2.2 Taxonomy of Stability Mechanisms
What You'll Learn: Why different stablecoins use different methods to maintain their dollar peg, the fundamental trade-offs each approach makes, and what Terra's $60 billion collapse taught the industry about stability design.
In the previous section, we saw how different actors work together to keep stablecoins stable. But how exactly do different stablecoins maintain their dollar peg? What happens behind the scenes to keep 1 USDC trading around $1, including during market stress?
The answer depends on which type of stablecoin you're using. Just as there are different ways to heat a home (gas furnace, electric heater, or wood stove) there are different mechanisms for keeping a stablecoin at its target value. Each approach comes with its own set of trade-offs between safety, efficiency, and control.
To understand these trade-offs, consider what happened to TerraUSD (UST) in May 2022. This algorithmic stablecoin relied on software mechanics instead of dollar reserves. It promised to maintain its peg through automated supply adjustments. For months it worked perfectly, growing to become one of the largest stablecoins with $18 billion in circulation. Then, in just a few days, it collapsed to near zero, wiping out $60 billion in total value across the Terra ecosystem. Thousands of people lost their life savings. The collapse sent shockwaves through the entire crypto market and taught everyone a harsh lesson: not all stability mechanisms are created equal [1].
This catastrophic failure validated what researchers call the "Stablecoin Trilemma." Think of it like the classic "good, fast, cheap" dilemma in business: you can usually pick two, but rarely all three.
Why these three factors matter fundamentally:
Price stability is the core promise of any stablecoin. Without it, the token fails its basic purpose
Decentralization provides censorship resistance and eliminates single points of failure that could freeze your funds
Capital efficiency determines scalability and user cost (how much collateral must be locked to mint $1). Inefficient systems tie up billions in idle collateral that could be productive elsewhere
The trilemma emerges because improving one dimension often requires sacrificing another. Want perfect stability? You'll need either centralized control (like USDC) or massive over-collateralization (like DAI). Want full decentralization with capital efficiency? You risk the instability that destroyed UST. This fundamental tension shapes every stablecoin design decision.
For stablecoins, the three desired qualities are:
Price stability: The token reliably maintains its peg to the dollar
Decentralization: No single company or government controls the system
Capital efficiency: You don't need to lock up excessive collateral
Most stablecoin designs excel at two of these qualities while compromising on the third. Understanding these trade-offs helps explain why certain designs dominate the market while others, like Terra, spectacularly failed [2].
Let's examine each major approach and see how real users interact with these different systems.
Fiat-Collateralized
This is the simplest and most popular model, used by market leaders like Tether (USDT) and Circle (USDC).
How it works: For every digital token in circulation, the issuing company holds one actual dollar (or dollar-equivalent assets like Treasury bills) in a bank account. It's like a digital receipt for real money, straightforward and easy to understand.
James's Story: Hong Kong Trading Desk James manages crypto trading for a hedge fund. When Bitcoin spiked to $108,000 in December 2024, he needed to quickly secure profits without moving money back to traditional banks. "I converted $50 million of Bitcoin to USDT in seconds," he explains. "I know Tether has actual dollars backing those tokens. When markets calm down, I can buy back in just as quickly." For traders like James, fiat-backed stablecoins provide a reliable parking spot for capital between trades.
Trilemma Analysis
Stability: High With real dollars backing each token, the peg remains strong. The main risk comes from the issuing company's management of reserves or the banks holding the money.
Capital Efficiency: High One dollar backs one token, no wasted capital.
Decentralization: Low You must trust a single company and the banks they use. If Circle goes bankrupt or loses banking partners, USDC holders face risk.
Commodity-Collateralized
Instead of dollars, these stablecoins are backed by physical commodities, primarily gold.
How it works: Each token represents ownership of a specific amount of gold stored in secure vaults. PAX Gold (PAXG) and Tether Gold (XAUT) let you own gold digitally without dealing with physical storage.
Trilemma Analysis
Stability: Moderate The token maintains a stable value relative to gold, but gold itself fluctuates against the dollar. You're getting exposure to gold prices, not dollar stability.
Capital Efficiency: High One ounce of gold backs one token.
Decentralization: Low Similar to fiat-backed models, you trust a company to store and manage physical gold.
Crypto-Collateralized
This approach uses other cryptocurrencies as backing while maintaining decentralization through smart contracts.
How it works: To create $100 worth of stablecoins, you must deposit $150 or more worth of cryptocurrency (like Ethereum) into a smart contract. This over-collateralization protects against crypto price swings. If your collateral value drops too low, the system automatically sells it to maintain backing.
Critical infrastructure - Price Oracles: But how does a smart contract know if Ethereum is worth $4,000 or $3,000? This is where oracles come in. They are external services that feed real-world price data to the blockchain. Without accurate price feeds, the entire system breaks. If an oracle reports wrong prices, either accidentally or through manipulation, it could trigger unfair liquidations (selling your collateral too early) or allow dangerous under-collateralization (not selling soon enough). Major protocols like MakerDAO use multiple oracle sources and time delays to prevent manipulation, but this remains a critical dependency.
