Stablecoins Explained: How They Work and Where the Risk Sits

Stablecoins are the quiet giant of crypto: tokens designed to hold a steady $1, with total supply around $300 billion as of September 2026, up nearly twelvefold from $27 billion at end-2020. They settle trades, move dollars across borders in minutes, and underpin most crypto lending. Two coins dominate — Tether’s USDT at about $183 billion (~59%) and Circle’s USDC at about $74 billion (~24%) — and 99% of the market is dollar-pegged.

But “stable” describes the target, not a guarantee: the peg is a promise, redemption is the mechanism, and when the mechanism fails, the results range from a bad weekend to a $40 billion wipeout. Here’s how the designs work, what they’re used for, and where the risk sits now that real laws are catching up.

The three designs

Fiat-backed (USDT, USDC). The issuer holds dollars and short-term Treasuries in reserve and issues one token per dollar. The peg holds through redemption: if the token slips to $0.99 on exchanges, arbitrageurs buy it cheap and redeem with the issuer for $1.00, pushing the market price back. It works as long as redemption is fast, credible, and backed by assets that are actually there. The entire risk question is the reserve — what backs the token and who verifies it.

Crypto-backed (DAI, USDe). Collateral is other crypto, over-collateralized to absorb volatility — lock $150 of ETH to mint $100 of DAI, for example. No bank account needed, which is the point: the system runs without a traditional issuer. But it depends on liquidation machinery working during crashes and honest price oracles. DAI, the largest at around $4.6 billion, has survived multiple crypto winters; smaller designs keep failing.

Algorithmic (the cautionary tale). No meaningful reserves — stability maintained by code and incentives. Terra’s UST was the flagship: when confidence cracked in May 2022, the defense mechanism hyperinflated sister token LUNA from about a billion tokens to trillions in days, and both went to near zero — roughly $40 billion destroyed, per the U.S. Department of Justice. Algorithmic stability is stable until, suddenly, it isn’t.

Below them, a mid-tier is growing — Ethena’s USDe, PayPal’s PYUSD, Ripple’s RLUSD, World Liberty’s USD1. Still a duopoly, but less of one than five years ago.

What they’re actually used for

• Trading rails. Most crypto trades — spot and futures — are quoted against USDT or USDC, and moving between positions without touching banks is the original and still the largest use.
• Dollar access. In countries with high inflation or capital controls, a phone-based dollar substitute is genuinely useful. IMF data shows more than 70% of major stablecoin conversions between 2021 and 2025 originated from non-dollar currencies — stablecoins are increasingly how the world holds dollars outside the U.S. banking system.
• Payments and remittances. Near-instant, near-free cross-border transfers. USDC overtook USDT in transaction volume in 2025 ($18.3T vs $13.3T) despite trailing in supply — a sign it’s used more for payments than trading.
• DeFi collateral. Stablecoins are the base layer of crypto lending: deposited, borrowed against, routed through automated strategies. This is also where tail risk concentrates, because a depeg in collateral cascades through every protocol holding it.

The trust question: reserves and who checks them

For fiat-backed coins, everything comes down to the reserve.

Tether publishes quarterly attestations through BDO, and in August 2026 KPMG completed a full audit of its 2025 financials with an unqualified opinion — the first Big Four audit in company history. Per its March 2026 attestation, Tether held roughly $141 billion in direct and indirect U.S. Treasury-bill exposure, a long way from its early years: in 2021 the CFTC fined it $41 million for misleading statements about whether USDT was fully backed by fiat between 2016 and 2018.

Circle publishes monthly USDC attestations (Deloitte audits annually), and about 88% of USDC reserves sit in a BlackRock-managed government money-market fund whose holdings are published daily. Circle went public in mid-2025 as the regulated, institution-facing issuer; Tether remains the liquidity king of trading.

Both are point-in-time snapshots, not continuous monitoring: they answer “were the reserves there on this date?” — the right question, asked on a schedule.

The law catches up

Stablecoins spent a decade in a gray zone. That era is ending on both sides of the Atlantic.

