How stablecoins keep their peg

What a peg really is

A stablecoin is a token designed to trade at a fixed value, most often one US dollar. Nothing in the token itself forces that price. On an exchange it trades like any other asset, and its price moves with supply and demand. The peg holds when there is a reliable way to turn the token into a dollar's worth of something else, and traders who profit from closing any gap.

That makes the question for any stablecoin simple to state: if the price slips to 99 cents, who buys it, and why are they confident they will get a dollar back?

Fiat-backed stablecoins

The largest stablecoins are issued by companies that hold reserves in cash, bank deposits and short-dated government debt. The mechanism is mint and redeem.

• An approved customer sends the issuer one dollar and receives one newly created token.
• The same customer can return a token and receive one dollar, at which point the token is destroyed.

If the market price falls below a dollar, those customers can buy tokens cheaply and redeem them at par, pocketing the difference and reducing supply. If the price rises above a dollar, they mint new tokens at par and sell them. This arbitrage is what keeps the market price within a fraction of a cent most of the time.

The weak points follow from the design. Direct redemption is usually limited to verified institutional customers, often with minimum sizes and fees, so ordinary holders rely on the secondary market. Reserves have to be both sound and reachable. In March 2023 a major dollar stablecoin briefly traded below 90 cents after its issuer disclosed that part of its cash was held at a bank that had just failed; the price recovered once it was clear depositors would be made whole. The episode showed that even fully backed tokens carry banking and timing risk. Attestations and audits of reserves, and the regulatory regime the issuer sits under, are therefore worth reading.

Crypto-collateralised stablecoins

A second family is issued by smart contracts rather than companies. A user locks up crypto assets such as ether in a vault and borrows stablecoins against them. Because the collateral is volatile, the system demands more than a dollar of collateral for every dollar issued, commonly 150 percent or more.

If the collateral's value falls towards a minimum ratio, the vault is liquidated: the collateral is sold, the debt is repaid and the borrower pays a penalty. The peg is supported by the fact that every token is a claim against more than a dollar of assets, by interest rates that the protocol adjusts to encourage or discourage borrowing, and in some designs by modules that swap the token one for one with fiat-backed stablecoins.

The risks are different. Liquidations depend on accurate price feeds and on a functioning market at the worst possible moment. A sharp fall combined with network congestion can leave the system with bad debt. Heavy reliance on fiat-backed tokens as collateral also imports their risks.

Algorithmic designs

A third group has tried to hold a peg with little or no external collateral, typically by pairing the stablecoin with a sister token that absorbs volatility. Holders can always swap one stablecoin for a dollar's worth of the sister token, which is minted on demand.

This works while the sister token has value. Under heavy redemptions, minting more of it pushes its price down, which requires minting yet more, and the loop can run to zero. The collapse of TerraUSD in May 2022 followed this pattern and erased tens of billions of dollars in market value within days. Several jurisdictions have since restricted or excluded designs of this kind from their stablecoin rules.

Reading a depeg

Small deviations are normal and usually reflect temporary imbalances in a trading pool. The signs that something more serious is happening are a discount that persists while redemptions are open, a halt or delay in redemptions, a sudden change in reserve disclosures, or liquidity draining from the main trading pools.

What to check before relying on one

• Who issues it, and under which regulator.
• What backs it, how often that is attested, and by whom.
• Who can redeem directly, at what size and cost.
• Whether the issuer can freeze or blacklist addresses, which most fiat-backed issuers can.
• How it behaved in previous periods of stress.

A stablecoin is a claim on something. Its stability is only as good as the claim.