# Stablecoins 101: What They Are, Types, and How the $1 Peg Works

**Published by:** [Meriem Barhoumi](https://paragraph.com/@meoumi/)
**Published on:** 2026-01-01
**Categories:** stablecoins, 101, usdc, tether, dai, rai
**URL:** https://paragraph.com/@meoumi/stablecoins-101

## Content

Imagine you walk into a crypto city. In this city, everything is noisy and dramatic. One day, ETH is up 20%. The next day, ETH is down 30%. That’s exciting if you’re gambling… but if you’re trying to save money, pay someone, set prices, or borrow, it’s a nightmare. So people in this city created something boring on purpose:A “digital dollar” that lives on the blockchain.That’s a stablecoin. A stablecoin’s job is simple:Try to stay close to $1.That target is called the peg.The $1 magnet (how stability works)Think of $1 as a magnet. When the coin goes to $0.98, something should pull it back up. When it goes to $1.02, something should push it back down. A good stablecoin isn’t “stable by magic”… It’s stable because it has a system that fights to bring it back to $1. And different stablecoins fight in different ways.Primary market vs secondary market (the part beginners miss)Before the types, one key idea:Secondary market = where most people buy/sell stablecoins (DEXs, exchanges). The price can move to $0.99, $1.01, etc.Primary market = where stablecoins are created or cashed out at the source (issuer/protocol). This is where minting and redemption usually happen.This matters because not every stablecoin lets everyone redeem directly. Some only let big institutions do it, and everyone else trades on the secondary market.Type 1: Fiat-backed stablecoins (the “bank vault” story)Picture a big company with a vault. Inside the vault: real dollars (or dollar-like assets). On the blockchain: tokens that represent those dollars. So the company says:“Give me $1, I’ll give you 1 token. Give me 1 token, I’ll give you $1 back.”That “swap it back for $1” is called redemption.Why does that keep it near $1?Because people love easy profit.If the coin is trading at $0.98, traders buy it cheap, redeem it for $1, and make $0.02 profit. That buying pushes the price back up.If the coin is trading at $1.02, traders create new coins for $1, sell them for $1.02, and profit. That selling pushes the price back down.That profit-driven balancing is called arbitrage. Pros: usually the most stable and widely used Cons: you must trust the company and the banking system behind itQuick “what could go wrong?”If people fear reserves aren’t solid, or redemption becomes limited, confidence drops → price can drift below $1.Some designs can freeze funds (issuer/policy risk).Type 2: Crypto-collateralized stablecoins (the “pawn shop” story)Now imagine a smart-contract pawn shop. You walk in with your ETH. The shop says:“If you lock up $150 worth of ETH, I’ll let you borrow $100 worth of stablecoins.”That extra safety cushion is called overcollateralization. The safety level is often described by a collateral ratio (how much collateral backs the debt).How does it stay near $1?If the stablecoin becomes too expensive (like $1.05): people are tempted to mint/borrow more, sell it for $1.05, and profit. More supply pushes it back toward $1.If the stablecoin becomes too cheap (like $0.95): borrowers buy it cheap, repay their debt, and unlock their ETH. Buying reduces supply and pushes it back toward $1.What if ETH crashes?If your collateral becomes too low, the system forces a sale to protect itself. That forced sale is called liquidation. Pros: more transparent (you can often see collateral on-chain) Cons: relies on liquidations + price feeds working during chaosQuick “what could go wrong?”A fast crash can overload liquidations.Bad price feeds (oracles) can cause incorrect liquidations or under-backing.Smart contract risk is always real.Type 3: Algorithmic stablecoins (the “robot central bank” story)Now we enter the risky neighborhood. Here, there is no simple “always redeem for $1” promise. Instead, there’s a robot that tries to manage the price using rules. Think:“If the price is low, I’ll do things to push it up.” “If the price is high, I’ll do things to push it down.”How?Some designs mint more coins when price is above $1Some designs reduce supply when price is below $1Some use a second token as a shock absorberSome use incentives that try to “force” good behaviorThe big weakness:This system depends heavily on confidence. If people stop believing the robot can defend $1, they rush to exit — and the peg can break fast. That’s why algorithmic stablecoins are usually considered the highest risk category.Quick “what could go wrong?”Confidence breaks → selling accelerates → peg defense can’t keep up.Some designs can spiral (“death spiral”) when the helper token collapses.A special word: PCV (Protocol Controlled Value)Some algorithmic/hybrid stablecoins create a “protocol treasury”. That treasury is called PCV. PCV = money the protocol controls to defend the peg. Mental picture:A central bank keeping reserves to buy/sell in the market to protect the price.Important detail:Users usually can’t directly redeem PCV like a normal $1 redemption system.PCV can help defend the peg… but it’s still a strategy, not a guarantee.Where stablecoins show up in DeFi (why you should care)Stablecoins are the “cash” of crypto. You’ll see them everywhere:Trading pairs: most crypto trades happen through stablecoinsLending/Borrowing: borrow stablecoins using ETH as collateralYield strategies: “stablecoin vaults” that pay interest (with risk)Payments: quick transfers that don’t swing like ETHStable ≠ safe (the most important beginner reminder)Stablecoins try to stabilize price, not eliminate risk. Different stablecoins come with different risks:Fiat-backed: issuer/bank/regulatory risk (and sometimes freeze risk)Crypto-backed: smart contract/oracle/liquidation riskAlgorithmic: reflexive/confidence risk (can break fast)So don’t ask only: “Is it stable?” Ask: “What makes it stable?”How to judge a stablecoin in 10 secondsWhen you see a stablecoin, ask:What backs it? Cash in banks? Crypto in smart contracts? Mostly incentives?Who can redeem? Everyone, or only institutions?What happens at $0.95? Who is guaranteed to buy it back, and with what money?What’s the worst-case failure? Freeze risk? Liquidation failure? Death spiral?Mini glossaryPeg: the target price (usually $1)Depeg: when it drifts away (like $0.97 or $1.04)Mint: create new tokensBurn: destroy tokens (reduce supply)Redemption: swapping 1 coin back for $1 (or $1 equivalent)Collateral: assets backing the stablecoinCollateral ratio: how much collateral backs the debt (safety buffer)Overcollateralized: backed by more than 1:1 (like $150 backing $100)Liquidation: forced selling of collateral when a loan becomes unsafeLiquidity: how easily you can buy/sell without moving the price muchArbitrage: people making profit by buying cheap and selling/redeeming higherPCV: protocol-controlled treasury used to defend the pegFinal takeawayWhenever you see a stablecoin, ask this one question:If it drops to $0.95, what force pushes it back to $1?“You can redeem it for $1” → strongest“It’s backed by collateral + liquidations” → strong if the system is robust“The protocol will defend it with incentives/treasury” → depends, riskier

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