Lecture 9: Stablecoins: Fiat-Backed vs Crypto-Backed
Instructor: Yu Feng, UCSB
CS190: Blockchain Programming and Applications
Lecture 9 — Understanding the backbone of DeFi liquidity and exploring how different stablecoin architectures maintain price stability in volatile crypto markets
Why DeFi Needs Stablecoins
While cryptocurrencies like Bitcoin and Ethereum are revolutionary, their extreme price volatility makes them impractical for everyday use. DeFi necessitates a stable unit of account and medium of exchange, a role perfectly filled by stablecoins. They provide a price anchor, offer a safe haven during market downturns, and enable programmable financial applications.
Price Anchor
Stable reference point for DeFi protocols
Safe Haven
Preserve value during crypto crashes
Programmable
Dollar functionality with smart contracts
The Massive Scale of Stablecoins
$150B
Total Supply
Circulating stablecoin supply as of 2025
80%
DEX Pairs
Trading pairs involving stablecoins
3
Major Players
USDT, USDC, and USDe dominate issuance
DeFi without stablecoins would be like a financial system without cash—theoretically possible, but practically unusable for everyday transactions and value transfer.
Fiat-Backed Stablecoins
The Centralized Approach
Fiat-backed stablecoins, like USDC and USDT, are issued by centralized companies. Each token is 1:1 backed by cash or short-term U.S. Treasury securities held in bank accounts.
The model requires trust in the issuer to maintain reserves and honor redemptions: users deposit fiat to get tokens, and redeem tokens to get fiat back.
User Deposits USD
Sends fiat to issuer's bank
Issuer Mints Tokens
Creates equivalent stablecoins
Reserves Held
Cash stored in regulated banks
How USDC Maintains the Peg
Circle maintains USDC's $1 peg through a simple arbitrage mechanism backed by guaranteed 1:1 redemption rights and audited reserves.
Price Below $1
If USDC trades at $0.99, arbitrageurs buy cheap tokens on the market and redeem them with Circle for $1, pocketing the difference. Demand increases, price rises.
Equilibrium at $1
Market forces and redemption rights keep USDC stable at exactly $1.00
Price Above $1
If USDC trades at $1.01, Circle mints new tokens and sells them, increasing supply. More tokens available drives price down to $1.
The mechanism works because Circle guarantees 1 USDC can always be redeemed for exactly $1 USD. Regular attestations of reserves provide confidence to the market.
Fiat-Backed Stablecoins
Advantages & Vulnerabilities
Advantages
Simple & Stable
Easy to understand 1:1 backing model with straightforward redemption
Institutional Trust
Regulated custody and attestations appeal to traditional finance players
Capital Efficient
No over-collateralization required—every dollar backs one token
Vulnerabilities
Centralization Risk
Issuers can freeze addresses and block transactions at will
Banking Dependency
USDC depegged to $0.88 in March 2023 when Silicon Valley Bank collapsed
Regulatory Exposure
Subject to government intervention and compliance requirements
USDC Depeg Crisis: Silicon Valley Bank Collapse
March 2023 - When Fiat-Backed Stablecoins Failed
In March 2023, the collapse of Silicon Valley Bank (SVB) directly impacted USDC, a major fiat-backed stablecoin. Circle, USDC's issuer, held significant reserves at SVB, which became inaccessible upon the bank's failure. This led to USDC temporarily depegging from $1.00, dropping to $0.88.
1
March 8-9, 2023
Concerns about SVB's financial health emerged.
2
March 10, 2023
SVB collapsed; USDC reserves became inaccessible, causing panic.
3
March 11, 2023
USDC depegged to $0.88 due to liquidity fears.
4
March 12, 2023
US regulators guaranteed SVB deposits; Circle confirmed full recovery of USDC reserves.
5
March 13, 2023
USDC fully regained its $1.00 peg.

