Who This Is For

Anyone using cryptocurrency will likely encounter stablecoins. They're widely used in crypto trading, DeFi, and transfers. This guide explains what stablecoins are, how they work, and the risks you should understand before using them.

What Are Stablecoins?

Definition: Cryptocurrencies designed to maintain a stable value relative to an asset, typically a fiat currency.

Most common target: $1 USD

The goal: Combine benefits of cryptocurrency (fast transfers, blockchain-based) with stability of fiat currency.

Why Stablecoins Exist

Problems they attempt to solve:

1. Volatility: Regular cryptocurrencies (Bitcoin, Ethereum) fluctuate wildly
2. Trading pairs: Need stable base for trading other cryptos
3. Value transfer: Moving value without volatility risk
4. DeFi usage: Need stable unit of account for lending, borrowing

Use cases:

• Trading between cryptocurrencies
• Parking funds during market volatility
• Cross-border transfers
• DeFi protocol participation
• Merchant payments (theoretically)

What Stablecoins Are NOT

Not:

• FDIC insured bank deposits
• Risk-free
• Guaranteed to maintain peg
• Backed by government
• Subject to same regulations as banks

They look stable, but they're still cryptocurrency with unique risks.

Types of Stablecoins

1. Fiat-Collateralized Stablecoins

Mechanism: Backed by reserves of fiat currency (typically USD) held by a company.

How they're supposed to work:

1. Company holds $1 USD for every stablecoin issued
2. You can redeem 1 stablecoin for $1 (theoretically)
3. Reserves are audited (ideally)
4. Arbitrage maintains price near $1

Examples:

• USDC (USD Coin) - Issued by Circle
• USDT (Tether) - Issued by Tether Limited
• BUSD (Binance USD) - Was issued by Paxos (being phased out)
• PYUSD (PayPal USD) - Issued by PayPal

Advantages:

• Simplest model to understand
• Most "stable" in practice (so far)
• Largest market cap stablecoins use this model

Risks:

• Trust in issuing company
• Reserve composition (are reserves actually 1:1?)
• Reserve quality (cash vs. commercial paper vs. other assets)
• Regulatory risk (company could be shut down)
• Counterparty risk (company could fail or freeze accounts)
• Redemption risk (can you actually redeem for $1?)

2. Crypto-Collateralized Stablecoins

Mechanism: Backed by other cryptocurrencies as collateral, often over-collateralized.

How they work:

1. Lock up $150 worth of crypto (e.g., ETH)
2. Mint $100 worth of stablecoin
3. Over-collateralization buffer protects against crypto price drops
4. If collateral value drops too low, position liquidated

Examples:

• DAI - Backed by crypto collateral in MakerDAO system
• sUSD - Synthetix stablecoin

Advantages:

• Decentralized (no single company)
• Transparent (on blockchain)
• No need to trust fiat reserves

Risks:

• Complexity (many moving parts)
• Liquidation risk (collateral can be liquidated)
• Governance risk (parameters controlled by token holders)
• Smart contract risk (bugs can be exploited)
• Collateral volatility (if crypto crashes severely, system can fail)
• Scaling challenges (requires lots of crypto locked up)

3. Algorithmic Stablecoins

Mechanism: Use algorithms and incentives to maintain peg without backing.

How they're supposed to work:

1. Algorithm expands supply when price above $1
2. Algorithm contracts supply when price below $1
3. Incentive mechanisms encourage arbitrage
4. "Pure" algorithm maintains stability

Examples:

• UST (TerraUSD) - Collapsed in May 2022
• FRAX - Partially algorithmic
• Many others that have failed

Advantages (theoretical):

• No reserves needed
• Fully decentralized
• Scalable without collateral requirements

Risks:

• Extremely high risk—many have completely failed
• Death spiral risk (losing peg triggers panic)
• Relies on market confidence
• Complex mechanisms users don't understand
• No real backing if confidence lost
• History of catastrophic failures

Major Stablecoins

USDT (Tether)

Type: Fiat-collateralized Issuer: Tether Limited Market cap: Largest stablecoin by market cap

Characteristics:

• Most widely used
• Available on many exchanges
• Most trading pairs
• Established in 2014

Concerns:

• Historical lack of transparency about reserves
• Questions about full backing
• Regulatory scrutiny
• Offshore company structure
• Legal controversies

Current status: Publishes attestations (not full audits), claims reserves back tokens.

USDC (USD Coin)

Type: Fiat-collateralized Issuer: Circle (with Coinbase involvement) Market cap: Second-largest stablecoin

Characteristics:

• More transparent than Tether
• Regular attestation reports
• Regulated in US
• Redemption process clearer

Concerns:

• Still centralized
• Company can freeze addresses
• Banking system dependencies
• 2023 brief de-peg during Silicon Valley Bank crisis

Current status: Considered more transparent than USDT, but still carries issuer risk.

