Evergreen Cryptocurrency stablecoins

Stablecoins Explained: How they work, what can go wrong, and the questions to ask

An evergreen intro the burning questions in crypto

by Mr Moonlight

Updated December 19, 2025

Stablecoins Explained: How they work, what can go wrong, and the questions to ask — Photo by CoinWire Japan / Unsplash

The cryptocurrency market is worth over $2 trillion, yet most people still cannot use Bitcoin to buy groceries or pay rent. The reason is simple: volatility. Bitcoin can swing 10% in a single day, making it impractical for everyday transactions. This is where stablecoins enter the picture, digital currencies designed to hold a steady value, typically pegged to traditional currencies like the pound sterling or US dollar.

As of mid-2025, the stablecoin market exceeds $230 billion, with these tokens now processing trillions in transactions annually. They have become essential infrastructure for cryptocurrency trading, cross-border payments, and decentralised finance (DeFi). Yet beneath their promise of stability lies a complex web of reserves, attestations, regulatory frameworks, and risks that every user should understand.

This guide explains how stablecoins work, what can go wrong, and the critical questions you should ask before trusting your money to one.

Why Stablecoins Exist and What Problems They Solve

Stablecoins emerged to solve a fundamental problem in the cryptocurrency ecosystem: the need for a stable medium of exchange and store of value. Traditional cryptocurrencies like Bitcoin and Ethereum are too volatile to serve as reliable money. A merchant accepting Bitcoin for a £100 purchase might find that payment worth £90 or £110 by the time they convert it back to pounds.

Stablecoins aim to combine the best of both worlds. They offer the technological advantages of cryptocurrencies (fast settlement, 24/7 availability, programmability, and borderless transfers) whilst maintaining the price stability of traditional currencies. This makes them useful for several key purposes.

Trading and liquidity: Cryptocurrency traders use stablecoins as a safe harbour during market volatility. Rather than converting back to pounds or dollars through a bank (which can take days and incur fees), traders can move into stablecoins instantly and remain within the crypto ecosystem.

Cross-border payments: Traditional international transfers can take several days and cost 5-10% in fees. Stablecoins enable near-instant settlement at a fraction of the cost, making them particularly valuable for remittances to developing countries.

DeFi infrastructure: Decentralised finance protocols need stable assets for lending, borrowing, and providing liquidity. Stablecoins serve as the foundation for these services, allowing users to earn interest or take loans without exposure to cryptocurrency volatility.

Inflation hedge: In countries experiencing currency instability or hyperinflation, stablecoins pegged to the US dollar or euro provide access to more stable stores of value. This use case has grown significantly in regions like Latin America and parts of Africa.

The appeal is clear: stablecoins promise the efficiency of blockchain technology without the wild price swings. But this promise depends entirely on how well the stablecoin maintains its peg, and that depends on what backs it.

Types of Stablecoins: Understanding the Mechanisms

Not all stablecoins are created equal. The method used to maintain price stability fundamentally affects the risks you face as a user. There are three main types, each with distinct characteristics.

Fiat-Backed Stablecoins

These are the most common and straightforward type. For every token issued, the issuer claims to hold an equivalent amount of traditional currency (or highly liquid assets like government bonds) in reserve. When you buy a fiat-backed stablecoin, you are essentially receiving a digital IOU for real money held somewhere else.

USDC (USD Coin), issued by Circle, exemplifies this model. Circle publishes monthly attestations showing that USDC is backed by cash and short-term US Treasury securities. As of December 2025, USDC has approximately $61 billion in circulation, with reserves held at regulated financial institutions.

Tether (USDT) is the largest stablecoin by market capitalisation, with over $150 billion in circulation. Tether holds approximately $98.5 billion in US Treasury bills, making it one of the largest non-sovereign holders of US government debt. However, Tether has faced persistent questions about transparency, as it has never undergone a full audit by a major accounting firm.

The strength of fiat-backed stablecoins lies in their simplicity and the tangible assets backing them. The weakness is that they require trust in the issuer and the institutions holding the reserves. You must believe that the reserves actually exist, are properly segregated, and will be available when needed.

Crypto-Collateralised Stablecoins

These stablecoins are backed by other cryptocurrencies rather than traditional money. Because cryptocurrencies are volatile, these stablecoins typically require over-collateralisation. For example, you might need to lock up £150 worth of Ethereum to mint £100 worth of stablecoins.

DAI, issued by MakerDAO, is the most prominent example. DAI maintains its dollar peg through a system of smart contracts that automatically manage collateral ratios. If the value of the collateral falls too far, the system automatically liquidates some of it to maintain backing.