This incident highlighted the centralization risk in fiat-backed stablecoins. Dependence on traditional banking infrastructure introduces vulnerabilities that challenge crypto's decentralized ethos.
Crypto-Backed Stablecoins
How DAI Works
DAI takes a radically different approach: users lock cryptocurrency as collateral in smart contract vaults, then mint DAI against that collateral. Everything happens on-chain with full transparency.
Lock Collateral
User deposits ETH or other approved crypto assets into a Maker Vault smart contract
Mint DAI
User generates DAI up to 150% collateralization ratio (e.g., $150 ETH backs $100 DAI)
Monitor Health
System tracks collateral value. If it drops below threshold, automatic liquidation triggers
Repay & Unlock
User returns DAI plus stability fee to reclaim their original collateral

Over-collateralization is key: DAI requires roughly 150% backing to absorb price volatility. If your $150 of ETH collateral drops to $130, the system liquidates your vault to protect DAI holders.
Maintaining the DAI Peg
Unlike fiat-backed stablecoins with a central redeemer, DAI relies on market incentives and the Peg Stability Module (PSM) to maintain its $1 value.
DAI Above $1
When DAI trades at $1.02, users are incentivized to open new vaults and mint more DAI to sell at premium. Alternatively, they swap USDC for DAI through the PSM at 1:1, increasing DAI supply.
DAI Below $1
When DAI trades at $0.98, vault owners repay loans (burning DAI) to retrieve valuable collateral. Others swap DAI for USDC through the PSM, reducing DAI supply.
The PSM as Stabilizer
The PSM acts as a "1:1 vending machine" for DAI and USDC, allowing users to swap them with minimal fees for instant arbitrage when DAI deviates from $1.
Crypto-Backed Stablecoins
Advantages & Challenges
Advantages
  • Decentralized & Transparent: All collateral visible on-chain, no single point of control
  • Censorship Resistant: No custodian can freeze your DAI or block transactions
  • Composable: Integrates seamlessly with DeFi protocols without permission
Challenges
  • Complex Mechanism: Vaults, liquidations, and governance create steep learning curve
  • Capital Inefficiency: Need >100% collateral locked to mint stablecoins
  • Smart Contract Risk: Code vulnerabilities could drain collateral
  • Indirect Centralization: Heavy reliance on USDC in PSM creates exposure
Technical Risk
Smart contract bugs and oracle failures
Market Risk
Collateral price crashes and liquidation cascades
Compositional Risk
Dependencies on other DeFi protocols and stablecoins
Side-by-Side Comparison
Both models trade off different dimensions of the stability-decentralization-efficiency triangle. USDC prioritizes simplicity and capital efficiency at the cost of centralization. DAI prioritizes decentralization and transparency at the cost of complexity and capital requirements.
The Peg Stability Module
Maker's Solution to Volatility
Introduced in late 2020, MakerDAO's Peg Stability Module (PSM) significantly reduced DAI's price volatility by enabling frictionless 1:1 swaps with USDC. While effective, this created a dependency on centralized USDC. To mitigate this, MakerDAO has diversified its backing to include real-world assets like U.S. Treasury bonds, generating yield and further stabilizing the peg.
45%
USDC Backing
Portion of DAI backed by USDC through PSM
30%
Treasury Bonds
Real-world asset diversification
25%
Crypto Collateral
ETH and other on-chain assets
Black Thursday: DAI's Stress Test
March 12, 2020 - When Crypto Markets Crashed
On March 12, 2020, global markets, including crypto, crashed due to the burgeoning COVID-19 pandemic. Ethereum's price plummeted from $200 to $90 within hours, causing a cascade of liquidations in the MakerDAO system. This "Black Thursday" event became a critical stress test for DAI, exposing vulnerabilities in its crypto-backed stablecoin design.
Market Collapse
Global markets saw massive sell-offs due to COVID-19 fears. ETH's price plummeted, leading to significant undercollateralization of MakerDAO vaults (CDPs).
