2.5 How Stablecoins Maintain Their Value

USDT and USDC use a reserve-backed model to maintain their dollar peg. For every token in circulation, the issuer holds equivalent reserves in traditional financial assets. These reserves typically include US dollar cash deposits, US Treasury bills, and other highly liquid instruments.

This means that if every holder of USDT or USDC simultaneously wanted to redeem their tokens for US dollars, the issuer should have sufficient reserves to fulfill all redemptions. The integrity of this system depends on the quality and liquidity of the reserve assets.

When there is demand for new stablecoins, authorized entities can deposit US dollars with the issuer and receive newly minted tokens in return. When tokens are redeemed, they are sent back to the issuer, burned (permanently destroyed), and the equivalent US dollars are returned to the redeemer.

This create-and-destroy mechanism is what fundamentally ties the token's value to the US dollar. If USDT trades above 1 USD on the open market, arbitrageurs can mint new USDT at 1 USD and sell it at the higher price, bringing the price back down. If it trades below 1 USD, they can buy cheap tokens and redeem them for 1 USD each.

Even without direct minting and redemption, market forces help maintain the peg. Thousands of traders around the world continuously watch stablecoin prices. When a stablecoin deviates from 1 USD, arbitrage opportunities arise.

If USDT drops to 0.99 USD, traders buy large quantities at the discount, increasing demand and pushing the price back up. If it rises to 1.01 USD, traders sell their holdings, increasing supply and bringing the price back down. This constant market activity keeps the peg tight.