United States — the GENIUS Act. Signed July 18, 2025, the first standalone federal law for payment stablecoins. Issuers must hold 1:1 reserves in a short list of high-quality assets — dollars, insured bank deposits, Treasury bills maturing within 93 days, overnight Treasury-backed repos, and government money-market funds. Corporate bonds, loans, crypto, and precious metals don’t qualify. Issuers must publish monthly reserve disclosures, get a federal or state license, and may not pay interest or yield to holders — a provision meant to stop stablecoins competing with bank deposits on rate. (Whether exchanges can still pay rewards on stablecoin balances is a live policy fight.) The core obligations take effect January 18, 2027 at the earliest; agencies missed the July 2026 rulemaking deadline, so the transition is still in motion.

European Union — MiCA. The EU’s stablecoin rules took force on June 30, 2024, requiring e-money authorization in at least one member state. Coinbase delisted USDT for European users by end-2024, Binance put it in sell-only mode, OKX dropped USDT pairs. Circle secured a French license on July 1, 2024 — the first global issuer to comply — and USDC has gained European share ever since.

The direction is clear: stablecoins are being regulated like the narrow banks they resemble.

Where the risk sits

Depeg risk — the record. Even fiat-backed coins wobble. In March 2023, Circle disclosed that $3.3 billion of USDC’s roughly $40 billion in reserves was stuck at the failed Silicon Valley Bank. USDC fell to about $0.87 — a record low — before the FDIC backstop and the Fed’s emergency facility restored confidence; it was back at $1 within days because the reserves were sound. The peg is only as strong as the banks behind it. DAI, which held roughly half its reserves in USDC, fell to about $0.90 in sympathy.

The failures since have all been smaller coins: Main Street’s msUSD collapsed 90% in June 2026 after on-chain liquidations overwhelmed it; Balance Coin lost 99% in hours in July 2026 when an oracle exploit let an attacker mint and dump tokens; Resolv USR fell 72% after an exploit minted 80 million unbacked tokens. Through all of it, USDT and USDC stayed within roughly 0.1% of $1 — scale and reserve transparency are doing real work.

Regulatory risk. The rules are still being written, and each draft moves the economics: the GENIUS Act’s yield ban already pushed stablecoin supply down roughly $15 billion in early August 2026 as holders rotated into yield-bearing tokenized Treasuries.

Issuer and freeze risk. A stablecoin is an IOU from a company — and a freezable one: Circle freezes USDC wallets when directed by law enforcement or courts. After a $270 million exploit at the Drift protocol in April 2026, the attacker moved stolen USDC across chains faster than it could be frozen. If your threat model includes censorship or seizure, a centralized stablecoin is the wrong tool.

Operational risk. Smart-contract bugs, oracle manipulation, and thin liquidity have killed more stablecoins than bad reserves have — the 2026 failures were almost all exploits or liquidity spirals, not accounting fraud. Code is part of the reserve.

Common misconceptions

“Stable means safe.” Stable means the price target is $1. The issuer’s credit risk, the reserves’ banking risk, and the rails’ smart-contract risk all remain.

“1:1 backed means risk-free.” Backed by what, verified by whom, redeemable how fast? USDC was “1:1 backed” the Friday SVB failed. Backing is necessary, not sufficient.

“The new laws eliminated the risk.” They raised the floor — reserve standards, disclosure, licensing. They didn’t repeal bank runs, exploits, or the fact that redemption takes time when everyone wants out at once.

Practical takeaways

Treat stablecoins as fintech products with counterparty risk, not dollars with extra steps. Keep only operational balances in them — trading, transfers, DeFi — not savings. Diversify across issuers, read the reserve attestations at least once, and size every position for the possibility it trades below $1 when you most need the dollar. The record shows it can.

The bottom line

Stablecoins are genuinely useful financial infrastructure — the dollar’s fastest distribution network, now with growing legal recognition on both sides of the Atlantic. Transparency is improving and the gray zone is closing. But the peg is a mechanism, not a law of nature. Read the reserve reports, remember Terra, and never hold more in any one coin than you can afford to see frozen or depegged.

Sources: DeFiLlama, CoinMarketCap, Circle, Tether/BDO, Reuters, CoinDesk

This article is educational and is not investment advice.