What Are Stablecoins and How Do They Work?

Stablecoins are crypto tokens built to hold a steady value, usually pegged to one US dollar, so they barely move while the rest of the market swings. They keep that peg in different ways: some hold real dollar reserves, some lock up extra crypto as collateral, and a few rely on an algorithm. For most people they work as digital dollars on the blockchain, used to trade, to move money, or to sit out volatility.

I have been trading since 2013, and the way I see stablecoins is simple: they are a place to park value, not an asset to bet on. The word "stable" does a lot of marketing here, because under real stress some of them do slip off the dollar. Below I will go through what stablecoins are, how each type holds its peg, and where the risks actually sit, before I add how I treat them myself.

In this article we'll cover:

• a stablecoin is a token pegged to a value, usually one dollar, that stays flat while crypto swings;
• three main types: fiat-backed with reserves, crypto-collateralized, and algorithmic;
• the peg holds through reserves and redemption, over-collateralization, or supply algorithms;
• "stable" is conditional: under stress coins can depeg, and the Terra collapse showed how fast.

Let's start with what a stablecoin actually is and which kinds exist.

What Are Stablecoins?

Stablecoin is a cryptocurrency designed to keep a steady price by tracking another asset, most often the US dollar at one to one. Unlike Bitcoin or what is crypto in general, which can swing wildly, a stablecoin aims to stay near a dollar.

There are three main types. Fiat-backed coins such as Tether (USDT) and USDC hold reserves in dollars and short-term assets, one unit of reserve behind each token. Crypto-collateralized coins such as DAI lock up other cryptocurrencies in smart contracts, usually worth more than the coins issued, to absorb crypto's own volatility. Algorithmic coins hold no full backing and try to defend the peg purely through code that expands or shrinks supply. The first two are the workhorses; the third is the experimental and far riskier branch.

How Stablecoins Keep Their Peg

Fiat-backed coins hold the line through reserves and redemption. When the price drifts below a dollar, arbitrage traders buy the coin cheap and redeem it one-for-one with the issuer, pocketing the gap and pushing the price back. When it drifts above, new issuance adds supply. The peg here is only as good as the reserves and the ability to actually redeem.

Crypto-collateralized coins use over-collateralization and liquidations: you might lock 150 dollars of Ethereum to mint 100 dollars of the coin, and if the collateral falls too far, smart contracts liquidate the position to protect the peg. Algorithmic coins instead mint and burn supply by rule, issuing more when the price is high and burning when it is low. That logic can look stable in calm periods and unravel fast when trust breaks, which is exactly the weak point of the model.

Stablecoin Risks: Depeg, Terra, and Frozen Funds

A stablecoin is designed to be stable, not guaranteed to be. Under market stress even big coins can lose the dollar: USDC briefly fell toward 87 cents during the March 2023 banking scare, and USDT has wobbled in past panics before recovering. A depeg is rarely one event; it is a chain reaction of redemptions, reserve doubts and congestion that widens the gap from a dollar.

The sharpest lesson came from the algorithmic side. In May 2022 the TerraUSD coin lost its peg and spiralled, wiping out tens of billions across its ecosystem in days as its paired token collapsed in a death spiral. Add two risks people forget: issuers of centralized coins can freeze tokens at flagged addresses, and regulators worldwide are tightening rules on reserves and redemption. Storing these assets safely is its own subject, covered in how to secure crypto.

My Take: A Stablecoin Is a Parking Spot, Not a Yield Machine

For me a stablecoin is the cash position between trades, somewhere to sit when I do not want exposure, and nothing more. The trouble starts when people treat it as an investment and chase the double-digit yields that the ads promise; that same chase is what blew up with Terra in 2022, where a famous high yield turned out to be the risk in disguise. My rule is plain: if something pays far above a bank and calls itself stable, the risk has not vanished, it has just moved out of sight. This is not advice for you personally, it is how I work: I lean on transparent, reserve-backed coins for parking only, I keep nothing critical in algorithmic models, and I never put the whole balance in one issuer. The honest limitation is that no stablecoin is risk-free, so the alternative to chasing yield is simply holding less of it and spreading across more than one name.