Cryptocurrencies have come a long way since Bitcoin’s debut in 2009. While they’ve introduced groundbreaking financial innovation, one persistent challenge remains: volatility. Prices swing wildly—sometimes by double-digit percentages in a single day—making them unreliable for everyday transactions or long-term value storage. This instability has led to growing interest in stablecoins, digital assets designed to maintain a consistent value, typically pegged to a fiat currency like the US dollar.
But how do stablecoins actually work? And what happens when they fail? Recent market events and academic research shed light on the mechanisms behind these digital currencies, the risks involved, and how stability can be better ensured in the future.
Understanding Stablecoins and Their Role
Stablecoins aim to bridge the gap between traditional finance and the decentralized world of blockchain. By pegging their value to stable assets—like the US dollar—they offer the benefits of cryptocurrency (fast, borderless transactions) without the extreme price swings. Popular examples include Tether (USDT), USD Coin (USDC), and the now-defunct TerraUSD (UST).
The appeal is clear: over $125 billion worth of stablecoins were issued globally by 2023, up from just $3 billion in 2019. However, this rapid growth has been shadowed by high-profile failures—most notably TerraUSD’s collapse in May 2022, which erased nearly $45 billion in value and shook investor confidence across the crypto ecosystem.
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The Mechanics Behind Algorithmic Stablecoins
Not all stablecoins are created equal. There are three main types:
- Fiat-collateralized (backed 1:1 by cash or cash equivalents)
- Crypto-collateralized (backed by other digital assets)
- Algorithmic (not backed by collateral, but stabilized through code and incentives)
The focus of recent research by Adrien d’Avernas (Stockholm School of Economics), Vincent Maurin (HEC Paris), and Quentin Vandeweyer (Chicago Booth) centers on algorithmic stablecoins—fully digital systems that rely on supply adjustments rather than tangible reserves.
These coins aim to maintain a $1 peg through dynamic supply management:
- When demand increases and price rises above $1, new coins are minted to bring the price down.
- When demand drops and price falls below $1, the issuer buys back coins from the market to reduce supply and restore value.
To fund buybacks during downturns, issuers offer future redemption tokens—digital promises that can be exchanged for new stablecoins once the price recovers. For example:
- If the price drops to $0.90, the issuer buys back coins and gives sellers these tokens.
- When confidence returns and the price hits $1.10, token holders redeem them for newly minted coins at $1, profiting from the spread while helping push the price back down.
This creates a self-correcting mechanism—in theory. Vandeweyer compares it to a central bank managing monetary policy: absorbing shocks using reserves and forward-looking incentives.
The Critical Role of Confidence and Equity Value
While elegant in design, algorithmic stablecoins depend heavily on market confidence. As Vandeweyer notes, “If everyone believes that they are in a stable equilibrium, then you’re going to behave as though it is stable.” But belief alone isn’t enough.
The system’s resilience hinges on the value of equity tokens—digital assets akin to company shares that represent ownership in the issuer’s future profits. These tokens provide the capital needed for buybacks during crises.
Consider this scenario:
- 1 million stablecoins are in circulation.
- Equity tokens have a market cap of $500,000.
- A sudden drop in demand causes the stablecoin price to fall to $0.40.
At this point, the issuer may try to create more equity tokens to raise funds for buybacks. But if investors lose faith, those new tokens could become worthless—rendering the rescue attempt futile. Without sufficient backing, there’s no way to restore the peg. This dynamic closely mirrors what happened with TerraUSD.
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Collateralization: A Safer Path Forward?
Recognizing these vulnerabilities, some experts argue that full collateralization is essential for long-term stability. Regulators like the U.S. Securities and Exchange Commission have proposed requiring stablecoin issuers to hold $1 in cash reserves for every $1 of coins issued.
This eliminates reliance on speculative equity or complex algorithms. However, it raises another question: Why would users prefer a fully backed stablecoin over actual dollars?
The answer lies in accessibility and utility:
- In countries with hyperinflation or restricted access to USD (e.g., Argentina, Nigeria), stablecoins offer a practical alternative.
- They enable instant cross-border payments without intermediaries.
- They integrate seamlessly with decentralized finance (DeFi) platforms for lending, borrowing, and earning yield.
Thus, even fully collateralized stablecoins can generate profit for issuers—not through seigniorage alone, but by facilitating global financial inclusion and innovation.
Lessons from Past Failures
The collapse of TerraUSD wasn’t just a technical failure—it was a crisis of trust amplified by flawed incentives. Similarly, USD Coin briefly depegged in March 2023 due to its partial backing by debt securities from Silicon Valley Bank before its collapse.
These incidents highlight a key insight: even partially collateralized systems carry risk when collateral itself is volatile. True stability requires either:
- Full cash backing
- Diversified, low-risk reserves
- Transparent audits and regulatory oversight
Without these safeguards, stablecoins remain vulnerable to panic-driven runs—especially during broader market stress.
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Frequently Asked Questions
Q: What is a stablecoin?
A: A stablecoin is a type of cryptocurrency designed to maintain a stable value, usually pegged to a fiat currency like the US dollar.
Q: Are all stablecoins safe?
A: No. Safety depends on the type—fully collateralized stablecoins backed by cash are generally safer than algorithmic ones relying on code and market incentives.
Q: Why did TerraUSD fail?
A: It relied on an algorithmic model that collapsed when confidence waned and equity token value plummeted during a demand shock.
Q: Can stablecoins make money for issuers?
A: Yes—by investing reserve assets conservatively or offering financial services in emerging markets where USD access is limited.
Q: Is regulation important for stablecoins?
A: Absolutely. Clear rules around reserves, audits, and disclosure help protect users and maintain systemic stability.
Q: What’s the future of stablecoins?
A: Expect increased regulation, greater adoption in emerging economies, and continued innovation in hybrid models combining collateral with smart incentives.
Conclusion
Making cryptocurrencies more stable isn’t just about smoothing out price charts—it’s about building trust, ensuring transparency, and designing resilient systems. While algorithmic models offer elegance, they also expose critical fragilities when confidence falters. The path forward likely lies in fully collateralized models with robust oversight, combined with global access and programmable utility.
As digital finance evolves, so too must our understanding of what “stability” really means—and how to achieve it in a decentralized world.
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