What is a Stablecoin? - When "Stable" Killed $45 Billion

In May 2022, Terra's stablecoin UST collapsed from $1 to essentially zero in 72 hours. Forty-five billion dollars evaporated. People lost their life savings. The "stable" in stablecoin became crypto's darkest joke. And yet stablecoins remain crypto's most critical infrastructure—processing more daily transactions than Visa in many regions, enabling billions in DeFi lending, giving millions access to dollars their governments deny them.

A stablecoin is a cryptocurrency designed to maintain stable value, typically pegged 1:1 to the U.S. dollar. One USDC should always equal $1. The promise is simple: combine the stability of traditional money with crypto's speed and programmability. No more watching your salary swing 20% between Monday and Friday because you got paid in Bitcoin.

That promise solves crypto's fundamental problem. Bitcoin was designed to replace traditional money but it's too volatile to actually use as money. You can't price products, keep savings, or run payroll in a currency that moves 15% daily. Stablecoins fix this by maintaining price stability while preserving crypto's advantages—instant settlement, programmable money, global access without banks.

Understanding stablecoins means understanding the tension between promise and reality. Terra taught us "stable" doesn't mean "safe." Even established stablecoins de-peg during crises. USDC briefly dropped to $0.88 in March 2023 when Silicon Valley Bank failed. Tether trades with persistent questions about whether its reserves exist. Yet the stablecoin market exceeds $180 billion because these things solve real problems—when they don't catastrophically fail.

How USDC Actually Works

Circle, the company behind USDC, holds actual dollars in bank accounts and U.S. Treasury bonds. You deposit $1 million with Circle, they mint 1 million USDC tokens and give them to you. Those tokens enter circulation through exchanges. When someone wants to cash out, they send USDC back to Circle and receive actual dollars. Circle burns those returned USDC tokens, keeping supply matched to reserves.

The peg stays at $1 through arbitrage. If USDC trades at $1.02 on exchanges, arbitrage traders buy $1 million USDC directly from Circle for exactly $1 million, then sell it on the market for $1.02 million, pocketing $20,000 profit while their selling pushes price back to $1. If USDC drops to $0.98, traders buy cheap USDC and redeem it with Circle for $1, making profit while reducing supply and pushing price back up.

This model requires trust. You're trusting Circle maintains reserves and processes redemptions honestly. You're trusting the banks holding those reserves won't fail. That trust is why USDC publishes monthly reserve attestations. But trust is also why USDC de-pegged when Silicon Valley Bank collapsed—Circle had $3.3 billion sitting in that failed bank.

USDC represents about $35 billion of the stablecoin market. The largest is Tether's USDT at over $95 billion, using the same basic model but with far less transparency. Then there's DAI at around $5 billion, using smart contracts and cryptocurrency collateral instead of trusting a company.

Why They Exist

Stablecoins solve the problem that makes crypto markets functional. Before stablecoins, when Bitcoin crashed at 3 AM and you wanted to sell, you couldn't instantly convert to USD. Banks are closed. Wire transfers take days. International users don't have USD bank accounts. You either held volatile crypto or exited completely.

Stablecoins solved this perfectly. Sell Bitcoin for USDC in seconds. Maintain dollar value. Stay liquid on-chain. Re-enter positions whenever you want. This is why over 70% of cryptocurrency trading volume involves stablecoin pairs.

For DeFi, stablecoins provide the foundation. You can't lend ETH when its value swings wildly—terrible for both sides. Stablecoins let you lend and borrow with predictable value. Without stablecoins, DeFi's $90+ billion ecosystem couldn't exist. Cross-border payments genuinely help real people too. Global remittances total over $700 billion annually with 6-7% fees. Stablecoins offer an alternative—send USDT for $1, settled in minutes. In countries with hyperinflation or capital controls, stablecoins offer dollar stability when governments restrict it.

How Terra Went Wrong

Terra's algorithmic stablecoin UST represents everything that can go catastrophically wrong when you try to create stability without real backing.

Terra had two tokens. UST was the stablecoin, pegged to $1. LUNA was a volatile cryptocurrency. The system maintained the peg through a mechanism: if UST traded above $1, arbitrageurs could burn $1 worth of LUNA to mint 1 UST, then sell that UST for profit. If UST traded below $1, arbitrageurs could buy UST cheap, burn it to mint $1 worth of LUNA, sell the LUNA, and profit.

