Tether
USD Coin
The Stability Paradox
Cryptocurrency's core value proposition — censorship resistance, permissionless access, programmable money — is fundamentally undermined for everyday commerce by price volatility. A loan denominated in ETH is difficult to service if ETH's dollar value drops 40% in a week. A salary paid in BTC creates unpredictable purchasing power. The stablecoin sector emerged to solve this: create tokens that inherit blockchain's programmability while maintaining a stable value relative to a fiat currency (almost always the US dollar).
The three major approaches to achieving this stability make fundamentally different tradeoffs between decentralization, capital efficiency, and risk profile. Examining each model — fiat-backed, crypto-collateralized, and algorithmic — reveals that stability is never free; it is always purchased at a cost, and understanding that cost is essential to understanding when each model works and when it fails catastrophically.
Fiat-Backed Stablecoins: USDT and USDC
The simplest model is the most intuitive: an entity holds real dollars (or dollar-denominated assets) in a bank account and issues tokens representing claims on those deposits. USDT (Tether), launched in 2014, pioneered this approach. Circle's USDC, launched in 2018 with stronger compliance infrastructure, later became the preferred choice for institutional and DeFi users.
The stability mechanism is straightforward. If USDT trades below $1.00, arbitrageurs can buy cheap USDT and redeem it for $1.00 in cash from Tether, profiting from the difference and pushing the price back up. If USDT trades above $1.00, arbitrageurs can deposit $1.00 and receive new USDT tokens to sell at the premium. This two-directional arbitrage keeps the peg tight.
The security of this model depends entirely on the trustworthiness of the issuer and the quality of the reserves. USDT's reserve composition has been a persistent controversy. Tether's 2021 settlement with the New York Attorney General revealed that USDT had not been fully backed by dollars throughout 2018-2019. Subsequent reserve attestations showed that a significant fraction of reserves were held in commercial paper (short-term corporate debt) rather than cash or US Treasury bills, creating credit and liquidity risk.
USDC, by contrast, publishes monthly attestations from major accounting firms and maintains reserves primarily in cash and short-duration US government securities. During the March 2023 Silicon Valley Bank crisis, USDC briefly depegged to $0.87 when Circle disclosed that $3.3 billion of its reserves were held at SVB. The depeg resolved within hours once Federal Reserve intervention protected depositors, but it illustrated that even high-quality fiat-backed stablecoins carry off-chain counterparty risk.
The Centralization Trade
Fiat-backed stablecoins achieve stability through centralization. The issuer can blacklist addresses, freeze funds, and comply with government requests to seize assets. USDT and USDC both have administrator functions that allow freezing specific addresses — a feature used in response to OFAC sanctions and law enforcement requests.
This centralization makes fiat-backed stablecoins incompatible with fully permissionless DeFi applications. A lending protocol that relies on USDC collateral could have that collateral frozen by Circle — the same financial control that makes USDC trustworthy for regulatory purposes creates systemic risk for DeFi applications built on top of it.
Crypto-Collateralized Stablecoins: DAI and MakerDAO
MakerDAO's DAI, launched in 2017, pioneered a different approach: maintain a stable peg without relying on any centralized entity holding dollars. Instead, users deposit cryptocurrency (initially only ETH, later a wider collateral basket) into smart contract "vaults" and mint DAI against it at an overcollateralization ratio — typically 150% or higher.
If a user deposits $1,500 worth of ETH, they can mint at most $1,000 in DAI (150% collateralization). The excess collateral provides a buffer: if ETH's price falls, the vault remains solvent until ETH drops more than 33%. When collateral falls below the minimum ratio, the vault is automatically liquidated — the collateral is sold at auction to repay the outstanding DAI plus a liquidation penalty.
The stability mechanism works through two levers. On the supply side, the Stability Fee (an interest rate charged on outstanding DAI) can be raised to discourage minting and contract supply, or lowered to encourage minting and expand supply. On the demand side, the DAI Savings Rate offers interest to DAI holders who deposit into the protocol, absorbing excess DAI supply.
Both levers are governed by MKR token holders through on-chain governance — making DAI's stability mechanism genuinely decentralized and censorship-resistant at the protocol level.