The advantage of crypto-collateralised stablecoins is transparency. All collateral is visible on the blockchain, and the mechanisms are governed by code rather than corporate decisions. The disadvantage is complexity and the risk that extreme market volatility could overwhelm the system's stabilisation mechanisms.

Algorithmic Stablecoins

These are the most experimental and controversial type. Algorithmic stablecoins attempt to maintain their peg without holding reserves, instead using algorithms to expand or contract supply based on demand. When the price rises above the peg, the algorithm mints new tokens to increase supply and push the price down. When the price falls below the peg, it incentivises users to burn tokens, reducing supply and pushing the price up.

This model sounds elegant in theory, but has proven catastrophically fragile in practice. The collapse of TerraUSD (UST) in May 2022 wiped out over $40 billion in value within days, demonstrating the "death spiral" risk inherent in algorithmic designs. When confidence evaporates, the mechanisms designed to restore the peg can instead accelerate the collapse.

Most experts now consider purely algorithmic stablecoins too risky for mainstream use. Regulatory frameworks like the EU's Markets in Crypto-Assets Regulation (MiCA) effectively ban them by requiring stablecoins to maintain adequate reserves.

How to Read an Attestation: What the Numbers Really Mean

If you are considering using a stablecoin, understanding reserve attestations is essential. These reports, typically issued monthly or quarterly, are meant to provide assurance that the stablecoin is properly backed. However, not all attestations are created equal, and knowing what to look for can help you assess real risk.

What an Attestation Should Contain

A proper attestation should clearly state three things: the total number of tokens in circulation, the total value of reserve assets, and a breakdown of what those reserves consist of. The reserve value should equal or exceed the value of tokens in circulation.

For example, Circle's USDC attestations show the exact composition of reserves, typically over 90% in cash and short-term US Treasuries, with the remainder in cash deposits at major banks. This level of detail allows users to assess both the adequacy and quality of backing.

Attestation vs Audit: Understanding the Difference

This distinction is crucial. An attestation is a limited review that verifies specific claims at a specific point in time. An audit is a comprehensive examination of an organisation's financial statements, internal controls, and business practices over a period.

Most stablecoins provide attestations, not audits. Tether, despite being the largest stablecoin, has never undergone a full audit by a major accounting firm, though it is reportedly in talks with a Big Four firm. This lack of comprehensive auditing has been a persistent source of concern.

Attestations also suffer from the "90-day trust gap" problem. Between quarterly reports, anything could happen to reserves without public knowledge. During these periods, issuers could theoretically deploy reserves for unauthorised investments, experience losses, or face operational failures, all without immediate detection.

Red Flags in Reserve Composition

Not all reserve assets are equally safe or liquid. When reading an attestation, watch for these warning signs:

High proportion of commercial paper or corporate debt: These assets are less liquid than cash or government securities and carry credit risk. During the 2022 market stress, questions about Tether's commercial paper holdings contributed to brief depegging events.

Vague categorisation: Terms like "other investments" or "secured loans" without detailed breakdown should raise concerns. What exactly are these assets, and how quickly can they be converted to cash?

Offshore or unregulated custodians: Where are the reserves held, and under what legal framework? Reserves held in jurisdictions with weak regulatory oversight or unclear bankruptcy protections pose additional risk.

Lack of segregation: Are reserve assets held separately from the issuer's operating funds? If not, they could be at risk if the issuer faces financial difficulties.

The Importance of Real-Time Verification

The most transparent stablecoins are moving beyond quarterly attestations towards continuous, real-time verification. Approximately 71% of leading stablecoins now publish real-time proof-of-reserves reports, allowing users to verify backing at any moment rather than waiting months for the next attestation.

This shift towards continuous transparency is being driven by both market demand and regulatory pressure. The US GENIUS Act, passed in July 2025, requires stablecoin issuers to publish monthly reserve composition reports, examined by registered public accounting firms.

What Can Go Wrong: The Risks of Stablecoins

Despite their name, stablecoins are not risk-free. Understanding the potential failure modes is essential for anyone considering using them.

Depegging Risk

A "depeg" occurs when a stablecoin's market price deviates from its intended peg. In 2023 alone, there were 609 depegging instances across various stablecoins, though most were minor and short-lived.

Small deviations of 1-2% are relatively common and often result from temporary liquidity imbalances on trading platforms. These typically resolve quickly through arbitrage, as traders buy the discounted stablecoin and redeem it at face value, or sell the premium-priced stablecoin after minting it at face value.