DAI

Type: Crypto-collateralized Issuer: MakerDAO (decentralized organization) Market cap: Smaller than USDT/USDC

Characteristics:

• Decentralized (no single company)
• Transparent on-chain
• Over-collateralized by crypto
• Complex mechanism

Concerns:

• Complexity (hard to understand fully)
• Governance risks
• Collateral composition has included USDC (centralized stablecoin dependency)
• Smart contract risks
• Can de-peg during extreme market events

Current status: Most successful crypto-collateralized stablecoin, but with added complexity.

How Stablecoins Maintain Their Peg

Arbitrage Mechanism

Theory: Market participants profit by restoring peg.

If trading at $1.01:

1. Arbitrageurs buy from issuer for $1
2. Sell on market for $1.01
3. Profit $0.01
4. Increased supply pushes price down to $1

If trading at $0.99:

1. Arbitrageurs buy from market for $0.99
2. Redeem with issuer for $1
3. Profit $0.01
4. Decreased supply pushes price up to $1

This works when:

• Redemption actually available
• Reserves are real
• Market is liquid
• Confidence remains

This fails when:

• Redemption restricted
• Reserves inadequate
• Panic selling
• Confidence lost

Practical Reality

Most of the time:

• Major stablecoins trade within 0.1% of $1
• Arbitrage keeps prices tight
• System appears to work

During stress:

• Can de-peg significantly (10%+ in severe cases)
• Liquidity dries up
• Redemption unclear or delayed
• Panic accelerates de-pegging

Historical examples:

• USDC briefly traded below $0.90 during SVB crisis (2023)
• UST spiraled to near-zero (2022)
• Various smaller stablecoins have failed entirely

Stablecoin Risks

1. De-Pegging Risk

What it is: Stablecoin loses its $1 value, trading significantly above or below.

Causes:

• Loss of confidence in backing
• Issuer problems
• Bank failures affecting reserves
• Liquidity crunch
• Market panic

Impact:

• Holdings worth less than expected
• Forced to sell at loss
• Can't easily exit position
• Cascade effect as others sell

Historical: USDC dropped to $0.87 briefly; UST went to ~$0.

2. Counterparty Risk

What it is: Reliance on issuing company's solvency and honesty.

Concerns:

• Company could fail
• Reserves could be mismanaged
• Fraud or misrepresentation
• Company could be shut down by regulators

You're trusting:

• Company's financial stability
• Accuracy of reserve claims
• Company's ability to handle redemptions
• Company's ongoing operations

Unlike banks: No FDIC insurance, less regulatory oversight.

3. Reserve Quality Risk

What it is: "Backing" may not be what you think.

Questions:

• Are reserves 100% cash or include other assets?
• Are reserves in safe assets or risky ones?
• Are reserves actually segregated and available?
• Are attestations accurate?

Historical issues:

• Tether admitting reserves included commercial paper, not just cash
• Lack of transparency about composition
• Attestations vs. full audits (attestations are weaker)

Impact: If reserves aren't what claimed, redemption may not be possible.

4. Regulatory Risk

What it is: Regulatory action against stablecoin or issuer.

Possibilities:

• Issuer forced to shut down
• Redemptions halted
• Assets frozen
• Stablecoin deemed security (legal issues)
• Banking access cut off

Recent developments:

• Increased regulatory scrutiny globally
• Some stablecoins shut down or restricted
• Ongoing regulatory uncertainty

Impact: Could make stablecoin unusable or irredeemable.

5. Centralization Risk

What it is: Issuer can control or censor your funds.

Company can:

• Freeze addresses (blacklist)
• Block transactions
• Prevent redemptions
• Change terms

This has happened:

• Addresses frozen for legal reasons
• Redemptions suspended during issues

Trade-off: Centralization enables compliance but creates control points.

6. Smart Contract Risk (for some stablecoins)

What it is: Bugs or exploits in smart contract code.

Concerns:

• Code vulnerabilities
• Hacks draining funds
• Unintended behavior
• Governance exploits

Primarily affects: Crypto-collateralized and algorithmic stablecoins

Historical: Multiple DeFi stablecoins affected by smart contract exploits.

7. Liquidity Risk

What it is: Can't buy or sell stablecoin easily during stress.

When it happens:

• Market panic
• Exchange issues
• General crypto downturn

Impact:

• Stuck in position
• Must accept unfavorable prices
• Can't exit when needed

Usually temporary but can be severe during crises.

8. Yield Trap Risk

What it is: Platforms offering high yields on stablecoins to attract deposits.

