What Is a Stablecoin and How Does It Work?

Bitcoin can swing 10% in a day. That’s exciting if you’re speculating and useless if you’re trying to pay a supplier, settle a trade or send money home. Stablecoins exist to fix that problem: they’re crypto tokens built to stay worth the same amount, usually exactly $1.

They’ve grown into one of the most-used parts of the crypto world, and in July 2025 the US passed its first federal law specifically for them. But not all stablecoins are built the same way, and the differences decide whether “stable” actually holds up under pressure.

This guide explains how stablecoins work, compares reserve-backed and algorithmic designs, looks at what happened when 2 well-known stablecoins lost their peg, and covers what the new US rules mean.

This is general information, not financial, investment or legal advice.

What a stablecoin is

A stablecoin is a digital token on a blockchain that aims to keep a fixed value against a reference asset. Most track the US dollar, but some track the euro, other currencies or gold.

People use stablecoins to:

• Move dollars on crypto networks, without converting back to a bank account each time
• Trade crypto, since many exchanges price assets against dollar stablecoins
• Send money across borders at any hour, often settling in minutes
• Use decentralized finance (DeFi) apps for lending, borrowing and trading
• Hold dollars where local currency is unstable or banking is hard to access

Stablecoins sit in your crypto wallet like any other token. If you’re new to that, start with our guide to hot wallets vs cold wallets.

How stablecoins keep their value

The basic promise is: 1 coin can always be swapped for $1. How an issuer backs that promise is what separates safe designs from risky ones.

Reserve-backed (fiat-collateralized) stablecoins

This is the most common type. A company issues the token and holds real-world assets in reserve, such as cash in bank accounts, short-term US Treasury bills and similar low-risk holdings.

Here’s the cycle:

1. A customer, usually a business or large trader, sends $1 million to the issuer.
2. The issuer creates (mints) 1 million tokens and holds the $1 million in reserves.
3. Tokens circulate and trade on exchanges and in wallets.
4. When someone redeems 1 million tokens, the issuer destroys (burns) them and sends back $1 million.

If the token trades at $0.99 on an exchange, traders can buy it cheaply and redeem it for $1, pushing the price back up. If it trades at $1.01, they can mint new tokens at $1 and sell them. That arbitrage is what keeps the price close to the peg, as long as people trust that redemptions will work.

Crypto-collateralized stablecoins

Some stablecoins are backed by other cryptocurrencies locked in smart contracts. Because crypto is volatile, they’re usually overcollateralized: you might lock up $150 of crypto to mint $100 of stablecoins. If the collateral’s value falls too far, the system automatically sells it to protect the peg.

Algorithmic stablecoins

Algorithmic designs try to hold the peg mostly with code and market incentives instead of real reserves. A common approach pairs the stablecoin with a second, volatile token from the same project. When the stablecoin drops below $1, the system lets people swap it for $1 worth of the second token, which is supposed to reduce supply and push the price back up.

The weakness is circular: the backing is a token whose value depends on confidence in the same project. When confidence breaks, both can collapse together.

Comparing the main designs

Key takeaway: A stablecoin is only as stable as what stands behind it. Ask 3 questions: what are the reserves, who holds them, and can ordinary holders actually redeem for $1?

When stablecoins broke: 2 lessons

TerraUSD (2022): an algorithmic collapse

TerraUSD (UST) was an algorithmic stablecoin paired with a sister token, LUNA. According to the SEC, UST lost its peg to the dollar in May 2022, and the prices of UST and its sister tokens fell close to zero. The SEC later said the collapse wiped out about $40 billion in market value nearly overnight. The SEC charged Terraform Labs and its co-founder Do Kwon with fraud in February 2023, alleging they misled investors about UST’s stability; a jury later found them liable.

The lesson: a peg held up by a token from the same project can unravel very quickly when people rush for the exit.

USDC (2023): a reserve-backed wobble

USDC is a reserve-backed stablecoin. In March 2023, its issuer, Circle, disclosed that about $3.3 billion of its reserves were held at Silicon Valley Bank, which had just failed. The Federal Reserve’s 2023 Financial Stability Report noted that USDC’s price fell as low as 87 cents. It recovered to about $1 after US authorities assured that uninsured deposits at the failed banks were safe, and Circle resumed redemptions.

