How do stablecoins work? A complete guide for traders

Stablecoins are digital currencies on blockchain networks designed to hold a steady value—usually pegged to $1.00. They're used across crypto for trading, lending, payments, and as a store of value between positions. This guide covers how they maintain that value, what backs them, how redemptions work, and what happens when things go wrong. For a primer on what stablecoins are and the basic types, see our beginner's guide.

Key takeaways about stablecoins

• Stablecoins are digital currencies designed to hold a steady value by being backed, or pegged. The systems that keep them stable vary, and each model has its own risks and considerations.

• The main stablecoin backing models are fiat-backed, crypto-backed, and algorithmic, with DAI as a crypto-collateralized example and TerraUSD as a failed algorithmic example.

• Most traders can't redeem stablecoins directly with the issuer. Institutional players can, and that's what keeps the price at a fixed amount for everyone else.

• The GENIUS Act (US) and MiCA (EU) now regulate stablecoin issuers and determine which tokens are available where.

• The stablecoin market hit $321 billion in April 2026, with USDT making up 59% of the total.

Disclaimer: This article is for educational purposes only. It is not financial advice, not a solicitation, and not for UK audiences. Stablecoins are risky and not suitable for all users.

How stablecoins maintain their value

Every stablecoin has a target price called the peg, commonly pegged to 1 USD, though some track other currencies (EURC tracks the euro and tGBP tracks the pound), or commodities (PAXG tracks gold).

No government enforces the peg. It holds through a self-correcting cycle called an arbitrage loop. For fiat-backed stablecoins like USDT, USDC, and mUSD, it works like this: the issuer promises to redeem each token for $1.00. If the market price drops to $0.98, large traders buy cheap tokens and redeem them for a full dollar, pocketing the difference. That buying pressure pushes the price back up. If the price rises above $1.00, the same traders mint new tokens at $1.00 and sell them higher, pushing it back down.

This loop works if two things are true: the reserves behind the token are real, and the redemption process actually functions. Both of these topics are covered below.

What backs a stablecoin

There are three main approaches to stablecoin backing. For a basic overview, see the beginner's guide to stablecoins.

Fiat-backed: An issuer holds reserves—cash, government bonds, or other liquid assets—and promises to redeem each token at face value. USDT, USDC, and mUSD all work this way. The quality of what's actually in the reserves varies significantly between issuers (see the reserves section below).

Crypto-backed: Instead of holding dollars, the system locks up more crypto than the stablecoin is worth; DAI is the main example, and creating $100 of DAI typically requires substantial overcollateralization in crypto, with the exact ratio varying by collateral type.

Algorithmic stablecoins: Software manages the token supply to keep the price on target, with no reserves or collateral behind it. This model has largely failed. TerraUSD collapsed in May 2022, destroying roughly $40 billion in value when its death spiral—falling price triggering more selling triggering lower price—couldn't be stopped.

Collateralization of stablecoins

For fiat-backed stablecoins, the target is simple: each stablecoin token in circulation is backed 1:1 with a dollar, euro, pound, or unit of currency in reserve. That's 1:1 collateralization.

For crypto-backed stablecoins, the ratio of collateralization needs to be much higher because crypto prices move fast. For example, DAI requires at least 150% collateralization for ETH vaults—$150 of ETH locked up for every $100 of DAI created. More volatile collateral types require 170% or more.

If the collateral drops in value, the smart contract (a program that runs automatically on the blockchain) starts selling it to keep the stablecoin fully backed. In normal markets this works smoothly. In a crash, it can cascade—forced selling pushes prices lower, which triggers more forced selling, which pushes prices lower still. This is closely related to how liquidation works in leveraged trading. For more on that, see perpetual futures liquidation mechanics.

One advantage of the crypto-backed model: collateralization ratios are visible onchain in real time. With fiat-backed stablecoins, reserve information depends on the issuer publishing it.

Reserves and transparency

When an issuer says their stablecoin is "backed 1:1," the next question is: backed by what?

Cash and short-dated government bonds are among the most liquid reserves, and they can often be sold quickly near face value even in stressed markets. Riskier assets like corporate bonds, secured loans, or other crypto are harder to sell quickly and can lose value at exactly the moment the issuer needs to liquidate them.

Here's what the major issuers hold:

mUSD is backed by short-term US Treasury bills held in regulated custody, issued by Bridge (a Stripe subsidiary) and powered by the M0 protocol.

USDC holds cash and short-dated Treasuries, with reserve information published through issuer disclosures and attestations.

