How Stablecoins Maintain Their Peg: USDT, USDC, and the Trust Spectrum

The Core Challenge: Stability in a Volatile Market

Cryptocurrencies are known for dramatic price swings — Bitcoin has seen 80% drawdowns and 10x rallies within single years. This volatility makes them poor mediums of exchange for everyday transactions and difficult to use as collateral in lending protocols. Stablecoins solve this by targeting a fixed exchange rate, almost always $1 USD, using mechanisms that range from simple bank accounts to autonomous algorithms running entirely on-chain. Understanding how each approach works — and where it can fail — is essential to understanding modern decentralized finance.

Fiat-Backed Stablecoins: The Simplest Design

The most widely used stablecoins — Tether (USDT) and USD Coin (USDC) — use the most straightforward possible peg mechanism: keep real dollars in a bank account and issue tokens that represent claims on those dollars.

How the Peg Holds

When an institution or authorized user deposits $1,000,000 into Tether's reserve account, Tether mints 1,000,000 USDT. When they redeem 1,000,000 USDT, Tether burns those tokens and wires back $1,000,000. This create-and-destroy mechanism, combined with arbitrage, keeps the price near $1.

If USDT trades at $0.99 on an exchange, arbitrageurs buy USDT cheaply, redeem it directly with Tether for $1 in cash, and pocket the difference. This buying pressure pushes the price back up. If USDT trades at $1.01, arbitrageurs deposit $1 with Tether, receive 1 USDT, sell it for $1.01, and profit $0.01. This selling pressure pushes the price back down.

Reserve Composition and Counterparty Risk

The critical question for fiat-backed stablecoins is what, exactly, is in the reserve. USDC publishes monthly attestations by Grant Thornton showing reserves held in short-duration US Treasuries and cash equivalents. Tether's reserve composition has historically been more opaque and has included commercial paper, secured loans, and other assets beyond pure cash.

This matters because fiat-backed stablecoins introduce traditional financial counterparty risk: the issuer could be insolvent, the reserve bank could fail (USDC briefly depegged to $0.87 during the Silicon Valley Bank collapse in March 2023 when $3.3 billion of its reserves were frozen), or regulators could freeze assets. The on-chain token is only as good as the off-chain institution backing it.

Crypto-Collateralized Stablecoins: Trustless but Complex

MakerDAO's DAI, launched in 2017, was the first major attempt to create a dollar-pegged stablecoin backed entirely by on-chain crypto assets — initially only ETH, later expanded to multiple collateral types. The design trades simplicity for trustlessness.

Collateralized Debt Positions

To mint DAI, a user locks ETH (or another accepted collateral) into a smart contract called a Vault. The protocol enforces a collateralization ratio — initially 150% for ETH, meaning you must lock $1.50 of ETH to mint $1.00 of DAI. This overcollateralization creates a buffer against price volatility.

If ETH falls in price and a Vault's collateral ratio drops below the liquidation threshold, the Vault is automatically liquidated: the protocol sells the collateral at a discount to repay the outstanding DAI debt, plus a liquidation penalty that goes into a reserve fund. This automated enforcement means DAI's solvency does not depend on any human acting honestly.

fee-and-peg-maintenance">The DAI Stability Fee and Peg Maintenance

MakerDAO uses interest rates — called the Stability Fee on borrowing and the DAI Savings Rate on deposits — to manage peg pressure. If DAI trades below $1, the protocol raises the Stability Fee (making it more expensive to borrow DAI, reducing supply) and raises the Savings Rate (making it more attractive to hold DAI, reducing selling pressure). If DAI trades above $1, it lowers both rates. DAI also maintains a PSM (Peg Stability Module) that allows direct 1:1 swaps between DAI and USDC, anchoring the peg through arbitrage with a fiat-backed stablecoin.

The Trade-Off: Capital Inefficiency

The requirement for 150%+ overcollateralization means crypto-collateralized stablecoins are inherently capital-inefficient. To put $1 million of DAI into circulation requires locking $1.5 million or more of ETH. This cost is borne by the borrowers in the form of foregone investment opportunity.

Algorithmic Stablecoins: Supply Elasticity Without Collateral

Algorithmic stablecoins attempt to maintain a peg using supply expansion and contraction rules, without holding a matching reserve. In theory, if a token trades above $1, the protocol mints more (expanding supply, pushing price down). If it trades below $1, it contracts supply (pushing price up).

The Seigniorage Shares Model

Early algorithmic designs used a two-token model: a stablecoin and a "share" or "bond" token that absorbs volatility. When the stablecoin trades above $1, new stablecoins are minted and distributed to share token holders. When it trades below $1, the protocol sells bonds at a discount, promising future stablecoin at a premium to incentivize people to burn stablecoins and reduce supply.

This model has a fatal structural weakness: it relies on continued demand growth to function. If confidence collapses, the bond discount deepens, share token holders are diluted, and confidence collapses further — a bank-run dynamic with no floor.

TerraUSD: The Canonical Failure

TerraUSD (UST) and its sister token LUNA illustrated this failure mode at catastrophic scale in May 2022. UST maintained its peg through a mint-burn mechanism: 1 UST could always be minted by burning $1 worth of LUNA, and vice versa. This arbitrage loop was meant to absorb peg deviations automatically.

The system was stable when demand for UST was growing. But when large holders began selling UST simultaneously, the peg slipped. The arbitrage mechanism required minting LUNA to absorb the selling — but minting LUNA inflated its supply, crashing its price, which further destabilized the peg, which required minting more LUNA. Within 72 hours, LUNA's market cap collapsed from $30 billion to near zero, and $18 billion of UST value was destroyed. The death spiral was self-reinforcing and unstoppable once it began.

Hybrid Approaches: Frax and Partial Collateralization

Frax Finance introduced a partial collateralization model where the stablecoin is backed by a mix of USDC (collateral) and its governance token FXS (algorithmic component). The collateral ratio adjusts dynamically based on market conditions — when demand for FRAX is high, the collateral ratio decreases (more algorithmic); when confidence is low, it increases (more collateral-backed).

This hybrid approach attempts to capture the capital efficiency of algorithmic designs while retaining the stability backstop of real collateral. As of 2024, Frax v3 has moved toward a predominantly collateral-backed model after the TerraUSD crisis shook confidence in purely algorithmic approaches across the industry.

Comparing the Four Approaches

Arbitrage as the Universal Mechanism

Across all stable peg designs, arbitrage is the universal corrective force. Any time a price deviation creates a risk-free profit opportunity — buying cheap USDC and redeeming it for $1, minting fresh DAI and selling it above $1, burning UST to mint LUNA and selling LUNA — rational market participants will exploit it and, in doing so, push prices back toward the target.

The stability of any peg therefore depends on two things: that the arbitrage path actually exists and is accessible, and that the mechanism being arbitraged is genuinely solvent. When either condition fails — as in TerraUSD's collapse — no amount of algorithmic rule-setting can substitute for the underlying economic reality.