Stablecoins: What They Are, How They Work, and Which to Trust

Why Stablecoins Matter, and Why They're Not All the Same

If you've spent any time researching cryptocurrency, you've likely encountered the argument that price volatility makes digital assets impractical for everyday use. Stablecoins were designed to solve exactly that problem. They're blockchain-based tokens engineered to maintain a consistent value, typically pegged to the US dollar, though some track the euro, Australian dollar, or even gold.

But calling all stablecoins "stable" is a bit like calling all investment funds "safe." The label describes an intention, not a guarantee. Understanding how a stablecoin maintains its peg determines whether it's a useful financial tool or a ticking systemic risk. For Australian investors, particularly those holding crypto within an SMSF, reporting gains to the ATO, or simply trying to avoid volatility between trades, this distinction is genuinely important.

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The Three Main Types of Stablecoins

1. Fiat-Backed (Custodial) Stablecoins

These are the simplest to understand and currently the most widely used. A centralised issuer holds fiat currency (or near-cash equivalents) in reserve and issues tokens on a 1:1 basis. If you hold 1,000 USDC, the issuer theoretically holds $1,000 USD in reserve, redeemable on demand.

Major examples:

• USDC, issued by Circle, regularly audited by Grant Thornton
• USDT (Tether), the largest by market cap, issued by Tether Limited; historically opaque about its reserve composition
• AUDD, an Australian dollar-denominated stablecoin issued by Novatti, pegged to the AUD

How they maintain the peg: Through direct redemption. If USDC trades above $1.00, arbitrageurs buy the underlying and mint new tokens to bring the price down. If it trades below, they redeem tokens for fiat to reduce supply.

Key risks:

• Counterparty risk, you are trusting the issuer to actually hold reserves. If Circle or Tether is mismanaged, fractionally reserved, or subject to regulatory seizure, redemptions could fail
• Custodial risk, the issuer controls the blacklist function. Both Circle and Tether have frozen individual wallets at law enforcement request
• Regulatory risk, ASIC has signalled increasing interest in regulating stablecoin issuers operating in Australia, and the Treasury's 2023 token mapping consultation explicitly identified "asset-backed tokens" as a priority category

What to look for: Monthly attestations (not just audits) from a reputable accounting firm, clear breakdown of reserves (cash vs. T-bills vs. commercial paper), and a legal entity domiciled in a jurisdiction with strong creditor protections.

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2. Crypto-Collateralised Stablecoins

These stablecoins are backed not by fiat but by other crypto assets, typically overcollateralised to account for price volatility. The most mature and widely trusted example is DAI, issued by the MakerDAO protocol on Ethereum.

How they work: A user deposits collateral (e.g., ETH) into a smart contract called a Collateralised Debt Position (CDP). They can then borrow DAI up to a certain percentage of their collateral's value, say, 66% for a 150% collateralisation ratio. If the value of their collateral falls toward the liquidation threshold, the protocol automatically sells the collateral to repay the debt and maintain solvency.

The peg mechanism is maintained through a combination of:

• Target Rate Feedback Mechanism, adjusting the DAI Savings Rate to incentivise supply/demand
• Liquidation incentives, bots ("keepers") profit from liquidating undercollateralised positions
• PSM (Peg Stability Module), allows direct 1:1 swaps between DAI and USDC at fixed rates, though this creates its own dependency on fiat-backed assets

Key risks:

• Collateral volatility, a rapid market crash (as seen in March 2020) can outpace liquidation mechanisms, leaving the system undercollateralised
• Smart contract risk, bugs or exploits in the underlying code can be catastrophic and irreversible
• Governance risk, MakerDAO operates as a DAO (decentralised autonomous organisation); major decisions are made by MKR token holders, who may have misaligned incentives
• Collateral concentration, DAI is now significantly backed by real-world assets (RWA) and USDC, which reintroduces centralised counterparty exposure

Who uses these: Traders who want to maintain crypto exposure while accessing liquidity, DeFi participants earning yield, and sophisticated investors who want transparency, every collateral position is auditable on-chain in real time.

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3. Algorithmic Stablecoins

This is where stablecoins get genuinely complex, and, in several notable cases, genuinely dangerous.