Major depegs of 10% or more are rarer but far more serious. They usually indicate fundamental problems with reserves, loss of confidence, or systemic stress. When USDC briefly depegged to $0.87 in March 2023, it was because Circle disclosed that $3.3 billion of reserves were held at the failing Silicon Valley Bank. The peg was restored within days once US regulators guaranteed the deposits, but the incident demonstrated how quickly confidence can evaporate.

Liquidity Risk

Even if reserves are adequate, they must be liquid enough to meet redemption demands. During periods of market stress, many users may simultaneously try to redeem their stablecoins for traditional currency. If reserves are tied up in illiquid assets, the issuer may be unable to process redemptions quickly, triggering panic and further depegging.

This risk is particularly acute for stablecoins with reserves in longer-term securities or less liquid assets. The requirement under new regulations for reserves to be held in highly liquid assets like cash and short-term government securities is designed to mitigate this risk.

Counterparty Risk

Fiat-backed stablecoins depend on multiple counterparties: the issuer, the banks holding reserves, and the custodians managing assets. Each represents a potential point of failure.

If the issuer becomes insolvent, what happens to the reserves? Under the US GENIUS Act, stablecoin holders receive "superpriority" in bankruptcy, meaning they have first claim on reserve assets. However, bankruptcy proceedings can still take time, and legal protections vary by jurisdiction.

If a bank holding reserves fails, are those funds protected? The Silicon Valley Bank incident showed that even regulated banks can fail suddenly. Diversification across multiple institutions and jurisdictions can reduce but not eliminate this risk.

Regulatory and Legal Risk

The regulatory landscape for stablecoins is evolving rapidly and remains fragmented across jurisdictions. The EU's MiCA regulation, the US GENIUS Act, and frameworks in Singapore, Hong Kong, and other jurisdictions all impose different requirements.

A stablecoin that is compliant in one jurisdiction may not be in another. In late 2024 and early 2025, several major exchanges delisted non-compliant stablecoins in the EU, including Tether (USDT), PayPal USD (PYUSD), and others that did not meet MiCA's reserve and authorisation requirements.

Users may find themselves unable to access or trade their stablecoins if regulatory changes force delistings or restrict usage. This regulatory fragmentation creates operational complexity and potential losses for users caught in the transition.

Operational and Technical Risk

Stablecoins operate on blockchain networks, which introduces technical risks. Smart contract bugs, network congestion, or security vulnerabilities could prevent transactions or enable theft. Whilst major stablecoins have been extensively audited, no system is entirely immune to technical failure.

Additionally, user error poses significant risk. Sending stablecoins to the wrong address, losing private keys, or falling victim to phishing attacks can result in permanent, irreversible loss. Unlike traditional banking, there is no customer service department that can reverse mistaken transactions.

Historical Case Studies: When Stablecoins Failed

Examining past failures provides valuable lessons about what can go wrong and why.

TerraUSD (UST) Collapse, May 2022

The collapse of TerraUSD remains the most spectacular stablecoin failure to date, wiping out over $40 billion in value within days. UST was an algorithmic stablecoin that maintained its dollar peg through a relationship with the LUNA token. Users could always mint $1 worth of LUNA by burning 1 UST, and vice versa.

This mechanism worked during stable conditions but created catastrophic feedback loops during stress. When large redemptions began in May 2022, the system minted massive quantities of LUNA tokens to absorb the selling pressure, diluting their value. As LUNA's price fell, confidence in UST evaporated, triggering more redemptions and more LUNA minting in a self-reinforcing death spiral.

Within days, UST fell from $1 to $0.10, whilst LUNA crashed from $87 to essentially zero. The collapse demonstrated the fundamental fragility of algorithmic stablecoins that lack real asset backing. It also triggered broader market contagion, contributing to the 2022 cryptocurrency bear market.

Key lesson: Algorithmic mechanisms without adequate reserves cannot withstand loss of confidence. Real assets matter.

Tether Depegging, October 2018

In October 2018, Tether briefly depegged 10% to $0.90 amid rumours about its reserves and withdrawal issues at Bitfinex, a related exchange. This incident followed longstanding concerns about whether Tether's reserves were adequate and properly segregated.

The depeg was relatively short-lived, but it highlighted the importance of transparency and the risks of opacity. Tether has since improved its disclosure practices, publishing quarterly attestations, but it still has not undergone a full audit by a major accounting firm.

Key lesson: Lack of transparency creates vulnerability to confidence crises, even if reserves are ultimately adequate.

USDC Depeg, March 2023

When Silicon Valley Bank failed in March 2023, Circle disclosed that $3.3 billion of USDC's reserves were held there. USDC briefly depegged 12% to $0.88 as users rushed to redeem or sell their holdings.