The Overcollateralization Cost
DAI's stability comes at a significant capital efficiency cost. A user who wants $1,000 in stablecoin liquidity must lock up $1,500+ in collateral. This capital inefficiency is the direct price of eliminating custodian risk. The collateral earns no yield while locked (though liquid staking collateral partially addresses this), and the user bears liquidation risk if the collateral asset drops rapidly.
MakerDAO has progressively added non-crypto collateral to improve capital efficiency and peg stability — most controversially, adding USDC and real-world assets (tokenized US Treasury bills via institutional partners) as collateral types. This pragmatic evolution has improved DAI's stability but reintroduced some of the centralization risks the model was designed to avoid.
Algorithmic Stablecoins: The High-Risk Frontier
Algorithmic stablecoins attempt the most ambitious goal: maintain a stable peg with minimal or no direct collateral, instead relying on algorithmic supply adjustments and market incentives. If successful, this would be the most capital-efficient model by far. The history of the sector is a cautionary tale about the limits of algorithmic stability.
Terra/Luna: The Death Spiral
Terra's UST, at peak the third-largest stablecoin by market cap, operated on a mint-and-burn mechanism. Users could always mint $1 of UST by burning $1 worth of LUNA (Terra's governance token), and could always burn $1 of UST to mint $1 worth of LUNA. This arbitrage mechanism was designed to maintain the peg: if UST fell below $1, arbitrageurs would buy cheap UST and burn it for LUNA, reducing UST supply and raising the price.
The mechanism worked while demand for UST was growing. The Anchor Protocol offered 20% APY on UST deposits, creating artificial demand that sustained the peg through constant growth. When Anchor's unsustainable yields attracted scrutiny and large UST holders began exiting in May 2022, the arbitrage mechanism ran in reverse: panic selling of UST required burning massive amounts to mint LUNA, hyperinflating LUNA's supply, collapsing LUNA's price, reducing the USD value of the mint-and-burn backstop, triggering more panic selling. $40 billion in combined market cap evaporated in approximately 72 hours.
The Terra collapse demonstrated that purely algorithmic stablecoins backed only by governance tokens are fundamentally circular: the system's solvency depends on confidence, and confidence collapses precisely when the system needs solvency most.
FRAX: Fractional-Algorithmic
FRAX, launched in 2020, attempts a middle path. Rather than full collateralization or pure algorithmics, FRAX maintains a dynamically adjusted collateral ratio. When demand is high and the peg is strong, the protocol reduces its collateral ratio — issuing more FRAX per unit of collateral. When the peg is weak, the protocol increases the collateral ratio.
At its most aggressive, FRAX operated at 85-90% collateral ratio, meaning each FRAX was backed by $0.85-0.90 in USDC plus algorithmic mechanisms. During the 2022 market stress, FRAX moved to essentially 100% collateral backing, demonstrating that the "algorithmic" component primarily functions as a capital efficiency mechanism during bull markets rather than a fundamental stability backstop.
Failure Modes and Systemic Risks
Each stablecoin model has characteristic failure modes:
Fiat-backed: Custodian insolvency, reserve mismanagement, regulatory seizure. Resilient to crypto market crashes but exposed to traditional financial system risks. Recovery from depeg depends on issuer intervention.
Crypto-collateralized: Rapid collateral price decline faster than liquidation mechanisms can process. MakerDAO's March 2020 "Black Thursday" demonstrated this: ETH's price dropped so fast that DAI liquidation auctions settled at near-zero bid with network congestion preventing normal participation. The protocol lost millions in DAI that couldn't be recovered through normal liquidation.
Algorithmic: Confidence collapse and death spirals, as Terra demonstrated. No pure algorithmic stablecoin has survived a serious market stress test without either breaking its peg or reverting to significant collateral backing.
The stablecoin landscape in 2024 reflects these lessons. Fiat-backed USDT and USDC dominate by market cap, despite their centralization. DAI has evolved into a hybrid with significant fiat collateral backing. Pure algorithmic models have largely failed or remained small. The search for a decentralized, capital-efficient, and stable token continues — the fundamental tradeoffs have not been resolved, only navigated with varying degrees of success.