Stablecoins Deep Dive — USDT, USDC, and the Collapse of UST

Stablecoins are the bedrock of the modern crypto economy. They function as the digital equivalent of dollars, providing a stable unit of account and medium of exchange in a market defined by volatility. From facilitating multibillion-dollar DeFi protocols to enabling near-instant global payments, their rise has been one of the most significant developments in the digital asset space. This deep dive explores the dominant players, the catastrophic failures, and the future of money in a digitised world.

What Stablecoins Are and Why They Exist

The core problem stablecoins solve is volatility. Bitcoin and other cryptocurrencies can experience price swings of 10-20% or more in a single day, making them impractical for everyday commerce, savings, or as a reliable settlement asset for financial contracts. If you pay for coffee with Bitcoin, its value could double before your transaction confirms. A DeFi lending position could be liquidated by a sudden market dip. Stablecoins address this by pegging their value to a stable external asset, most commonly the U.S. dollar.

There are three primary categories of stablecoins, distinguished by their stabilisation mechanism:

1. Fiat-Collateralised: These are the most common. A central issuer holds reserves of traditional assets (like dollars, bonds, or commercial paper) in a bank account. For every one stablecoin token issued, there is meant to be one dollar's worth of assets in reserve. USDT (Tether) and USDC (USD Coin) are the leading examples.
2. Crypto-Collateralised: These are backed by a surplus of other crypto assets held in smart contracts. To mint $100 of such a stablecoin, a user might have to lock up $150 or more of ETH. This overcollateralisation acts as a buffer against the collateral's price volatility. DAI is the most prominent example.
3. Algorithmic: These aim to maintain their peg through software-based rules, often involving a seigniorage mechanism with a paired volatile token. They are not directly backed by collateral but by market incentives. The failed UST was the most ambitious attempt at this model.

With a collective market cap exceeding $150 billion, stablecoins have become the essential plumbing of the crypto economy. They are the most common trading pair on exchanges, the primary asset for lending and borrowing in DeFi, and the unit of account for NFT marketplaces. Increasingly, they are also proving to be a killer app for cross-border payments and remittances, offering a speed and cost-efficiency that legacy banking systems cannot match. While Bitcoin introduced decentralised money, stablecoins introduced a usable medium of exchange for the digital age.

Tether (USDT) — The Controversial Giant

Launched in 2014 as Realcoin, Tether (USDT) is the oldest and largest stablecoin. Its simple promise—that every USDT is backed 1:1 by a U.S. dollar held in reserve—propelled it to become the crypto market's primary source of liquidity. For years, it has been the default stablecoin for traders on major exchanges like Binance, enabling rapid movement between volatile assets without touching the traditional banking system.

Despite this dominance, Tether has been dogged by controversy surrounding the composition and adequacy of its reserves. For years, the company operated with opaque financials, refusing to conduct a full audit from a top-tier accounting firm and instead providing periodic "attestations." This lack of transparency fueled speculation about whether it was truly fully backed, especially during periods of massive USDT issuance that coincided with crypto bull markets.

The skepticism was validated in 2021 when Tether and its sister company Bitfinex settled with U.S. regulators.

In its October 15, 2021 order, the U.S. Commodity Futures Trading Commission (CFTC) fined Tether $41 million for making "untrue or misleading statements." The investigation found that over a 26-month period from 2016 to 2018, Tether's reserves were sufficient to back USDT tokens in circulation only 27.6% of the time. The company had commingled reserve funds with corporate funds and held non-cash assets like "receivables" as part of its backing.

In response to regulatory pressure, Tether now provides quarterly breakdowns of its reserves. As of early 2024, the majority of its reserves consist of highly liquid U.S. Treasury bills, with smaller allocations to cash, secured loans, and other investments. The company has moved away from the riskier commercial paper that once constituted a significant portion of its backing.

So why does USDT continue to dominate? The answer lies in network effects and liquidity. As the first mover, USDT established itself on nearly every crypto exchange, creating the deepest order books and tightest spreads. For high-frequency traders and large market makers, this liquidity is paramount. They use USDT because it is the most efficient asset for their strategies, even while acknowledging the persistent "tail risk" of a potential depeg. This makes Tether a systemic linchpin of the crypto market, where its failure could trigger a cascading crisis.

