Stablecoins

Introduction

Module 05 introduced stablecoins briefly as one of DeFi's core building blocks. This lesson slows down and looks at what actually keeps a stablecoin's price steady, and why "stable" is a design goal, not a guarantee.

A stablecoin is a token engineered to hold a steady value, usually pegged to a fiat currency like the US dollar. How that peg is maintained differs enormously between designs, and that difference is exactly where the risk lives.

By the end of this lesson you'll be able to tell fiat-backed, crypto-backed and algorithmic stablecoins apart, understand what a reserve attestation actually proves, and recognize the warning signs that tend to precede a depeg.

Types of Stablecoins

Nearly every stablecoin in use today falls into one of three broad designs, each trading off decentralization, capital efficiency and risk differently.

Each model answers the same question, what stands behind this token, in a very different way.

How the Peg Is Maintained

A peg isn't enforced by a rule, it's maintained by arbitrage: whenever the price drifts away from the target, someone has a financial incentive to trade it back.

If a fiat-backed stablecoin trades below $1, arbitrageurs can buy it cheaply and redeem it for $1 from the issuer, pushing demand (and price) back up. If it trades above $1, they can mint new tokens for $1 and sell them for a profit, pushing price back down.

This mechanism only works if redemption and minting are actually reliable, if an issuer freezes redemptions, the arbitrage loop breaks and the peg can drift indefinitely.

Over-Collateralization

Crypto-backed stablecoins can't rely on a stable asset as collateral, so they compensate by requiring more collateral value than the stablecoin they issue.

If $100 of ETH is deposited to mint $70 of a stablecoin, the position can absorb roughly a 30% drop in ETH's price before the collateral is no longer sufficient to back what was issued.

If collateral value falls below the required ratio, the position can be liquidated automatically to protect the system, a mechanic covered in Module 06: Lending.

Reserve Attestation

Fiat-backed issuers regularly publish a reserve attestation, a report from an accounting firm confirming that reserves of a certain value existed on a specific date.

An attestation is not the same as a full audit. It confirms a snapshot, not that reserves are always fully backing every token in circulation, nor how those reserves are invested or how quickly they could be accessed.

Treat attestations as a useful data point, not as proof that a stablecoin can never break its peg.

Algorithmic Stablecoins

Algorithmic stablecoins try to hold their peg through code and incentives instead of holding real collateral. A common design pairs the stablecoin with a second, volatile token that absorbs the difference.

When the stablecoin trades below its peg, the protocol lets users burn it in exchange for newly minted volatile token, reducing the stablecoin's supply and, in theory, pushing its price back up.

• No independent collateral. Backing comes from confidence in the system itself, not from assets held elsewhere.
• Reflexive design. The mechanism that defends the peg depends on the volatile token holding value, which itself depends on confidence in the peg.
• Death spiral risk. If confidence breaks, both tokens can fall together, since minting more of the volatile token to defend the peg only works while someone is still willing to buy it.

This design can work while confidence holds, but it removes the safety net that collateral-backed models have.

Historical Depegs

Two well-documented cases show how differently a depeg can play out depending on what actually backs a stablecoin.

The same word, depeg, describes a temporary wobble in one case and a permanent collapse in the other. What backs the token is what determines which one you're looking at.

Risks & Red Flags

Not every stablecoin carries the same risk, but a few warning signs are worth checking before relying on one.

• Opaque reserves. An issuer that won't publish regular attestations, or discloses vague reserve composition, is harder to trust by default.
• Reflexive backing. Any design where the peg depends on confidence in another token issued by the same protocol carries the algorithmic risk covered above.
• Thin liquidity. A stablecoin that's hard to buy or sell at its peg price in size is more likely to slip during stress, even if it's fully backed.
• Regulatory exposure. Reserves held at a single bank or jurisdiction can become temporarily inaccessible for reasons that have nothing to do with the stablecoin's own design.
• Unsustainable yield. A stablecoin offering yield well above what fiat savings or DeFi lending normally pay is often subsidizing that rate from somewhere, and that somewhere matters.

Summary

Stablecoins hold their value through one of three broad designs, fiat reserves, crypto over-collateralization, or algorithmic incentives, and each trades decentralization for a different kind of risk.

A reserve attestation is a useful signal but not a guarantee, over-collateralization absorbs volatility but isn't limitless, and algorithmic designs remove the collateral safety net entirely. The single most useful habit from this lesson is asking what actually backs a stablecoin before treating its peg as guaranteed.

Glossary

Peg

The target value a stablecoin is designed to maintain, usually a fiat currency.

Collateralization Ratio

The value of backing assets held relative to the stablecoins issued.

Depeg

An event where a stablecoin's market price moves meaningfully away from its target peg.

Reserve Attestation

A report (not a full audit) confirming a stablecoin issuer's reserves at a point in time.

Algorithmic Stablecoin

A stablecoin that uses code and incentives, rather than collateral, to hold its peg.

Arbitrage

Buying an asset where it's cheap and selling where it's expensive, the mechanism that keeps a stablecoin's price close to its peg.

Over-Collateralization

Backing a loan or a stablecoin with collateral worth more than the amount issued, to absorb price volatility.

Liquidation Threshold

The collateralization ratio below which a position can be automatically closed to protect the system.

Quiz

Check your understanding of this lesson before moving on. Incorrect answers point you straight back to the relevant section.