On paper, elegant. In practice, fatal—it only worked if people continued believing it would work. The system was backed by nothing except confidence. No reserves. No collateral. Just a mechanism relying on perpetual demand for LUNA.

To drive adoption, Terra offered 19-20% yields through Anchor Protocol. Those yields attracted billions and made UST the third-largest stablecoin at $18 billion. But those yields weren't sustainable—essentially paying new depositors with new deposits, classic Ponzi dynamics hidden behind DeFi terminology.

In May 2022, large UST withdrawals triggered the death spiral. As people rushed to exit, the algorithm minted massive amounts of LUNA to absorb selling pressure. LUNA hyperinflated from 350 million tokens to 6.5 trillion tokens in days. The more LUNA flooded the market, the less it was worth. The less LUNA was worth, the more had to be minted. Both tokens collapsed to near-zero, wiping out $45 billion.

Every major uncollateralized algorithmic stablecoin has failed or required bailouts. You cannot create stable value from nothing using clever algorithms. Stablecoins need either real reserves like USDC or overcollateralized assets like DAI.

The Honest Risks

Even working stablecoins carry real risks. USDC dropped to $0.88 in March 2023 when Silicon Valley Bank failed—Circle had $3.3 billion in that bank. The peg recovered within days, but "safe" stablecoins are vulnerable to banking system failures.

Tether maintains its peg despite persistent transparency concerns. They publish quarterly attestations but not full audits. Their reserves include Treasury bills, corporate bonds, and loans beyond cash. Yet USDT survived Terra's collapse and multiple crises without significant de-pegging.

Centralization risks matter. Circle and Tether can freeze your funds—they've done this for law enforcement. They operate under regulatory pressure that could force KYC requirements, geo-blocking, or outright bans in some jurisdictions.

Crypto-backed stablecoins like DAI face different risks: smart contract bugs and extreme market crashes that liquidations can't keep up with. DAI is censorship-resistant with fully on-chain collateral, but it now uses USDC as 30-40% of its backing, creating Circle dependency.

Never assume any stablecoin is completely safe. Terra proved billions in market cap offers no protection from flawed design.

The Pragmatic Approach

Use stablecoins for what they're good at: trading between crypto positions, short-term DeFi yields, and cross-border payments where speed outweighs de-pegging risks.

Don't use stablecoins as long-term savings—they're not FDIC-insured. Don't put in more than you can afford to lose. Don't assume the peg is guaranteed. And absolutely avoid algorithmic stablecoins—every major example has failed catastrophically.

USDC is considered safest due to U.S. regulation and transparent reserves. DAI offers decentralization with on-chain collateral but carries smart contract risk. USDT has the deepest liquidity but transparency concerns persist.

Diversify across multiple stablecoins to reduce single-point-of-failure risk. Split between USDC and DAI to avoid both centralized and smart contract risks.

What Comes Next

Stablecoins aren't going away. They solve too many real problems. They enable crypto trading. They power DeFi. They provide dollar access where governments restrict it. The question isn't whether stablecoins will exist—it's what form they'll take under increasing regulation.

Governments are moving toward comprehensive stablecoin regulation. The likely outcome is a two-tier system: compliant stablecoins like USDC that are regulated as banks, require KYC, and operate with full transparency. Then there are decentralized stablecoins like DAI that exist in regulatory gray zones, maintaining permissionless access but facing potential restrictions.

The Terra collapse accelerated regulatory interest. When $45 billion evaporates and regular people lose their savings, regulators pay attention. Expect increasing requirements for reserve transparency, third-party audits, and potentially full banking licenses. These requirements will make stablecoins safer but also more expensive and centralized.

Major fiat-backed stablecoins have proven resilient through multiple crises. They've processed trillions in transactions without catastrophic failures—Terra aside. Use stablecoins for what they're good at—trading, moving value, accessing yields. Just understand they're not as stable as actual dollars in insured bank accounts.

Further Reading:

• Circle USDC Transparency - Monthly reserve attestations
• Tether Transparency Reports - Quarterly reserve data
• MakerDAO Governance - DAI collateral parameters
• DeFi Llama Stablecoins - Real-time market data
• Terra/LUNA Collapse Timeline - Detailed analysis
• Bank for International Settlements - Stablecoin regulatory framework
• Federal Reserve Research - Economic impact study
• IMF Crypto-Asset Regulation - Global perspective