Stablecoins have grown into a financial powerhouse with a collective market capitalisation exceeding $250 billion. What are stablecoins? They are a type of digital asset linked to specific assets, mostly fiat currencies like the US dollar, to maintain a steady value.
Unlike traditional cryptocurrencies, which experience dramatic price fluctuations, stablecoins provide stability through their backing mechanisms. The majority of stablecoins rely on a designated item or collection of assets to sustain their steady value. Interestingly, almost 99% of the global stablecoin market is pegged to the US dollar. Currently, stablecoins are primarily used for buying or selling cryptoassets and making cross-border payments. With projections suggesting the stablecoin market could grow to between $500 billion and $750 billion in the coming years, understanding what are stablecoins and what they are used for has become increasingly important for investors and financial institutions alike.
How Does a Stablecoin Work?
At the core of every stablecoin lies a mechanism designed to maintain price stability. Stablecoins achieve this stability primarily through pegging their value to external references—typically fiat currencies like the US dollar. However, some are pegged to commodities, such as gold, or to other cryptocurrencies.
The lifecycle of a stablecoin typically follows several key stages:
- Issuance: A private entity creates the stablecoin and pegs it to a stable asset. For every stablecoin issued, the company generally holds an equivalent value in the reference currency.
- Recording: The stablecoin is made available to the public via a blockchain ledger, which records ownership and transactions.
- Circulation: Users can transfer stablecoins peer-to-peer or through intermediaries, storing them in digital wallets.
- Redemption: Holders can exchange their stablecoins back to the underlying asset at the same value, though issuers often set minimums and may charge fees.
What fundamentally differentiates stablecoins from volatile cryptocurrencies is their stabilisation mechanism. Most stablecoins maintain their stable value through collateralisation—backing the digital token with reserve assets. These reserves typically comprise cash, cash equivalents, or highly liquid securities.
For instance, Circle’s USDC is backed by approximately 90% short-term US Treasuries or repurchase agreements, with the remainder held in cash. This backing ensures that holders can redeem their stablecoins at any time for their underlying asset.
Additionally, market arbitrage plays a crucial role in maintaining the peg. If a stablecoin slips below its AUD 1.53 peg (equivalent to US$1) to AUD 1.50, traders are incentivised to purchase these discounted stablecoins and redeem them for AUD 1.53 of collateral, thereby contracting the supply. On the other hand, traders would produce more stablecoins to sell at a profit until the price normalises if it rises over the peg.
Some stablecoins employ over-collateralisation—where the value of deposited collateral exceeds the value of minted stablecoins—to provide an additional safety buffer against volatility. This is particularly important for crypto-backed stablecoins, where the underlying assets may fluctuate significantly in value.
Stablecoins make an effort to offer the advantages of blockchain technology without the severe price volatility that other cryptocurrencies are known for by using these strategies.
The 2 Main Types (Safe vs. Risky)
The stablecoin landscape divides into two main categories, each with fundamentally different risk profiles and mechanisms for maintaining their value.
Fiat-Backed Stablecoins (The Gold Standard)
Fiat-backed stablecoins represent the most common and trusted approach in the market. These digital tokens are secured by short-term government securities held by third-party custodians or by reserves of real currencies, like the US dollar. For every stablecoin issued, the company holds an equivalent value in reserve assets.
The most prominent players in this category include Tether (USDT) and USD Coin (USDC), with market capitalisations of approximately AUD 99.38 billion and AUD 68.80 billion, respectively. These stablecoins maintain their peg through a straightforward mechanism. If the price drifts above or below AUD 1.53, arbitrage opportunities incentivise traders to either create or redeem tokens until the price normalises.
Fiat-backed stablecoins derive their stability from reserve management. USDC, for example, focuses on cash and short-term Treasuries for greater transparency and lower risk. Furthermore, these stablecoins undergo regular audits to verify their reserves, though transparency varies across issuers.
Algorithmic Stablecoins (The Warning)
In contrast, algorithmic stablecoins operate without sufficient reserve assets. Instead, they rely on complex algorithms and incentive mechanisms to maintain their peg by adjusting the token supply in response to market demand.
The European Central Bank suggests algorithmic stablecoins should be treated as unbacked crypto-assets. This classification is well-founded, as these tokens are inherently fragile and prone to catastrophic failures.
The most infamous example occurred in May 2022, when TerraUSD (UST)—then the third-largest stablecoin with a market capitalisation of AUD 27.52 billion—completely collapsed. UST operated through a related crypto-asset called TerraLuna, which was designed to absorb price pressures. However, when confidence faltered, both tokens entered a “death spiral.” The mechanism issued more TerraLuna tokens, further depressing its price. Within a week, almost AUD 68.80 billion of market capitalisation was wiped out.
This collapse demonstrated the fundamental weakness of algorithmic stablecoins—they function only as long as market participants believe in their value. Once confidence breaks, there are no real assets to support redemptions, leaving holders with worthless tokens.
Why Use Stablecoins Instead of Cash?
Beyond merely mimicking cash in digital form, stablecoins offer practical advantages that traditional money simply cannot match. Their capacity to resolve practical financial issues that conventional systems find difficult to handle is the reason for their increasing use. When the market peaks, swapping your volatile assets into USDC is the fastest way to execute your crypto exit strategy without waiting for a bank wire.
Speed and Efficiency
Traditional cross-border payments typically travel through multiple correspondent banks, resulting in delays of 3-7 days and fees averaging 6.62%. Moreover, these transfers are limited by banking hours and numerous intermediaries. Stablecoins eliminate these constraints by enabling direct transfers between parties.