Algorithmic stablecoins attempt to maintain their peg not through collateral, but through software-driven supply adjustments and economic incentive design. Instead of reserves, they rely on a self-referential mechanism where market participants are incentivised to arbitrage the token back to its peg.

The most significant example, and cautionary tale, is TerraUSD (UST), which collapsed in May 2022, wiping approximately $40 billion USD from the market in less than a week. UST maintained its peg through a mint-and-burn relationship with LUNA, Terra's native token. If UST fell below $1, holders could burn UST to mint $1 worth of LUNA. But this mechanism depended entirely on sustained confidence and demand. Once confidence broke, a death spiral ensued: burning UST minted more LUNA, which further diluted LUNA's value, which destroyed confidence in UST further, and so on, to zero.

Why they're inherently fragile:

• The peg is maintained by belief in the mechanism, not by hard assets
• In a crisis, the incentive to exit overwhelms the incentive to arbitrage back to the peg
• They are reflexively unstable, the same forces that support the peg during growth accelerate its collapse during stress

Current landscape: Most pure algorithmic stablecoins have either failed or migrated toward partial collateralisation. FRAX, for example, began as a partially algorithmic design and has progressively moved toward full collateralisation following the Terra collapse.

The lesson here is straightforward: if a stablecoin cannot clearly explain what backs its peg in terms of hard, redeemable assets, the answer is probably "nothing but momentum."

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How to Assess Stablecoin Risk

For Australian investors evaluating which stablecoins to use, whether for trading, DeFi yield, or treasury management within a business, the following framework applies:

1. Examine the collateral

• Is it fiat? Get the attestation reports. Look for cash and short-duration government bonds, not commercial paper or affiliated-party loans.
• Is it crypto? Check the collateralisation ratio and the liquidation logic. Is it over 150%? Is there a circuit breaker?
• Is it "algorithmic"? Treat with extreme caution.

2. Assess the issuer

• Is it a regulated entity? USDC issuer Circle is registered with FinCEN in the US. Tether is domiciled in the British Virgin Islands with lighter regulatory oversight.
• Has it undergone independent attestation or a full audit? There is a difference: an attestation confirms reserves at a point in time; a full audit involves broader financial statement review.
• Has it ever broken its peg and by how much? USDC briefly traded at $0.87 in March 2023 following Silicon Valley Bank's collapse (Circle held ~$3.3B in deposits there). It recovered, but the episode demonstrated that even well-regarded stablecoins carry tail risk.

3. Consider the smart contract infrastructure

• For DeFi-native stablecoins, review whether the smart contracts have been audited by reputable firms such as Trail of Bits, OpenZeppelin, or Certora.
• Is there a bug bounty programme? A meaningful one suggests the team takes security seriously.
• Is there an admin key or upgrade mechanism that could be exploited?

4. Understand your regulatory position in Australia

• The ATO treats stablecoins as crypto assets for tax purposes. Swapping from ETH to USDC is a CGT event, you must calculate a gain or loss at the time of the transaction, even if USDC is "worth" the same in dollar terms as when you exit.
• ASIC has not yet established a domestic stablecoin licensing regime, but the 2023-24 regulatory reform agenda suggests this is coming. Stablecoins offered to retail investors in Australia may increasingly be captured under financial services law.
• SMSF trustees using stablecoins should ensure their investment strategy document explicitly permits crypto assets and that holdings are valued at market price each financial year.

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Practical Takeaways

• For most investors, fiat-backed stablecoins (USDC, USDT) are the practical choice for parking value between trades or moving funds on-chain. Prefer USDC for transparency; be cautious with Tether given its historical opacity.
• For DeFi participants, DAI remains the most battle-tested decentralised option, but acknowledge its increasing centralised collateral exposure.
• Avoid algorithmic stablecoins without thorough due diligence and a clear understanding of what backstops the peg during a crisis. If the answer is "game theory," that is not sufficient.
• Diversify stablecoin exposure if holding significant sums. Don't keep $500,000 AUD equivalent in a single issuer, counterparty risk is real.
• Track every swap for tax purposes. The ATO's data-matching programme now extends to major exchanges operating in Australia, and stablecoin transactions are not exempt from CGT reporting.

Stablecoins are genuinely useful financial infrastructure when designed well and managed responsibly. The skill is in knowing which category you're dealing with, because the word "stable" on its own tells you almost nothing.