Stablecoins explained: how they try to hold $1

What is a stablecoin?#

The Bank for International Settlements (BIS) defines stablecoins as crypto tokens that live on decentralised ledgers and promise to always be worth a fixed amount in fiat currency, for example one dollar ^[1]. A 2021 US government report used similar words: digital assets designed to maintain a stable value relative to a national currency or other reference assets ^[2]. The UK's Financial Conduct Authority (FCA) gives Tether (USDT) as an example ^[3].

Why would anyone want a crypto token that is not supposed to move? The same US report found that stablecoins were mainly used to trade, lend or borrow other digital assets, mostly on crypto trading platforms ^[2]. The FCA also sees a possible future in faster, cheaper payments, including across borders ^[3]. Our stablecoin glossary entry has the one-line version.

How do stablecoins try to hold $1?#

A reserve-backed stablecoin works like a claim on a pool of assets. You pay the issuer money, the issuer creates tokens and holds reserve assets, and later a holder can hand tokens back and get money out. BIS puts it this way: the issuer's reserve asset pool and its capacity to meet redemptions in full back the promise ^[1]. Every new token has to be paid for upfront in full ^[1].

Not every stablecoin is built this way, and not every reserve is equally safe. The table groups the designs our sources describe. The EU's MiCA regulation does not use the word "stablecoin" as a legal term; it calls a token pegged to one official currency an e-money token, and a token pegged to anything else an asset-referenced token ^[4].

Sources: 2021 US report on stablecoins ^[2], MiCA definitions and recital 41 ^[4], Federal Reserve on TerraUSD ^[5].

Can a stablecoin lose its peg?#

Yes. BIS notes that stablecoins trade on secondary markets at an "exchange rate" that can deviate from par, and that they frequently fail to live up to their promise of par convertibility ^[1]. The FCA adds that some so-called stablecoins have no assets backing them and have lost their value completely after delinking ^[3]. "Stable" describes the goal, not a guarantee.

The bigger danger is a run. The 2021 US report warned that if an issuer does not honour redemptions, or users lose confidence that it will, runs could harm users and the wider financial system; even the prospect of a stablecoin not performing as expected could set off a self-reinforcing cycle of redemptions and fire sales of reserve assets ^[2]. In November 2022 the Federal Reserve wrote that stablecoins remained vulnerable to runs ^[5].

What happened to TerraUSD?#

TerraUSD (UST) is the clearest case in our sources of a stablecoin failing completely. The US Securities and Exchange Commission (SEC) described UST as a so-called "algorithmic stablecoin" that supposedly kept its dollar peg by being interchangeable for another token, LUNA ^[6]. In its February 2023 charges, the SEC alleged that UST was marketed as paying as much as 20 percent interest through the Anchor Protocol ^[6].

In May 2022, UST depegged from the dollar and its price and the prices of its sister tokens fell close to zero ^[6]. The Federal Reserve wrote that UST had a market value of about $18 billion before the collapse, that it largely lacked assets to back its value, and that both UST and the whole Terra blockchain, including LUNA, were wiped out ^[5].

The lesson for beginners is about yield. The Federal Reserve noted that UST's demand, as with many other stablecoins, was mainly driven by the return investors could earn ^[5]. A high return on something described as "stable" is a reason to ask harder questions, not a reason to relax.

How are stablecoins regulated?#

Rules arrived only recently, and they differ by region. The table summarises what our sources confirm; it is not legal advice, and it does not tell you whether any named stablecoin complies. For the wider picture, see crypto regulation basics.

Sources: MiCA definitions and recitals 67 and 68 ^[4]; US Treasury notice on the GENIUS Act ^[7]. The US notice is an early step in rulemaking, not final rules.

One US date matters for anyone outside the rules: from July 18, 2028, digital asset service providers generally may not offer or sell a payment stablecoin to people in the United States unless a permitted issuer issued it ^[7]. MiCA's no-interest rule exists to reduce the risk that e-money tokens are used as a store of value ^[4]. Regulation does not turn a stablecoin into a bank deposit: the SEC warns that accounts at crypto asset firms do not get SIPC or FDIC type protections ^[8].

How can you check a stablecoin before using one?#

1. Find out who issues it

   A named issuer under clear rules is a starting point, not a guarantee. Check how it fits the EU rules (e-money token or asset-referenced token) or the US rules (permitted payment stablecoin issuer) ^[4] [7].

2. Read what backs it

   Look for a recent reserve report and what it holds. US permitted issuers must publish reserve composition monthly ^[7]. No report, or a design with nothing behind it, is a warning sign ^[3].

3. Check whether you can redeem

   Ask whether you can hand tokens back to the issuer yourself and on what terms, or whether you can only sell them to other users at the market price ^[1].

4. Treat a high yield as a red flag

   MiCA's recitals say e-money token holders should not be granted interest ^[4], and the GENIUS Act bars permitted issuers from paying interest or yield just for holding ^[7]. A return offered by someone else comes with that firm's risks.

5. Decide where it is held

   If a custodian is hacked, shuts down or goes bankrupt, you may lose access ^[9]. See custodial vs non custodial wallet and what exchange collapses teach.

Mistakes beginners make with stablecoins#

• Treating a stablecoin like cash in a bank

  Crypto accounts do not get SIPC or FDIC type protection ^[8], and in the UK FSCS cover is highly unlikely ^[3].

• Assuming $1 means $1 at any time

  Market prices can deviate from par ^[1]. If you must sell during stress, you take the price on offer.

• Chasing the yield

  TerraUSD was marketed with up to 20% interest, as the SEC alleged ^[6], and its value was wiped out ^[5].

• Thinking all stablecoins are alike

  Reserves range from bank deposits and Treasury bills to riskier assets ^[2], and some designs have no reserves at all.

Frequently asked questions#

The bottom line#

A stablecoin is a promise of a fixed value, and the promise is only as strong as the reserves, the redemption rights and the issuer behind it. The target is $1, but prices can slip, runs can happen, and TerraUSD shows that a design with little backing can go to nearly zero. Check the issuer, the reserves and where you hold the tokens, and be wary of any yield. Then read why crypto is so volatile and our risk disclosure.

Education only. This page is not investment, tax or legal advice. Trading and crypto can lose you money. See our risk disclosure.