Red flags:

• Unsustainably high interest rates
• Unclear source of yield
• Promises of "risk-free" high returns

Reality:

• High yields come from high risk
• Many "stablecoin yield" platforms have failed
• Your stablecoins may be used in risky strategies

Examples of failures:

• Anchor Protocol (20% on UST before collapse)
• Celsius (offered high rates, then froze withdrawals and bankrupted)
• Various other platforms

More: DeFi Explained: What It Is and the Risks

When to Use Stablecoins (and When Not To)

Reasonable Use Cases

1. Short-term trading on exchanges:

• Converting between crypto assets
• Parking funds briefly between trades
• Taking advantage of trading opportunities

Key: Short duration, actively managed, accept risks

2. DeFi participation (if you understand risks):

• Providing liquidity
• Lending/borrowing
• Participating in protocols

Key: Only with funds you can afford to lose, understand protocol risks

3. Cross-border transfers (sometimes):

• Faster than traditional banking
• Lower fees than wire transfers
• Recipient can accept crypto

Key: Transfer quickly, don't hold long-term, both parties understand process

Questionable Use Cases

1. Long-term savings: Problem: No interest, counterparty risk, no insurance

Better: FDIC-insured savings account

2. Emergency fund: Problem: De-peg risk, redemption risk, exchange access issues

Better: Traditional savings in regulated bank

3. "Safe" crypto exposure: Problem: Stablecoins aren't safe, they're less volatile

Reality: Still carry significant risks

4. Retirement savings: Problem: Long time horizon, better options exist, unnecessary risk

Better: Traditional retirement accounts

Stablecoin Best Practices

If You Use Stablecoins

1. Minimize holdings:

• Only hold what you're actively using
• Convert to fiat when not needed
• Don't treat as savings account

2. Choose established stablecoins:

• USDC, USDT, DAI have most history
• Still risky but more tested
• Avoid new or unknown stablecoins

3. Understand what backs it:

• Read about reserve composition
• Check for regular attestations/audits
• Understand redemption process

4. Don't chase yield:

• High interest on stablecoins = high risk
• Understand where yield comes from
• Many high-yield platforms have failed

5. Monitor news:

• Regulatory developments
• Issuer problems
• Reserve updates
• De-pegging events

6. Have exit plan:

• Know how to convert to fiat
• Understand redemption process
• Have accounts on multiple exchanges
• Don't wait for crisis to figure it out

7. Diversify stablecoin holdings (if significant):

• Don't put all in one stablecoin
• Different types (fiat-backed, crypto-backed)
• Reduces single-point-of-failure risk

8. Never invest more than you can afford to lose:

• Despite "stable" name, they're risky
• Treat like any crypto holding
• Apply same risk management

Red Flags

Avoid stablecoins with:

• [ ] No clear information about backing
• [ ] Anonymous team
• [ ] Purely algorithmic (history of failures)
• [ ] No regular attestations or audits
• [ ] Unclear redemption process
• [ ] Very small market cap (liquidity risk)
• [ ] Promises of high guaranteed yields
• [ ] Overly complex mechanisms
• [ ] Recent launch without track record
• [ ] Regulatory issues or warnings

Stablecoin Checklist

Before using a stablecoin:

• [ ] Do I understand what backs this stablecoin?
• [ ] Do I know who issues it and their reputation?
• [ ] Have I reviewed recent attestations/audits?
• [ ] Do I understand the redemption process?
• [ ] Am I comfortable with counterparty risk?
• [ ] Is this stablecoin widely used and liquid?
• [ ] Do I have an exit plan if it de-pegs?
• [ ] Am I only holding what I'm actively using?
• [ ] Have I considered just using fiat instead?

If you can't answer these confidently, reconsider using that stablecoin.

Key Takeaways

• Stablecoins attempt to maintain stable value (usually $1) but aren't risk-free
• Three types: fiat-collateralized (most common), crypto-collateralized, algorithmic (highest risk)
• Major stablecoins: USDT, USDC (fiat-backed), DAI (crypto-backed)
• Risks include de-pegging, counterparty failure, reserve issues, regulatory action
• Not FDIC insured or government guaranteed
• Algorithmic stablecoins have repeatedly failed catastrophically
• Use for short-term trading/transfers, not long-term savings
• Minimize holdings, understand backing, have exit plan

Remember: "Stablecoin" is a goal, not a guarantee. They're more stable than other crypto, but they're not stable like cash in an insured bank account.

Further Reading

• DeFi Explained: What It Is and the Risks
• Crypto Basics: Safe Beginner Guide
• Common Crypto Scams: How to Avoid Them
• Safe Transaction Habits