A stablecoin keeps its peg by giving someone a profitable reason to correct any deviation from $1. For the dominant fiat-backed designs — USDC, USDT, PYUSD, RLUSD — that reason is direct redemption: hand back one token, receive one dollar of reserves. Everything else follows from that guarantee. For crypto-collateralised designs, the anchor is on-chain liquidation engines. For algorithmic stablecoins, it is incentive structures that, as May 2022 demonstrated, can fail catastrophically when confidence collapses.
The redemption anchor
The simplest peg mechanism is also the most reliable. A fiat-backed issuer holds one dollar (or an equivalent liquid asset like a short-term Treasury) for every token in circulation. If the token trades at $0.998, a trader buys tokens on the open market, redeems them at the issuer for $1.00, and pockets the two-cent spread. That buying pressure lifts the price back toward $1. If the token trades at $1.003, the same issuer will mint new tokens against new dollar deposits, increasing supply until the price falls back.
The key is that redemption is real and liquid. The arbitrage only works if the issuer will actually exchange tokens for dollars at par, on demand, in size. This is why reserve quality matters: a reserve of liquid Treasuries and overnight deposits supports fast, large redemptions. A reserve that includes illiquid loans or assets that cannot be sold quickly can leave redemptions delayed or partial — undermining the mechanism precisely when confidence is most needed.
How market arbitrage works minute to minute
Issuers process redemptions, but most of the moment-to-moment price correction happens in secondary markets through automated trading. Bots continuously compare the price of a stablecoin across centralised exchanges, decentralised protocols, and the issuer's redemption portal. When a price gap appears, they trade it closed within seconds.
The mechanics depend on the direction of the deviation:
- Below peg: Bots buy the discounted token on the open market and either sell it where it is priced higher or queue a redemption. This creates buying pressure on the lagging venue and supply pressure on the higher-priced one.
- Above peg: Anyone holding dollars can go to the issuer, deposit a dollar, receive a new token, and sell it at the premium. This minting pressure increases supply until the price normalises.
The arbitrage is self-financing: the profit from correcting a deviation also pays the person correcting it. For large, liquid stablecoins, this keeps deviations in normal conditions within a fraction of a cent.
What "breaking the peg" actually means
A peg breaks when the arbitrage mechanism fails — when the profit from correcting a deviation cannot be realised because:
- The issuer cannot or will not process redemptions (counterparty risk, reserve illiquidity);
- The redemption mechanism is circular rather than anchored externally; or
- Trust in the issuer collapses faster than arbitrage can correct it.
USDC's brief de-peg in March 2023 illustrates the first case. When Circle disclosed that $3.3 billion of its reserves were held at Silicon Valley Bank, which had just been seized by regulators, the market immediately priced in the possibility that redemptions might be impaired. USDC fell sharply on some venues — touching multi-cent discounts to par — before the Federal Deposit Insurance Corporation guaranteed all deposits and Circle confirmed it could honour redemptions in full. The peg recovered within hours once the uncertainty about the reserves resolved.
The TerraUSD collapse: what a circular peg looks like
TerraUSD (UST) was an algorithmic stablecoin that had no dollar reserves at all. Its peg rested on an arbitrage loop between UST and a sister token called LUNA. If UST fell below $1, traders were incentivised to burn UST to mint LUNA at a profit — reducing UST supply, pushing the price back up. If UST rose above $1, traders burned LUNA to mint UST, increasing supply.
The mechanism worked while LUNA had independent value. When a large UST sell-off began in May 2022 and LUNA's price began to fall, the mechanism became reflexive. Burning UST to mint LUNA produced more LUNA, which depressed LUNA's price further, which reduced the incentive to burn UST, which allowed UST to fall further. The spiral erased UST's peg within days and destroyed an estimated $40 billion in market capitalisation across the UST/LUNA ecosystem. The broader crypto market cascaded downward in response.
The lesson regulators and the market drew is that a stablecoin peg needs an external anchor — actual liquid dollars, not a second token whose value depends on the first. The US GENIUS Act (signed July 2025) and the EU's MiCA regulation both mandate 1:1 reserve backing for payment stablecoins, with the reserves held in cash or short-term government securities.
Crypto-collateralised stablecoins
A third design sits between fiat-backed and algorithmic: crypto-collateralised stablecoins like DAI (issued by MakerDAO). These hold on-chain assets (typically ETH and other major tokens) as collateral, but at an over-collateralised ratio — historically around 150% or more. If you borrow $100 of DAI, you must lock up at least $150 of ETH.
The peg holds through a liquidation engine: if the value of the collateral falls toward the value of the outstanding DAI, smart contracts automatically sell the collateral to buy back DAI, reducing supply and pushing the price back toward $1. The system works as long as collateral can be liquidated faster than its price falls. The failure mode is a "black swan" price crash in which collateral values collapse too quickly for the liquidation bots to act, leaving the system under-collateralised.
Why the peg matters for payments
A payment rail that uses a stablecoin with a credible peg behaves like a dollar rail. A payment rail that uses a volatile native token does not — the recipient's dollar value at settlement differs from the sender's at initiation, which creates FX risk even on a same-currency transfer.
This is why purpose-built payment chains like Tempo are designed around stablecoins rather than native tokens. Tempo has no native gas token; gas is paid directly in USD-denominated TIP-20 stablecoins. The chain carries only assets engineered to stay at $1. The peg mechanics of those assets — reserve backing, arbitrage, redemption — are what make the payment rails usable for real commerce.
The bottom line
A stablecoin holds its $1 peg because any deviation creates a profitable trade that corrects it. For fiat-backed stablecoins, that trade is redemption: a dollar in, a dollar out, always. The reserves are the foundation — if they are liquid, transparent, and sufficient, the peg holds. If they are opaque, illiquid, or circular, the peg is fragile. TerraUSD is the definitive demonstration of what happens when the mechanism lacks an external anchor.
For a breakdown of the specific reserve compositions of the largest stablecoins and where to verify them, see What are stablecoin reserves?.