Stablecoin transactions settle within minutes or seconds, regardless of time or day. This speed proves vital for businesses managing international operations—exporters receive funds immediately rather than waiting days, whilst treasuries move money instantly between subsidiaries.
The simplified path from sender to recipient also drastically reduces costs. Instead of accumulating wire transfer fees, interchange charges, and currency conversion markups, stablecoin transfers typically incur only minimal blockchain network fees.
Parking Profits
During market volatility, stablecoins function as a safe harbour for crypto investors. Traders use them as “dry powder” when moving between crypto positions, allowing quick position changes without converting to fiat currencies.
This capability lets investors lock in gains during downturns whilst remaining in the digital ecosystem, ready to re-enter positions when opportunities arise. Essentially, stablecoins serve as the “base asset” for on-chain trading, facilitating rapid asset rotation.
Global Access
Perhaps most importantly, stablecoins provide financial access where traditional systems fall short. For individuals in high-inflation countries without access to US dollars, stablecoins offer a reliable store of value.
Notably, countries like India, Nigeria, and Indonesia rank among the most active stablecoin users, driven by grassroots demand for accessible cross-border payments. This accessibility extends to underbanked populations, who can receive digital dollars without requiring a US bank account.
As regulatory clarity improves, stablecoins will continue expanding beyond crypto trading into mainstream financial applications, potentially reaching AUD 3.06 trillion by 2028.
The Risks: Are They Truly Safe?
Despite their stability-focused design, stablecoins carry risks that prudent investors must understand. These digital assets face unique vulnerabilities that can challenge their foundational promise of maintaining a stable value.
The “De-Peg” Risk
A “de-peg” occurs when a stablecoin’s price deviates significantly from its target value. These events can unfold with alarming speed—TerraUSD’s collapse erased over AUD 91.74 billion in market value within days, spreading financial contagion across decentralised markets. Even established stablecoins aren’t immune; during market turmoil, Tether has traded as low as 94 cents on the dollar.
De-pegging typically begins with market stress or confidence crises that create selling pressure exceeding stability mechanisms. This initial deviation often triggers automated selling and panic exits, creating self-reinforcing downward spirals. Consequently, in interconnected DeFi systems, these events can quickly spread, triggering liquidations across multiple protocols.
The Importance of Audits
Regular, independent audits serve as the primary defence against stablecoin failures. Indeed, monthly audits with mandatory reconciliation might have identified discrepancies in failed stablecoins before their collapse. Nonetheless, traditional quarterly auditing schedules remain inadequate for assets operating continuously on global blockchains, where disruptions can occur within hours.
Effective auditing must reconcile blockchain transparency with custodial opacity. This means verifying both on-chain data (token minting/burning) and off-chain reserves—the traditional financial assets backing stablecoins. Given that timing mismatches between blockchain transactions and off-chain settlement can mask discrepancies, audits must harmonise these data sources to prevent market destabilisation.
Conclusion – What are Stablecoins?
Stablecoins represent a significant evolution in the digital asset space, combining the advantages of blockchain technology with mechanisms for maintaining value stability. Unlike volatile cryptocurrencies, these digital tokens maintain consistent value through various backing strategies, predominantly pegging to the US dollar. Their market capitalisation already exceeds $250 billion, with projections suggesting potential growth to $500-750 billion in the coming years.
Throughout this overview, we’ve examined how stablecoins function through issuance, recording, circulation, and redemption processes. The distinction between fiat-backed stablecoins (backed by actual reserves) and algorithmic stablecoins (relying on complex mechanisms without sufficient reserves) remains crucial for investors to understand. The TerraUSD collapse indeed demonstrated the catastrophic consequences of algorithmic models when confidence falters.
Stablecoins address genuine financial challenges by enabling near-instant settlement times and dramatically lower fees than traditional cross-border transfers. Additionally, they serve as essential safe harbours during market volatility, allowing traders to preserve gains without exiting the digital ecosystem completely. Their accessibility also provides underbanked populations and those in high-inflation economies with access to stable value stores. Because stablecoins are tied to fiat currency, holding them for years exposes you to the same risks we covered in our Bitcoin vs. Inflation guide. They are a temporary parking spot, not a long-term investment.
As regulatory frameworks continue to develop, stablecoins will likely expand beyond cryptocurrency trading into mainstream financial applications. Their ability to combine the efficiency of digital assets with stability of value positions them as potentially transformative tools in the global financial system. Users who understand both the benefits and risks will undoubtedly find themselves better to navigate this evolving financial frontier.
How do fiat-backed stablecoins maintain their value?
Fiat-backed stablecoins maintain their value through reserve management. For every stablecoin issued, the company holds an equivalent value in reserve assets, such as cash or short-term government securities. To ensure stability and transparency, these reserves are regularly audited.
What are the advantages of using stablecoins over traditional cash?
Stablecoins enable faster, more efficient cross-border transactions, settling within minutes or seconds, regardless of time or day. They also provide a safe harbour for crypto investors during market volatility and offer global access to stable value stores, particularly beneficial for those in high-inflation countries.
What risks are associated with stablecoins?
The primary risk associated with stablecoins is the potential for “de-pegging,” in which a stablecoin’s price deviates significantly from its target value. This can occur during market stress or confidence crises, potentially leading to rapid value loss and financial contagion across decentralised markets.
How important are audits for stablecoin stability?
Regular, independent audits are crucial for maintaining stablecoin stability. They help verify both on-chain data and off-chain reserves, ensuring the stablecoin’s backing is sufficient and transparent. Effective auditing practices are essential to prevent market destabilisation and maintain user confidence in the stablecoin’s value.