Elena's Story: Berlin DeFi Developer Elena holds 10 ETH worth $40,000 but needs cash for expenses without selling her crypto. She deposits her ETH into MakerDAO and borrows $25,000 worth of DAI stablecoins against it. "It's like a home equity loan, but for crypto," she explains. "I keep my ETH exposure while accessing liquidity. The 160% collateralization gives me a safety buffer if ETH drops." For DeFi users like Elena, crypto-backed stablecoins enable sophisticated financial strategies.
Trilemma Analysis
Stability: Moderate to High Over-collateralization and automatic liquidations maintain the peg, but extreme market crashes can stress the system. Liquidation occurs when collateral value falls below a predetermined ratio. For example, if your $150 ETH collateral backing $100 DAI falls to $149, the protocol automatically auctions your ETH to repay the DAI loan plus a penalty fee (typically 13%), protecting the system's solvency.
Capital Efficiency: Low You need $150+ of collateral to create $100 of stablecoins, tying up significant capital.
Decentralization: High Everything runs on transparent smart contracts without centralized control.
Algorithmic
The most ambitious approach attempts to maintain stability through supply and demand algorithms rather than backing assets.
How it works: Think of it like a central bank that automatically prints or destroys money to maintain price stability. When demand increases and price rises above $1, the algorithm creates new tokens to increase supply and lower price. When demand falls below $1, it tries to reduce supply. This family of designs (often called "seigniorage-style") promises efficiency without collateral.
The Terra/UST mechanism specifically worked through a mint-burn arbitrage system between two tokens: UST (the stablecoin) and LUNA (the volatile governance token). Here's the intended mechanism:
When UST traded above $1: Traders could burn $1 worth of LUNA to mint 1 UST, then sell that UST for more than $1, profiting from the difference
When UST traded below $1: Traders could buy UST for less than $1, burn it to mint $1 worth of LUNA, then sell the LUNA for profit
This arbitrage mechanism was supposed to create natural buying and selling pressure to maintain the peg. The fatal flaw? It required LUNA to maintain value to absorb UST selling pressure.
The cautionary tale of Terra: Do Kwon, Terra's founder, believed this dual-token system could maintain UST's dollar peg indefinitely. For a while, it seemed to work, with UST growing to $18 billion in circulation. Then in May 2022, large withdrawals triggered a death spiral: as confidence wavered and UST depegged, the algorithm minted billions of LUNA tokens to absorb UST redemptions, causing LUNA's price to crash from $80 to near zero in days. Without valuable LUNA to back the arbitrage mechanism, UST lost its peg permanently. The system that promised algorithmic stability instead proved that confidence, not code, was its true foundation [3].
Trilemma Analysis
Stability: Very Low Without external backing, these systems are vulnerable to confidence crises and death spirals. A death spiral occurs when selling pressure on the volatile token (LUNA) reduces its value, requiring more tokens to be minted to maintain the stablecoin peg, which further dilutes value, creating a self-reinforcing cycle of collapse.
Capital Efficiency: High in theory, fragile in stress No collateral needed, just algorithms managing supply.
Decentralization: High Fully automated on-chain mechanisms.
Learning from Resilience: Stablecoins That Survived Crisis
Not all stablecoins crumble under pressure. Understanding why some survive while others fail provides crucial insights into robust design.
DAI's Battle-Tested Stability: Since 2017, MakerDAO's DAI has weathered multiple crypto market crashes, including the March 2020 "Black Thursday" when ETH dropped 50% in 24 hours. While the system showed stress (some positions were liquidated below target prices), DAI maintained its peg through automatic liquidations and governance adjustments. The key? Over-collateralization provided a buffer, and transparent on-chain mechanics allowed users to monitor system health in real-time.
USDC's Rapid Recovery: When Silicon Valley Bank collapsed in March 2023, Circle had $3.3 billion trapped in the failed bank. USDC briefly traded as low as $0.87 as panic spread. Yet within 72 hours, after the Federal Reserve guaranteed deposits, USDC returned to $1. Circle's diversified banking relationships, transparent communication, and regulatory compliance enabled this quick recovery. The incident actually strengthened USDC's position as institutions saw how rapidly it could handle crisis.
USDT's Persistent Dominance: Despite years of regulatory scrutiny, banking challenges, and persistent questions about reserves, Tether has processed over $1 trillion in redemptions without failing to honor a single one. During the May 2022 Terra collapse, USDT absorbed $7 billion in redemptions in 48 hours while maintaining its peg. Whether through luck or design, USDT's massive liquidity and market maker relationships have proven remarkably resilient.