USDT reserves are dominated by US Treasuries (~80%), with smaller allocations to secured loans, gold, Bitcoin, and other investments, verified quarterly by BDO Italia.

Most issuers publish "attestations," rather than full audits. An attestation confirms reserves matched tokens on one specific date—a snapshot. An audit examines records, controls, and processes over time. Most of the industry still runs on attestations.

Redemption of stablecoins explained

Redemption is the process of handing a stablecoin back to the issuer and receiving dollars (or equivalent assets) in return. It's what makes the arbitrage loop work—without functioning redemption, the loop has no anchor and the peg has no floor.

What most traders don't realize: direct redemption is usually limited to institutional players—banks, market makers, and qualified firms. When a regular trader sells USDC on an exchange, they're trading with another person on the open market, not redeeming with Circle. The price stays near $1.00 because those institutional players can redeem, and their activity keeps the market honest. But retail access to that mechanism is indirect.

Speed matters. Some issuers process redemptions within hours, others take days. During high-demand periods—exactly when everyone wants out—processing times can stretch. The GENIUS Act requires permitted issuers to honor redemptions at a fixed monetary value, though detailed implementation rules may still be subject to regulation.

What happens when things go wrong with stablecoins?

A depeg is when a stablecoin's price moves meaningfully away from its target and doesn't snap back right away. These events have become less frequent—depeg events dropped roughly 80% after 2023 as regulation and reserve practices improved, and only 9 depegs exceeding 1% deviation were recorded across major stablecoins in 2025. But the risk hasn't disappeared. Three patterns repeat:

Trust collapses. Holders doubt the reserves and rush to sell. USDC dropped to $0.87 during the Silicon Valley Bank crisis in March 2023 when traders couldn't be sure the reserves were accessible.

The mechanism fails. TerraUSD's algorithmic system entered a death spiral in May 2022—falling prices triggered more selling, which triggered more selling. It never recovered.

Problems spread. When one stablecoin depegs, others that depend on it can follow. During the SVB crisis, DAI depegged too because more than half its backing was USDC.

For traders, this matters directly: if a stablecoin used as collateral for a leveraged position drops even 2–3%, that alone can force the position closed—even if the underlying trade hasn't moved.

How the major stablecoins compare

Stablecoin yield

Stablecoins can earn returns through lending programs on blockchain networks. Depositors put stablecoins in, borrowers take them out and pay interest, and the depositor earns a share. Rates move based on borrowing demand—there's no fixed return.

MetaMask's Stablecoin Earn lets users deposit USDC, USDT, or DAI into Aave directly from the app. There's no lock-up period and no additional MetaMask fees. Deposits generate a receipt token (like aUSDC for a USDC deposit) that tracks the original amount plus accumulated earnings.

The risks are different from a bank account. A flaw in the lending program's code could result in lost funds. Returns can compress if borrowing demand drops. And if the stablecoin itself depegs, the deposit loses value regardless of interest earned.

A brief overview of stablecoin regulations

The US and EU both passed stablecoin-specific laws in 2024–2025, and the effects are already visible.

The US GENIUS Act requires issuers to hold 1:1 reserves in cash, central bank deposits, or short-dated government bonds, publish monthly reserve reports, and establish reserve protections for stablecoin holders.

The EU's Markets in Crypto-Assets Regulation (MiCA) requires issuers to be formally authorized in the EU. Tether didn't apply, so USDT is no longer available on major EU exchanges.

Which stablecoins are available depends on where the trader is. A token freely tradeable in the US may not be on EU exchanges, and vice versa.

Stablecoin article summary

Stablecoins maintain their value through arbitrage loops, reserve backing, and overcollateralization—not through guarantees. The three dominant models are fiat-backed (USDT, USDC, mUSD), crypto-backed (DAI), and algorithmic (largely failed after the TerraUSD collapse in 2022). Reserve quality varies: cash and short-dated government bonds are the safest backing, while riskier assets can fail under redemption pressure. Most traders interact with stablecoins on the open market, not through direct redemption with the issuer—institutional players handle that, and their activity is what keeps the price stable. The GENIUS Act in the US and MiCA in the EU now set requirements for reserve composition, reporting, and issuer licensing, and determine which stablecoins are available in which jurisdictions. As of April 2026, the stablecoin market stood at $321 billion, with USDT accounting for 59% of the total. MetaMask supports USDT, USDC, DAI, and mUSD across major blockchain networks, with stablecoin lending through Aave and spending through MetaMask Card.