USDC — The Regulated Alternative

Founded in 2018 by payments company Circle in partnership with Coinbase, USD Coin (USDC) was engineered from the ground up to be a transparent and regulated stablecoin. Its goal was to capture the institutional and DeFi markets that were wary of Tether's opaque history. USDC's core value proposition is its conservative reserve policy: 100% of its backing is held in cash and short-term U.S. Treasury bills.

This commitment to transparency is backed by monthly attestations from a major accounting firm (initially Grant Thornton, later Deloitte), which verify the quantity and composition of the reserve assets. This approach has made USDC the preferred stablecoin for many DeFi protocols, institutional investors, and businesses looking for a compliant digital dollar.

However, USDC is not immune to risk. Its reliance on the traditional banking system was starkly illustrated in March 2023 during the collapse of Silicon Valley Bank (SVB).

When SVB failed on March 10, 2023, Circle revealed it held $3.3 billion of its cash reserves—roughly 8% of USDC's total backing—at the bank. The uncertainty over whether these funds could be recovered caused widespread panic. USDC's price broke its $1.00 peg, plummeting to as low as $0.87 as holders rushed to sell. The peg was only restored after U.S. regulators announced that all SVB depositors would be made whole, highlighting how even the 'safest' stablecoins are exposed to systemic risks from their fiat banking partners.

The SVB incident served as a powerful lesson: fiat-backed stablecoins inherit the risks of the traditional financial system they depend on. Despite this scare, USDC's swift recovery and Circle's transparent communication reinforced its reputation relative to Tether. Its embrace of regulation and clear reserve policy continues to make it a dominant force, particularly within the Ethereum DeFi ecosystem where trust and predictability are essential.

The UST Catastrophe — A Case Study in Algorithmic Failure

The story of Terra's UST is a cautionary tale of hubris, flawed design, and unsustainable incentives. Created by Do Kwon and Terraform Labs, UST was an algorithmic stablecoin designed to maintain its $1 peg through a dual-token mechanism with its sister currency, LUNA. Users could always mint 1 UST by burning $1 worth of LUNA, or burn 1 UST to mint $1 worth of LUNA. This reflexive relationship was supposed to keep UST stable through arbitrage incentives.

To bootstrap demand, Terra launched the Anchor Protocol, a lending platform that offered an unprecedented and ultimately artificial yield on UST deposits. For over a year, users could earn nearly 20% APY on their stablecoins.

The 20% "Anchor Rate" was the central pillar of Terra's growth strategy. It was not a market-driven rate but a direct subsidy funded by Terraform Labs and the Luna Foundation Guard's venture capital reserves. This created immense, inorganic demand for UST, attracting tens of billions in deposits from users chasing yield, while masking the fundamental fragility of the underlying algorithmic peg.

The house of cards came crashing down in May 2022. The attack began with several large, coordinated sales of UST on the decentralised exchange Curve, causing UST to slightly depeg. This triggered algorithmic selling and widespread panic. As users rushed to redeem their UST for $1 worth of LUNA, the supply of LUNA began to hyperinflate. This created a "death spiral": the more LUNA was minted, the more its price fell, requiring even more LUNA to be minted to redeem each UST. The peg mechanism, designed to absorb small shocks, catastrophically failed under heavy pressure.

Within 72 hours, the system collapsed. The price of LUNA fell from around $80 to a fraction of a cent, and UST depegged permanently, eventually trading for pennies. Over $40 billion in market value was erased, wiping out the savings of countless investors. In the aftermath, Do Kwon became an international fugitive before his arrest in Montenegro in March 2023. He faces criminal fraud charges in both the United States and South Korea. For analysis of the Terra/Luna collapse and other crypto manias, see Bubblepedia →

Decentralised Stablecoins — DAI and Beyond

In the wake of Tether's opacity and UST's collapse, the case for truly decentralised stablecoins has grown stronger. The trailblazer in this category is DAI, created by the MakerDAO protocol. Launched in late 2017, DAI has survived multiple severe market crashes and remains the most battle-tested decentralised stablecoin. Its stability comes from overcollateralisation: users mint DAI by locking up crypto assets like ETH or WBTC in a smart contract "vault," with the value of the collateral required to be significantly higher than the value of the DAI borrowed (e.g., a 150% collateralisation ratio).

