What Is a Stablecoin? A Guide to Cryptocurrencies That Aim for Stable Value

Imagine you want to send money to a family member overseas using cryptocurrency, but you are worried that the price of Bitcoin might fall by 5% before the transfer settles. Or you have made a gain trading Ethereum and want to park the proceeds in something that should be more stable, without withdrawing back to a bank account.

In both cases, the price swings of typical cryptocurrencies are a problem. Stablecoins are one way people try to reduce that risk. They are designed to combine some features of cryptocurrencies, such as speed and global reach, with the relatively steady value of traditional money, although this stability is never guaranteed.

What is a stablecoin?

A stablecoin is a type of cryptocurrency that aims to track the value of an external asset, often called a "peg". While the price of Bitcoin is driven purely by market supply and demand, which can cause sharp and sudden moves, a stablecoin is engineered to stay close to a chosen reference price, most commonly 1.00 US dollar (about £0.80, depending on the exchange rate), though stablecoins can be volatile and may not maintain their peg.

You can think of a stablecoin as a digital token that tries to behave like cash on a blockchain. Similar to holding a balance in a payment app, you can hold stablecoins in a crypto wallet and send them to other wallets at any time. Unlike many banking systems, transfers can usually be made 24/7 and across borders, although you may still pay network or platform fees and you remain exposed to crypto-specific risks.

How stablecoins aim to maintain value

To keep a token as close as possible to its target value, issuers usually use some form of backing or reserve.

For every stablecoin created, the issuer may hold assets in a reserve that are meant to support its value. When someone redeems a stablecoin for traditional currency, the issuer is expected to use the reserve to pay out and then remove the redeemed token from circulation. In theory, this means every token is backed by "real world" value.

In practice, that theory relies on several assumptions. The quality and liquidity of the reserves, how they are managed, and the strength of the legal structure all matter. Not all stablecoins follow the same approach, and not all pegs have held in stressed markets.

The four main types of stablecoins

Stablecoins are usually grouped by how they try to keep their peg.

1. Fiat‑collateralised

This is the most common structure. These tokens say they are backed 1:1 by government‑issued currency (fiat), such as US dollars or euros, sometimes combined with short‑term government bonds and cash‑like assets.

• Examples: USDC, EURC
• How it works: If there are 1 billion tokens in circulation, the issuer should hold assets worth about 1 billion US dollars (roughly £790 million) in bank accounts or approved investments.

If reserves are high quality, liquid and properly segregated, this can support price stability. However, holders must trust that the reserves actually exist, are accessible in a crisis and are not encumbered. You are also exposed to the solvency and governance of the issuing company and its banking partners.

2. Crypto‑collateralised

These stablecoins are backed by other cryptocurrencies rather than cash in a bank. Because crypto collateral such as Ethereum is volatile, these systems use "over‑collateralisation" to provide a buffer.

• Example: USDS
• How it works: To create (mint) USD $100 worth of a stablecoin, a user might need to lock up USD $150 worth of Ethereum or another approved asset in a smart contract.

If the value of the collateral falls too far, the protocol can automatically sell (liquidate) it to make sure there is always enough backing behind the stablecoin.

This model reduces reliance on a single company, but introduces other risks. Smart contracts can have bugs, collateral prices can crash quickly and blockchain congestion can delay transactions. In extreme conditions, liquidations can be painful and users may lose a significant part of their collateral.

3. Commodity‑backed

These stablecoins are linked to the value of physical assets, most often gold.

• Examples: PAX Gold (PAXG).
• How it works: Each token represents a specific claim on a physical asset, for example one troy ounce of gold held in a vault.

This gives people a digital way to get exposure to commodities without arranging storage or transport themselves. However, you are relying on the issuer, the custodian and the legal framework that connects the token to the underlying asset. If something goes wrong with any of these, the token may not reflect the expected value of the commodity.

4. Algorithmic and synthetic

These are the most complex and speculative types. Instead of holding simple reserves on a 1:1 basis, they use algorithms, smart contracts or hedging strategies to try to keep the price steady.

• Examples: Ethena (USDe).
• How it works: The system may automatically create or destroy tokens depending on market demand, or it may use derivatives and trading strategies to target a certain value.

These designs can be fragile. Several high‑profile algorithmic stablecoins have failed completely, with their prices collapsing and never recovering. The mechanisms can be difficult to understand and may perform very differently under stress than they do in normal market conditions.