However, Circle's transparent communication and the swift regulatory response (the FDIC guaranteed all deposits at Silicon Valley Bank) enabled quick recovery. The peg was restored within days, and Circle's reputation for transparency was ultimately strengthened.

Key lesson: Even well-managed, transparent stablecoins face risks from the traditional financial system. Diversification of reserves and clear communication during crises are essential.

TrueUSD (TUSD) Depeg, January 2024

TrueUSD traded down to $0.926 in January 2024 amid concerns about its reserves. The stablecoin faced a challenging year, with Binance removing trading pairs in March and eventually delisting it entirely. In September 2024, the US Securities and Exchange Commission settled charges with the issuer for fraudulent and unregistered sales of investment contracts involving TUSD.

Key lesson: Regulatory compliance and reserve management are not optional. Failures in either area can be fatal to a stablecoin's viability.

Questions to Ask Before Using a Stablecoin

Before trusting your money to any stablecoin, ask these critical questions:

1. What type of stablecoin is it? Fiat-backed stablecoins with transparent reserves are generally lower risk than algorithmic or crypto-collateralised alternatives.

2. Who issues it, and are they regulated? Issuers subject to regulatory oversight in major jurisdictions (US, EU, UK, Singapore) face stricter requirements and supervision.

3. What backs the stablecoin? Look for reserves held primarily in cash and short-term government securities. Be wary of vague categories or high proportions of commercial paper and corporate debt.

4. How transparent is the reserve reporting? Monthly attestations from reputable accounting firms are the minimum standard. Real-time proof-of-reserves is even better. Avoid stablecoins that provide only quarterly reports or lack independent verification.

5. Where are reserves held, and are they segregated? Reserves should be held at regulated financial institutions, preferably diversified across multiple banks and jurisdictions. They should be legally segregated from the issuer's operating funds.

6. Has the stablecoin ever depegged? If so, how severe was the depeg, how long did it last, and what caused it? How did the issuer respond?

7. What are the redemption terms? Can you redeem directly with the issuer, or must you sell on exchanges? Are there minimum redemption amounts or fees? How quickly are redemptions processed?

8. What legal protections exist? In the event of issuer insolvency, what claims do stablecoin holders have on reserves? This varies significantly by jurisdiction.

9. What is the stablecoin's regulatory status? Is it compliant with regulations in your jurisdiction and the jurisdictions where you might use it?

10. What do independent analysts and regulators say? Look for assessments from blockchain analytics firms, financial regulators, and independent researchers.

Red Flags: Warning Signs to Avoid

Certain warning signs should make you think twice before using a stablecoin:

Lack of regular, independent attestations: If a stablecoin does not publish at least quarterly attestations from a reputable accounting firm, avoid it.

Vague or incomplete reserve disclosures: Detailed breakdowns of reserve composition should be readily available. Vague categories or missing information suggest something to hide.

History of significant depegging events: Whilst minor, brief depegs are not necessarily disqualifying, repeated or severe depegs indicate fundamental problems.

Regulatory enforcement actions: If regulators have taken action against the issuer, this is a serious red flag.

Algorithmic mechanisms without reserves: Purely algorithmic stablecoins have repeatedly failed. Avoid them.

Offshore issuers in unregulated jurisdictions: Whilst not automatically disqualifying, issuers in jurisdictions with weak regulatory oversight pose higher risk.

Lack of transparency about team and operations: Legitimate stablecoin issuers are transparent about who runs them and how they operate.

Conclusion: Using Stablecoins Wisely

Stablecoins represent a genuine innovation in digital finance, offering the efficiency of blockchain technology with the stability of traditional currencies. They have become essential infrastructure for cryptocurrency markets and show promise for cross-border payments and financial inclusion.

However, the "stable" in stablecoin is a promise, not a guarantee. That promise depends on adequate reserves, transparent reporting, sound risk management, and appropriate regulation. As a user, your protection lies in understanding how stablecoins work, what can go wrong, and how to assess the quality of different options.

The regulatory landscape is maturing rapidly, with frameworks like the US GENIUS Act and EU MiCA pushing towards higher standards for reserves, transparency, and consumer protection. This is positive for the long-term health of the stablecoin ecosystem, even if it creates short-term disruption as non-compliant projects are forced to adapt or exit.

For UK users, the key is to choose stablecoins from regulated issuers with transparent reserves, regular independent attestations, and a track record of maintaining their peg through market stress. Ask the right questions, watch for red flags, and never invest more than you can afford to lose. Stablecoins are powerful tools, but like any financial instrument, they require informed, cautious use.

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