and Circle can and do freeze balances at particular addresses, usually at the request of law enforcement. A frozen balance cannot be moved by anyone, including you.

What to check before you rely on one

• Who issues it, and in which country are they regulated? Rules for stablecoin issuers are new and still changing, including in the EU, so check the current position rather than an old article.
• What do they say backs it, and do they publish reports? Read what the report actually covers.
• Can you, personally, redeem with the issuer, or only trade on an exchange? For most people it is the second one.
• Which chain is your balance on? The same name exists on many chains, and they are not interchangeable without a bridge or an exchange.

A stablecoin is a promise from a company, written as a token. That is useful, and it is not the same thing as a dollar in a bank.

Education, not financial advice. Nothing here recommends holding any particular token.