Stablecoins work by using one of three mechanisms to keep their price fixed at $1 USD: holding real-world reserves like cash or government bonds, locking up excess crypto as collateral, or using coded algorithms to expand and contract supply. Arbitrage traders enforce the peg in real time on open markets.
- Fiat-backed stablecoins (like USDT, USDC) hold real dollars or equivalents in reserve for every token in circulation.
- Crypto-collateralized stablecoins (like DAI) lock up excess crypto as collateral to absorb price swings.
- Algorithmic stablecoins (like the now-collapsed UST) use code and incentive loops instead of hard collateral.
- Arbitrage traders are the invisible enforcement layer that keeps prices at exactly $1 on open markets.
- Depegs happen fast. Knowing the early warning signs can help you protect capital before the worst hits.
Three Ways Stablecoins Hold Their Peg: How Stablecoins Work
Fiat-Backed: The Simplest Model
Tether (USDT) and USD Coin (USDC) are the clearest examples of how stablecoins work in practice. For every token issued, the issuer holds an equivalent amount of cash, short-term government bonds, or other liquid assets in a bank or custodian account. The promise is simple: you can always redeem one USDT for one dollar.
USDT’s market cap exceeded $110 billion as of mid-2025, according to CoinMarketCap data, making it the largest stablecoin by circulation. That is a lot of reserves to manage and audit. Tether publishes quarterly attestations, though critics argue full independent audits would offer stronger proof. You can read about Tether’s reserve management actions, including freezing over $500 million in USDT, to see how issuers exercise control over circulating supply.
Crypto-Collateralized: Over-Collateralised by Design
MakerDAO’s DAI works differently. To mint $100 worth of DAI, you lock up significantly more than $100 in ETH or other accepted crypto as collateral, often 150% or more. That over-collateralization acts as a buffer if ETH’s price drops sharply.
If collateral falls below a safe threshold, the protocol automatically liquidates it to protect the peg. This model is more decentralized than fiat-backed coins, but it is also capital-inefficient. You are locking up more than you borrow, which limits how widely it can scale.
Algorithmic: High Risk, No Hard Collateral
Algorithmic stablecoins try to maintain the peg through coded incentive systems rather than real-world assets. TerraUSD (UST) used a dual-token model with its sister coin LUNA: burning LUNA minted UST and vice versa. In theory, the system would self-correct. In practice, it did not.
When confidence collapsed in May 2022, UST lost its peg and LUNA’s price went to near zero within days. Over $40 billion in combined market cap was wiped out, according to CoinGecko data. That event remains the clearest proof that algorithmic pegs without sufficient collateral backing are extremely fragile.
The Arbitrage Loop That Enforces $1
Arbitrage is the real enforcement engine behind every stablecoin peg, and it is worth understanding clearly. When USDT trades at $0.98 on an exchange, traders buy it cheaply, redeem it directly with Tether for $1, and pocket the difference. That buying pressure pushes the price back up to $1.
The same logic works in reverse. If USDT trades at $1.02, traders mint new USDT (or buy dollars and sell USDT) until the premium disappears. This loop only works reliably if the issuer actually honors redemptions and if enough liquidity exists in the market.
On Indian platforms like WazirX, CoinDCX, or ZebPay, USDT trades in INR pairs. Local arbitrage can create tiny INR premiums during high-volume periods, especially when the rupee moves sharply. That is normal market behavior, not a stablecoin depeg signal by itself.
Famous Depegs and What Broke
UST / LUNA Collapse (May 2022)
UST’s depeg is the most studied case in crypto history. A coordinated sell-off drained the Luna Foundation Guard’s Bitcoin reserves, which were meant to defend the peg. Once confidence cracked, the algorithmic burn-and-mint loop became a death spiral instead of a stabilizer.
The collapse wiped out savings for thousands of retail investors globally, including many in India who had parked funds in Anchor Protocol for its high-yield APY, which was widely reported at around 19-20% annually. It is a sharp reminder that high yields from stablecoins are almost always a signal of high underlying risk.
USDC’s Brief Depeg (March 2023)
USDC briefly fell to around $0.87 when Silicon Valley Bank collapsed. Circle confirmed in a public statement that approximately $3.3 billion of its reserves were held at SVB. This was a fiat-backed stablecoin depegging not because of algorithmic failure, but because of traditional banking risk. USDC recovered to $1 once regulators guaranteed SVB deposits, but the episode showed that “backed by dollars” only helps if those dollars are actually accessible.