The lesson: even well-backed stablecoins depend on where reserves are held. A bank failure can trigger a run if holders fear they can’t redeem.

What the GENIUS Act changes

The Guiding and Establishing National Innovation for US Stablecoins (GENIUS) Act was signed into law on July 18, 2025 as Public Law 119-27. It creates a federal framework for “payment stablecoins,” meaning dollar-pegged coins designed for payments and redeemable for a fixed amount. Key points:

• Licensed issuers only. Payment stablecoins must be issued by permitted issuers, such as subsidiaries of insured banks or approved nonbank issuers, under federal or qualifying state oversight.
• 1-to-1 reserves. Issuers must hold identifiable reserves at least equal to outstanding coins, limited to safe assets such as cash, insured deposits, short-term Treasury bills, Treasury-backed repos and government money market funds.
• Monthly disclosure. Issuers must publish their reserve composition each month, and reports must be examined by a registered public accounting firm.
• No reuse of reserves. Reserves generally can’t be pledged or rehypothecated.
• No interest to holders. Issuers can’t pay holders interest or yield just for holding the coin. Lawmakers and regulators are still debating whether rewards paid by exchanges and other third parties fall outside that ban.
• Bankruptcy priority. Holders get priority over other creditors if an issuer fails.
• A study of algorithmic designs. The law directs Treasury, with other regulators, to study non-payment stablecoins, including “endogenously collateralized” coins that rely on another token from the same issuer, the design behind TerraUSD.

The law generally takes effect on the earlier of 18 months after enactment (January 18, 2027) or 120 days after regulators issue final implementing rules, so many details are still being finalized. This is not legal advice; check the law and regulators’ guidance for current status.

Stablecoins vs bank deposits and other dollars

Stablecoins aren’t bank deposits and aren’t FDIC insured. For more on that difference, see is your money FDIC insured in a fintech app. If you want yield on cash, a high-yield savings account works differently and carries insurance at insured banks.

Where stablecoins are heading

Stablecoins are increasingly showing up in mainstream finance:

• Payments and payouts. Payment providers are adding stablecoin settlement for merchants and cross-border payouts. Compare options in our guides to embedded finance and real-time payments and sending money internationally.
• Tokenized assets. Stablecoins often serve as the cash leg when tokenized funds and bonds trade on blockchains. See the tokenization of real-world assets.
• Bank-issued tokens. The GENIUS Act lets bank subsidiaries issue payment stablecoins, so more banks may enter the market.

How to evaluate a stablecoin before using it

If you’re considering holding or accepting a stablecoin, run through this checklist:

1. Check the design. Is it reserve-backed, crypto-collateralized or algorithmic?
2. Read the reserve reports. Look for monthly, independently examined reports that show exactly what’s held.
3. Check who regulates the issuer. Under the GENIUS Act, look for a permitted US issuer or a comparable foreign regime.
4. Understand redemption. Can you redeem directly, or only by selling on an exchange? Are there minimums or fees?
5. Watch the peg history. Has it held during market stress?
6. Secure your wallet. Stablecoins can be stolen like any crypto, and transfers usually can’t be reversed.
7. Mind taxes and records. Talk to a tax professional about reporting, especially for business use.

Conclusion

A stablecoin is a crypto token designed to stay worth a fixed amount, usually $1. Reserve-backed stablecoins hold cash and Treasury bills and promise redemption; algorithmic ones rely on code and a sister token, a design that failed spectacularly with TerraUSD. The GENIUS Act now requires US payment stablecoins to hold 1-to-1 safe reserves and disclose them monthly, which should make the market safer, but stablecoins still aren’t bank deposits. Know what backs a coin before you trust it with real money.

Sources

• Congress.gov: GENIUS Act, Public Law 119-27 — enacted July 18, 2025; reserve, disclosure, interest and study provisions
• Congress.gov: S.1582 GENIUS Act bill page — legislative history and votes
• SEC press release 2023-32 — charges against Terraform Labs and Do Kwon; UST depeg in May 2022
• SEC press release 2024-73 — settlement and $40 billion loss in market value
• Federal Reserve: May 2023 Financial Stability Report, funding risks — USDC falling as low as 87 cents after SVB
• Federal Reserve FEDS Notes: Lessons from the SVB failure and its impact on stablecoins — USDC redemption surge and recovery