Track 5 · Tokens · lesson 9

What actually backs a stablecoin

10 min

A stablecoin is an ERC-20 like the one you wrote, with one extra promise: one token should always be worth one dollar.

Nothing in the contract enforces that. The peg is a claim about the world outside, and the interesting question is always what makes the claim credible.

Three ways to try

Fiat-backed — USDC, USDT. A company holds dollars in a bank and issues tokens against them. Redeem a token, get a dollar. Simple, and it works as well as the company does.

Crypto-backed — DAI. Lock up more crypto than you borrow — say $150 of ETH for $100 of DAI — and the excess absorbs price falls. If your collateral drops too far, it is liquidated automatically.

Algorithmic — no meaningful collateral, just a mechanism promising to balance supply and demand. This category has a poor record.

The trade is always the same shape. Fiat-backed is the most reliable and the most centralised: the issuer can freeze your tokens, and USDC's issuer has done exactly that on request from law enforcement.

Crypto-backed is decentralised and capital-inefficient — you must lock more value than you get.

Algorithmic promises both and has repeatedly delivered neither.

What happened to Terra

In May 2022, UST was algorithmic. Its peg relied on being able to burn UST for $1 of a sister token, LUNA, whenever UST traded below a dollar.

The mechanism worked while people believed in LUNA. When confidence went, the arbitrage minted enormous quantities of LUNA, whose price collapsed, which destroyed the very thing backing UST.

Roughly $40 billion evaporated in under a week.

Predict

A fiat-backed stablecoin claims full reserves. What would make that claim trustworthy?

Choose one answer

Why they matter anyway

Despite all that, stablecoins are the most used product in crypto. They settle more value than most payment networks, because "a dollar that moves like an email" is genuinely useful — for remittances, for savings in countries with unstable currencies, and as the unit every DeFi protocol prices in.

Check

Where does a fiat-backed stablecoin's value actually come from?

Choose one answer

Worth remembering

  • A stablecoin is an ordinary ERC-20; the peg is a claim about the outside world, not a contract feature.
  • Fiat-backed is reliable and centralised — issuers can and do freeze tokens.
  • Crypto-backed is decentralised but requires over-collateralisation.
  • Algorithmic designs promise both and have repeatedly failed; Terra destroyed ~$40bn in a week.
  • No on-chain mechanism can verify an off-chain bank balance.