Pure algorithmic stablecoins, like TerraUSD (UST), which relied entirely on code and token mechanics without real asset backing, are now largely defunct.

Ethena's USDe uses algorithmic strategies and is often called a "synthetic dollar," but unlike UST, it is backed by crypto assets (staked Ethereum) and uses derivatives contracts to hedge against price movements.

This means it has actual collateral behind it, unlike pure algorithmic models that collapsed when market confidence broke down.

Real‑life examples: How stablecoins are used

Stablecoins are used for more than just moving between cryptocurrencies. Here are some common use cases, along with the risks you should be aware of.

Global remittances

Sending money overseas through banks can be slow and costly. Some people choose to buy stablecoins in one country, send them to a recipient's crypto wallet in another, then have the recipient convert the stablecoins back into local currency.

Transfers can settle in minutes and may avoid some traditional bank fees. However, there are still costs to buy and sell the stablecoin, and both parties take on crypto risks, such as price slippage, platform failure and the possibility that the stablecoin could de‑peg during the process.

Decentralised Finance (DeFi)

Stablecoins are widely used in DeFi applications. Users can deposit stablecoins into lending protocols, liquidity pools or other products that pay a return.

Because the token’s price is intended to be stable, returns might appear more predictable than if you used Bitcoin or other volatile assets. In reality, DeFi carries significant risks. Smart contracts can be hacked, protocols can fail, yields can drop suddenly and there is usually no recourse if funds are lost. Higher advertised returns often come with higher levels of risk.

Trading and capital preservation

Traders often move in and out of stablecoins when markets are volatile. Converting from Bitcoin or Ether into a stablecoin allows them to reduce exposure to price swings while staying within the crypto ecosystem.

This can be quicker than withdrawing to a bank account and may avoid certain fees. That said, switching to a stablecoin does not remove risk. You remain exposed to the stablecoin issuer, any exchange or wallet you use, and the possibility that the peg fails. Tax treatment varies by country, and trades into and out of stablecoins can still create taxable events, so you should get independent tax advice.

Risks and red flags

Stablecoins are designed to be less volatile than many other cryptoassets, but they still carry meaningful risk. Before you hold or use them, consider the following.

• De‑pegging events: A stablecoin can trade below or above its target price, especially in stressed markets or when confidence drops. For example, a token aiming for 1.00 US dollar may trade at 0.95 US dollars (around £0.75) or less. Some stablecoins have recovered from such events, others have not. There is no guarantee that a peg will be restored.
• Reserve quality and transparency: For asset‑backed stablecoins, you need to trust that the issuer actually holds suitable reserves. Reputable issuers publish regular reports from independent firms, although these are often "attestations" rather than full audits. Be careful with tokens that offer limited or unclear information, or that hold risky or illiquid assets as backing.
• Centralisation and control: Many fiat‑backed stablecoins are issued by companies that can freeze or block tokens at specific wallet addresses if required by law or policy. This can help tackle fraud and sanctions breaches, but it also means users are dependent on the issuer’s decisions and compliance processes.
• Counterparty and operational risk: As a holder, you rely on the issuer staying solvent and on the safekeeping of the reserves. If the issuer, its banks or its custodians fail or lose access to funds, the stablecoin’s value could be affected. In many cases you have limited legal rights or protections compared with money in a regulated bank account.
• Technology and smart contract risk: Some stablecoins operate using complex smart contracts. Coding errors, hacks or network outages can lead to loss of funds or temporary loss of access. Even if a bug is fixed, you might not get your money back.
• Regulatory risk: Rules around stablecoins are still developing in many countries. Future regulations could restrict certain products, increase compliance costs or affect how and where tokens can be used or redeemed.

The future of stablecoins

As the crypto market develops, stablecoins are attracting more attention from regulators, financial institutions and payment firms. In Europe, for example, the Markets in Crypto‑Assets (MiCA) framework is introducing stricter requirements for reserves, governance and disclosures for certain types of stablecoins.

At the same time, some traditional financial organisations and payment providers are exploring their own tokens or partnerships that use stablecoins for settlement. This could make them more visible in everyday payments and finance, but it also means closer supervision and potentially tighter rules.

It is possible that stablecoins will continue to play a role as a bridge between traditional money and digital assets. However, they remain experimental in many respects. Their stability is not guaranteed, their legal and regulatory treatment is evolving, and anyone using them should understand that they are taking on significant risk.