Massive Liquidations Triggered
ETH's value falling below liquidation thresholds triggered automated MakerDAO liquidations. Users rushed to add collateral or repay debt, overwhelming the network.
Oracle Delays & Congestion
Ethereum network congestion and high gas prices caused delays in oracle price updates, leading to inaccurate liquidation prices.
Failed Liquidation Auctions
High gas fees and network delays prevented liquidation bot bids. Many auctions received zero bids, allowing ETH to be acquired for free, leaving the protocol with uncovered debt.
DAI De-peg
Facing insolvency and a lack of market makers, demand for DAI surged as users repaid vault debt, pushing its price to $1.10.
Resolution & Lessons Learned
MakerDAO passed emergency proposals, including increasing the debt ceiling and introducing USDC as collateral. This highlighted the need for more robust oracles, improved liquidation, and greater decentralization.
Algorithmic Stablecoins
The UST/LUNA Experiment
Terra's UST represented a third category: algorithmic stablecoins with no collateral backing. Instead, UST maintained its peg through a mint/burn relationship with LUNA, Terra's volatile governance token.
UST at $1
System in equilibrium with demand matching supply
UST Above Peg
Users burn $1 of LUNA to mint 1 UST, increasing UST supply
UST Below Peg
Users burn 1 UST to mint $1 of LUNA, decreasing UST supply
The mechanism worked beautifully during growth phases when confidence was high. But it contained a fatal flaw: it relied entirely on market confidence rather than real collateral.
The Death Spiral
UST Collapse (May 2022)
Initial Depeg
UST drops below $1 due to large withdrawals from Anchor Protocol, triggering panic
Mass Redemptions
Users rush to burn UST for LUNA. System mints billions of new LUNA tokens to absorb demand
LUNA Hyperinflation
LUNA supply explodes from 350M to 6.5 trillion tokens. Price crashes from $80 to $0.0001
Total Collapse
With LUNA worthless, UST has no backing. Confidence evaporates. $40B in value destroyed

Critical Lesson: Algorithmic stablecoins without real collateral are fundamentally fragile. They work in expansion but fail catastrophically during contractions when the system most needs stability. The death spiral is nearly impossible to stop once it begins.
Hybrid Models & Future Directions
The industry is converging toward hybrid approaches that combine the best elements of different stablecoin architectures while mitigating their weaknesses.
Real-World Assets
Tokenized Treasuries and bonds
Crypto Collateral
ETH and other decentralized assets
DAO Governance
Community control over parameters
Transparency
Regular audits and proof-of-reserves
Fiat Integration
Some centralized backing for stability
USDC is improving transparency with more frequent attestations. MakerDAO is investing heavily in U.S. Treasury bonds—essentially "crypto meets traditional finance." The goal is finding the optimal balance between stability, decentralization, and capital efficiency.
Key Takeaways
DeFi's Foundation
Stablecoins are the backbone of DeFi liquidity, enabling lending, trading, and value transfer without constant exposure to crypto volatility
Fiat-Backed Trade-offs
Simple, capital-efficient, and trusted by institutions—but centralized and vulnerable to banking system failures
Crypto-Backed Trade-offs
Decentralized, transparent, and censorship-resistant—but complex, capital-intensive, and exposed to smart contract risk
Algorithmic Fragility
Innovative and elegant in theory, but catastrophically fragile without real collateral backing during market stress
Hybrid Future
Next generation combines crypto collateral with real-world assets, balancing decentralization with stability through diversified backing
Next Up
Lecture 10: DeFi Mechanics
We'll dive deep into Automated Market Makers (AMMs) and decentralized exchange design. Learn how constant-product formulas enable permissionless trading, explore liquidity provision strategies, and understand the mathematics behind impermanent loss.
AMM Mathematics
Constant-product and other bonding curves
Liquidity Provision
Becoming a market maker in DeFi