These successes share common factors: transparent operations (even if imperfect), strong liquidity provisions, and either robust collateralization or deep institutional backing. They demonstrate that well-designed stablecoins can survive extreme stress that would break traditional financial systems.
Comparison of Stablecoin Stability Mechanisms
Fiat-Collateralized
USDT, USDC
Real dollars/T-bills
High
High
Low
Commodity
PAXG, XAUT
Physical gold
Moderate
High
Low
Crypto-Collateralized
DAI, MIM
Over-collateralized crypto
Moderate-High
Low
High
Algorithmic
UST (failed), USDN
Supply algorithms
Very Low
Very High
High
Synthetic/ Delta-Neutral
USDe, suiUSDe
Digital assets + short futures
High
High
Moderate
Emerging Hybrid and Novel Models
The lessons from Terra's collapse are driving innovation in new directions:
U.S. Treasury-Backed Yield-Bearing Stablecoins: Companies like Ondo (USDY) and Hashnote (USYC) offer stablecoins backed specifically by U.S. Treasuries that pass interest earnings to token holders. Instead of issuers keeping all the profit from reserves, users receive yields similar to money market funds [4].
Fractional-Algorithmic Stablecoins: Frax (FRAX) attempts to find middle ground by combining partial USDC backing with algorithmic mechanisms. This hybrid approach aims for better capital efficiency than pure crypto-backing while avoiding the fragility of pure algorithmic designs [5].
Understanding these different mechanisms and their trade-offs helps you evaluate which stablecoins to trust with your money. Fiat-backed options dominate for good reason: they offer the best stability for everyday use, even if they require trusting centralized issuers. But knowing how each type works (and what can go wrong) remains essential for anyone using stablecoins.
Synthetic Dollar Models with Delta-Neutral Strategies: A sophisticated new approach emerged with Ethena's USDe, which has grown to over $14 billion in market capitalization. These synthetic dollars maintain their peg through a balanced portfolio strategy: holding digital assets (like Bitcoin or Ethereum) while simultaneously taking short positions in futures markets. This "delta-neutral" approach cancels out price movements, if the underlying asset drops 10%, the short position gains 10%, preserving the dollar value. [6]
The October 2025 launch of suiUSDe on the Sui blockchain demonstrates this model's expansion beyond Ethereum. Like its predecessor USDe, suiUSDe generates yield from two sources: staking rewards from the underlying digital assets and funding payments from perpetual futures positions. During bull markets, traders typically pay funding to maintain long positions, creating consistent income for the short side that these stablecoins occupy.
This approach offers an interesting middle path in the trilemma: it achieves high capital efficiency (no over-collateralization needed) and reasonable decentralization (positions are transparent and verifiable on-chain) while maintaining stability through market-neutral positioning rather than pure collateral backing. The trade-off? Complexity and counterparty risk from derivatives exchanges. If a major exchange fails or funding rates turn deeply negative for extended periods, the model faces stress.
Why this matters for users: Unlike traditional stablecoins where issuers keep all reserve profits, synthetic dollar models can share yield with holders, potentially offering 5-15% annual returns during normal market conditions. However, this yield comes with additional risks that pure fiat-backed stablecoins avoid.
Now that we understand the different ways stablecoins maintain their value, let's look at the actual process of creating and destroying these tokens. This "mint-burn lifecycle" is where the theory meets practice, turning dollars into digital tokens and back again.
Key Takeaways:
The trilemma forces trade-offs (stability + efficiency → centralized, stability + decentralization → overcollateralized)
Fiat-backed dominates markets (USDT/USDC offer stability but require trusting companies)
Crypto-backing enables decentralization but requires 150%+ collateral (DAI, MIM)
Algorithmic stablecoins proved fatal (UST's $60B collapse showed confidence matters more than code)
References
[1] What happened to the $3.5 billion Terra Reserve? - https://www.elliptic.co/blog/what-happened-to-the-3.5-billion-terra-reserve-elliptic-follows-the-bitcoins
[2] Overcoming the Stablecoin Trilemma: Designing and Simulating a Decentralized, Stable, and Capital-Efficient Peg Maintenance System - https://www.scirp.org/journal/paperinformation?paperid=137781
[3] Stablecoins: Fiat-backed vs Crypto Collateralized vs Algorithmic - https://www.elliottdavis.com/insights/stablecoins-fiat-backed-vs-crypto-collateralized-vs-algorithmic
[4] Stablecoins 101: Behind crypto's most popular asset - https://www.chainalysis.com/blog/stablecoins-most-popular-asset/
[5] What do I need to know about stablecoins? - https://www.ubs.com/us/en/wealth-management/insights/article.1886983.html
[6] Sui, SUIG, and Ethena to Launch Native suiUSDe - https://blog.sui.io/suig-ethena-suiusde-stablecoin/
© 2025 Protokol Innovation Labs | Licensed under CC BY 4.0
Last updated