Warning Signs Before a Depeg
Watching a few specific signals can give you early warning of a stablecoin depeg risk. A persistent price gap on major exchanges, like USDT trading at $0.97 for hours rather than seconds, is a red flag. So is a sudden spike in redemption requests or a sharp drop in the issuer’s reserve proof.
For algorithmic stablecoins, watch the secondary token (like LUNA for UST). When that token starts falling hard and fast, the burn mechanism loses its teeth. Also watch on-chain data: large wallet outflows from stablecoin pools on DeFi platforms often precede public panic.
| Stablecoin Type | Example | Collateral | Depeg Risk Level | Redemption Mechanism |
|---|---|---|---|---|
| Fiat-Backed | USDT, USDC | Cash, T-bills | Low-Medium | Direct issuer redemption |
| Crypto-Collateralized | DAI | ETH, WBTC (150%+) | Medium | Protocol liquidation |
| Algorithmic | UST (defunct) | None (code-based) | Very High | Token burn/mint loop |
India-Specific Context: Tax and Regulatory Risk
Indian investors treating stablecoins as “safe parking” need to understand the tax reality. Under India’s VDA tax framework, any gain from swapping crypto into a stablecoin is taxable at 30% flat, with no deduction for losses from other assets. A 1% TDS also applies on transactions above the threshold on Indian exchanges. You can get a full breakdown at our guide to crypto tax in India.
The RBI has historically been cautious about stablecoins, viewing dollar-pegged tokens as a potential threat to rupee stability. The regulatory picture is still evolving. Read our detailed explainer on the stablecoin ban debate in India to stay current. If regulations tighten, access to USDT or USDC on Indian exchanges could change quickly.
Stablecoins are not a guaranteed safe haven. If the broader crypto market drops sharply and you are holding stablecoins while wondering what comes next, our piece on whether crypto will recover gives useful context on market cycles.
Frequently Asked Questions
How do stablecoins work and stay at $1?
Stablecoins stay at $1 through a combination of reserve backing and arbitrage. If the price drops below $1, traders buy the cheap stablecoin and redeem it for $1 from the issuer, earning a profit and pushing the price back up. If it rises above $1, the reverse happens. This loop works continuously on exchanges worldwide, including Indian platforms like CoinDCX and ZebPay.
What backs USDT and USDC?
USDT (Tether) is backed by a mix of cash, cash equivalents, U.S. Treasury bills, and other short-term assets. USDC (Circle) is backed primarily by cash and short-term U.S. Treasuries held in regulated financial institutions. Both publish periodic attestations of their reserves, though neither has completed a full independent audit as of this writing.
What is an algorithmic stablecoin?
An algorithmic stablecoin maintains its peg using coded rules and token incentives rather than real-world collateral. When the price falls below $1, the algorithm burns the stablecoin to reduce supply. When it rises above $1, new tokens are minted. The model works in stable conditions but can collapse catastrophically if market confidence breaks, as seen with UST in 2022.
Are stablecoins taxed in India?
Yes. Under India’s VDA framework, swapping any cryptocurrency into a stablecoin is treated as a taxable disposal. Gains are taxed at a flat 30% with no loss offset allowed. A 1% TDS applies on qualifying transactions on Indian exchanges. Holding a stablecoin itself does not trigger tax, but any conversion in or out of it can.
What are the warning signs of a stablecoin depeg?
Key warning signs include: the stablecoin trading below $0.99 or above $1.01 for a sustained period rather than just seconds; a sharp increase in large-wallet redemptions; the issuer pausing or restricting withdrawals; and, for algorithmic coins, the secondary token (like LUNA) dropping sharply. On-chain data showing heavy outflows from DeFi liquidity pools is also a serious early indicator.
Risk disclosure: Stablecoins carry real risks including issuer insolvency, regulatory action, smart contract bugs, and peg failure. They are not equivalent to cash or bank deposits. Never hold more in stablecoins than you can afford to lose access to.
This is not financial advice. Data as of July 2025. Last updated: July 2025. Reviewed by the CryptoWire editorial team.
