Stablecoins: What They Are and How They Break

A stablecoin is a token designed to hold a fixed value, usually one US dollar. The design is simple; the ways it fails are not, and understanding them explains why yield products built on stablecoins have collapsed.

The mechanism

There are three broad designs, and the difference in risk is substantial.

Fiat-backed stablecoins hold the equivalent in bank reserves and redeem for dollars on demand. This is the model most people mean when they say stablecoin.

Crypto-collateralised stablecoins are minted against other crypto deposited as collateral. They are over-collateralised and algorithmically managed, which introduces mechanism risk that fiat-backed does not have.

Algorithmic ones use a mint-and-burn mechanism and incentives rather than reserves. Their history is the worst of the three.

Why fiat-backed ones hold

The backing is auditable, and the redemption path is direct: send it, receive dollars. That is why the largest stablecoins have held their peg through multiple crises while algorithmic designs failed immediately.

The caveat is that holding a stablecoin is a claim on the issuer's reserves, so issuer solvency and redemption access matter more than the token's mechanism.

What a depeg looks like

A depeg is a sustained departure from the target price, usually downward. It tends to happen when redemption is stressed, when liquidity thins, or when market confidence in the backing weakens.

The mechanism matters for recovery. A fiat-backed stablecoin that briefly loses its peg often returns once redemptions clear, because the backing is still there. An algorithmic one has no external source of value to draw on, so the peg becomes a self-reinforcing problem.

Why this matters for yield

Yield products promising returns on stablecoins inherit the stablecoin's risk plus the protocol's. A high APY paid in a token with a shaky peg is not a high yield; it is compensation for a risk most users did not know they were taking.

Check what backs the yield source and what backs the asset being farmed. Two unexamined dependencies stacked on each other is a common way this goes wrong.

Using them sensibly

Use stablecoins for what they are good at: a unit of account and a low-volatility settlement asset. Check the issuer and the redemption mechanism before holding a large balance, and treat unexplained peg movement as information rather than noise.

Checking what backs the asset

Fiat-backed stablecoins publish attestations of reserves. That is not the same as an audit, and it is not the same as seeing the reserves, but it is meaningfully better than no disclosure.

Crypto-collateralised stablecoins are over-collateralised, so the mechanism is designed to hold. The failure modes are different: liquidation cascades during a market crash, or a depegs driven by redemption demand rather than by reserve quality.

Reading a stablecoin APY

Ask what is paying it. If the answer is borrowers in a lending market, the rate reflects demand and defaults. If the answer is a token that prints, the rate reflects dilution and will fall as capital arrives.

Practical handling

Treat a stablecoin as a settlement and working asset rather than a savings vehicle. Use it where you need a unit of account, and move longer-term holdings to an asset you can hold without relying on a third party's redemption promise continuing to work.

Reading a stablecoin APY

Before accepting any figure, check the source:

• If borrowers pay it, the rate reflects demand and defaults.
• If a token prints, the rate reflects dilution and will fall as capital arrives.
• If it comes from a reward pool, check what is funding that pool.

Frequently asked questions

Can a stablecoin go below one dollar?

Yes. It has happened, usually when redemptions are stressed or liquidity thins. The more significant question is whether it recovers, which depends on whether there is real backing to redeem into.

What is the difference between USDC and USDT?

Both are fiat-backed, but they are issued by different companies with different reserves and different redemption processes. The practical question is whether the issuer's reserves are attested and whether redemption currently works, not which ticker is more familiar.

Why does a stablecoin APY sometimes collapse?

Because the yield is being paid by someone, and when that source disappears so does the rate. A high stablecoin yield usually means the protocol or the borrower is taking risk that is not stated in the headline figure.