Stablecoins in DeFi: Pegs, Promises, and the Terra Collapse

Part of the series DeFi Decoded

Stablecoins are the lifeblood of DeFi. They promise the stability of fiat currencies with the flexibility of crypto—and serve as the core trading pair, collateral, and unit of account in decentralized finance. But when a stablecoin loses its peg, the entire system trembles. In this fifth installment of the FinTelegram DeFi Series, we explore the types of stablecoins, how they function in DeFi, and what the collapse of Terra’s UST taught us about hidden risks.

Key Points:

• Stablecoins are digital assets pegged to a fiat currency (usually USD).
• They are vital for trading, lending, and collateralization in DeFi.
• There are three major types of stablecoins: fiat-backed, crypto-backed, and algorithmic.
• The collapse of Terra (UST) in 2022 wiped out over $40 billion in value and shattered trust in algorithmic designs.
• Regulatory pressure is mounting, especially in the US and EU under MiCA.

Short Narrative:

Stablecoins make DeFi usable. Without them, users would need to price every transaction in volatile assets like ETH or SOL—impractical and risky.

The top stablecoins in DeFi (as of 2025):

• USDT (Tether) – Fiat-backed, centralized
• USDC (Circle) – Fiat-backed, regulated
• DAI (MakerDAO) – Crypto-backed, decentralized
• FRAX – Hybrid model (was partly algorithmic)
• LUSD (Liquity) – Crypto-collateralized, immutable

Types of Stablecoins

1. Fiat-Backed (Centralized)

• Backed 1:1 by bank reserves or treasury instruments.
• Issued by companies like Tether or Circle.
• Pros: Easy to understand, low volatility.
• Cons: Requires trust in centralized issuer and banking system.

2. Crypto-Backed (Decentralized)

• Backed by overcollateralized crypto (e.g., ETH).
• Issued via smart contracts (e.g., MakerDAO’s DAI).
• Pros: Censorship-resistant, transparent.
• Cons: Complex liquidation mechanisms and sensitive to volatility.

3. Algorithmic (Uncollateralized or partially backed)

• Maintains peg via supply/demand incentives.
• Terra’s UST was the poster child—and its catastrophic failure.
• Pros: Capital-efficient in theory.
• Cons: Prone to death spirals and loss of confidence.

Case Study: Terra/UST Collapse

In 2022, UST was the third-largest stablecoin. It promised a dollar peg backed only by algorithmic balancing with its sister token, LUNA.

When confidence dropped and users began exiting, UST couldn’t hold the peg.
The result:

• $45 billion in value erased.
• LUNA hyperinflated to near-zero.
• Retail investors devastated.
• Major DeFi apps like Anchor evaporated overnight.

🧨 Lesson: Peg stability must be credible, not just coded.

Key Concepts Introduced:

• Stablecoin
• Fiat-Backed vs. Crypto-Backed vs. Algorithmic
• Collateralization Ratio
• Depeg Event
• Liquidity Death Spiral

Risks to Watch:

1. Lack of Transparency: Some fiat-backed coins don’t disclose full reserves.
2. Overreliance in Protocols: Protocols that only accept one stablecoin are vulnerable to its collapse.
3. Regulatory Risk: Authorities may ban or restrict centralized stablecoins.
4. Liquidity Crises: Bank runs on stables (e.g., USDC briefly lost peg in 2023 during SVB collapse).

Actionable Insight for Readers:

Before relying on a stablecoin:

• Check the reserve model and audit status.
• Diversify across types—not just issuers.
• Use decentralized stablecoins for DeFi-native applications, but understand the risks.
• Monitor peg health on tools like Curve, CoinGecko, or DeFiLlama.

Call for Information:

Do you have insight into stablecoin manipulation, depeg events, or hidden reserve structures?

👉 Report anonymously via Whistle42.com — and earn $TCO rewards for impactful intel.