If the value of the collateral drops and nears the threshold, the vault is automatically liquidated to ensure the DAI in circulation remains fully backed. While this model is highly capital-inefficient compared to fiat-backed stablecoins, its core advantage is its lack of reliance on a central custodian or the traditional banking system. All collateral is held and managed transparently on-chain.

To improve its peg stability, especially during times of high demand, MakerDAO introduced the Peg Stability Module (PSM). This mechanism allows users to mint DAI by swapping USDC on a 1:1 basis. While highly effective at keeping DAI pegged to $1, it has introduced a new centralisation risk.

The search for the ideal decentralised stablecoin continues. Newer projects like Frax (which uses a hybrid fractional-algorithmic model) and Liquity's LUSD (which only accepts ETH as collateral to maximise censorship resistance) are exploring different points on the design spectrum. The core challenge remains finding the right balance between peg stability, capital efficiency, and true decentralisation.

The Regulatory Crackdown

The sheer size and systemic importance of the stablecoin market have brought it under intense scrutiny from global regulators. In the U.S., agencies have begun to take decisive action. The CFTC's settlement with Tether was a clear warning shot. More recently, in February 2023, the Securities and Exchange Commission (SEC) sent a Wells notice to Paxos, the issuer of Binance USD (BUSD), alleging that BUSD is an unregistered security. This prompted Paxos to halt issuance, and Binance is phasing out support for the asset, effectively ending BUSD's run as a top-three stablecoin.

This action signals a more aggressive posture from the SEC and raises fundamental questions about the legal classification of all stablecoins. Concurrently, U.S. lawmakers are debating several versions of a 'Stablecoin Act' which would establish a federal framework for issuance, reserve requirements, and supervision.

This trend is global. The European Union's Markets in Crypto-Assets (MiCA) regulation, set to take full effect in 2024, imposes strict rules on stablecoin issuers, including requirements to hold reserves in segregated accounts with European banks. In Australia, agencies like AUSTRAC (for anti-money laundering) and ASIC (for consumer protection and financial services) are closely monitoring the space, with the Treasury consulting on a new regulatory framework for digital assets.

While this crackdown creates short-term uncertainty, regulatory clarity is a necessary step for the maturation and mainstream adoption of stablecoins. Clear rules of the road will allow compliant issuers to flourish and give institutions the confidence to integrate digital dollars into their operations.

Using Stablecoins in Australia

For Australian users, stablecoins offer a powerful on-ramp to the global crypto economy. They can be acquired on major exchanges, typically by depositing Australian Dollars (AUD) via bank transfer or PayID and then trading AUD for a stablecoin like USDC or USDT.

It's vital to understand the tax implications. The Australian Taxation Office (ATO) treats cryptocurrencies, including stablecoins, as assets subject to Capital Gains Tax (CGT). This means converting AUD into a stablecoin is a CGT event. For example, if you convert AUD to USDC when 1 AUD = 0.66 USD, and later convert it back when 1 AUD = 0.64 USD, you have made a capital gain, even though the USD value of your holdings remained the same. Every swap between different crypto assets is also a CGT event.

Given the high frequency of stablecoin transactions in DeFi and trading, meticulous record-keeping is essential. Using a specialised crypto tax tool can automate this process. Platforms like Koinly can connect to your exchange and wallet accounts to track your transaction history and generate tax reports. For a deeper understanding of your obligations, see our full guide. Learn More about Australian crypto tax.

Beyond trading, stablecoins can be put to work to generate yield. Some centralised platforms allow you to earn interest by lending out your stablecoins. For example, you can deposit USDC on Coinbase and earn a variable return. Always be aware of the counterparty risk involved in any lending activity.

Finally, security is paramount. While it's convenient to keep stablecoins on an exchange for trading, holding significant amounts requires better security. Consider withdrawing your stablecoins to a self-custody wallet where you control the private keys. For maximum protection, a hardware wallet like a Ledger is the industry standard, keeping your keys offline and safe from hackers. When accessing exchanges, using a reputable VPN service like NordVPN can add an extra layer of security and privacy to your activities.