Stablecoins Explained: How They Work and the Risks Most People Miss

Stablecoins are crypto tokens designed to hold a fixed value, usually one US dollar. They are used to move money between crypto exchanges, to park funds between trades and, increasingly, to send value across borders. With stablecoins explained in plain terms, the key point is simple: the "stable" part is a promise made by a specific issuer, and the strength of that promise depends on what backs it, who can redeem it and which rules apply. This guide covers how they work, the risks people tend to miss and how India taxes them.

What a stablecoin is

The Bank for International Settlements (BIS), the central banks' own bank, describes stablecoins as crypto tokens that live on decentralised ledgers and promise to always be worth a fixed amount in fiat currency. Most are issued by a single entity, and the BIS describes them as akin to digital bearer instruments: whoever holds the token holds the claim (BIS Annual Economic Report 2025, Chapter III).

The same chapter notes that over 99% of stablecoins are denominated in US dollars, and that growth is concentrated in the two largest: USDT, issued by Tether, and USDC, issued by Circle.

How stablecoins hold their peg

The BIS groups stablecoins into three designs: those backed by fiat-denominated short-term assets, those backed by crypto collateral, and algorithmic arrangements. The first type accounts for the lion's share of the market (BIS).

Type	What backs it	How the peg is meant to hold	Main weakness
Fiat-backed	Cash, bank deposits, short-term government bills held by the issuer	Large holders can mint or redeem at one dollar with the issuer; traders arbitrage small gaps	Depends on the issuer's honesty, the quality and access to reserves, and its banks
Crypto-collateralised	Other crypto-assets locked in smart contracts, usually worth more than the stablecoins issued	Over-collateralisation and automatic liquidation if collateral value falls	Sharp crypto crashes, smart-contract bugs, liquidation spirals
Algorithmic	Little or no external reserve; a linked token and code-based incentives	Supply expands or contracts as traders swap between the stablecoin and its sister token	Confidence can collapse in a "death spiral" once redemptions start

The arbitrage loop, in plain terms

For a fiat-backed coin, the idea is that if the token trades at 99 cents on an exchange, an eligible customer can buy it there and redeem it with the issuer for one dollar, pocketing the difference and pushing the price back up. If it trades above a dollar, they can mint new tokens at one dollar and sell them. This only works while the issuer redeems promptly and the market believes the reserves are there.

The risks most people miss

1. You probably cannot redeem it yourself

Retail holders often assume a stablecoin is as good as a dollar in a bank. The terms say otherwise.

Circle's USDC terms state that only users with a Circle Mint account can redeem USDC directly with Circle, and that a holder who does not register for one is not entitled to redeem with Circle. They also state that USDC held in a Circle Mint account is not subject to deposit insurance protection (Circle, USDC Terms).
Tether's fee schedule sets a minimum redemption of 100,000 US dollars, a redemption fee of the greater of 1,000 dollars or 0.1%, and a 150 dollar verification fee (Tether, Fees).

For most individuals, "redeeming" in practice means selling the token to someone else on an exchange at whatever price that market offers. In calm times that is close to a dollar. In a panic, it may not be.

2. Reserves are only as good as the disclosures and the issuer

In February 2021, the New York Attorney General announced a settlement with Tether and the Bitfinex exchange. The office said it had found that Tether's claim that its tokens were fully backed by US dollars at all times was not true for periods when it held no reserves backing tethers one-for-one, and the companies agreed to pay 18.5 million dollars in penalties and to publish the categories of assets backing tethers (New York Attorney General, 2021). Disclosure has improved since then, but the episode shows why "backed one-to-one" is a claim to check, not a fact to assume.

3. Algorithmic designs can fail completely

TerraUSD (UST) was an algorithmic stablecoin marketed with yields of up to 20% through the Anchor Protocol. According to the US Securities and Exchange Commission's complaint against Terraform Labs, UST lost its dollar peg in May 2022, and the price of UST and its sister tokens fell to close to zero (SEC press release 2023-32). A stablecoin offering an unusually high yield deserves extra suspicion: the yield has to come from somewhere.

A stablecoin is only as stable as the promise behind it, and most holders are relying on that promise second-hand.

4. Pegs can wobble even for well-backed coins

The BIS notes that because each stablecoin is a claim on a specific issuer, "singleness" cannot be guaranteed and different stablecoins can trade at varying rates. It cites research documenting various instances of stablecoins failing to sustain parity, and warns that holders can redeem at short notice, which creates a tail risk of fire sales of reserve assets in a run (BIS).

5. No interest, and the platform risk on top

The BIS notes that stablecoins have not so far offered interest income themselves. Any yield you see advertised on a stablecoin balance is coming from the platform lending or deploying your tokens, which adds the platform's own risks. If the exchange or lending platform fails, your claim is against it, not against the stablecoin issuer.

6. Wider concerns for countries like India

The BIS lists loss of monetary sovereignty and capital flight as major concerns, particularly for emerging market and developing economies, along with "stealth dollarisation" and the use of stablecoins to bypass integrity safeguards. These system-level worries help explain why Indian authorities have taken a cautious line on crypto.

How other regulators are responding

Global standards. The Financial Stability Board's final recommendations of July 2023 say global stablecoin arrangements should give all users a robust legal claim against the issuer and/or the reserve assets, and that for coins referenced to a single fiat currency, redemption should be at par into fiat (FSB, 2023).
European Union. The Markets in Crypto-Assets Regulation (MiCA) sets uniform EU rules for crypto-assets, including asset-referenced and e-money tokens, and applied in full from 30 December 2024, according to the European Securities and Markets Authority.
United States. The GENIUS Act was signed into law on 18 July 2025. A White House fact sheet says it requires 100% reserve backing with liquid assets such as US dollars or short-term Treasuries, monthly public disclosure of reserve composition, and priority for stablecoin holders' claims over other creditors if an issuer becomes insolvent (The White House, 2025).

These rules apply to issuers and service providers in those jurisdictions. They do not give an Indian user of an offshore exchange any local remedy, and they do not change how India taxes your transactions.

India's position: stablecoins as virtual digital assets

The definition

The Finance Act 2022 introduced the term "virtual digital asset" (VDA). The Finance Ministry's memorandum explaining the Bill defines it as any information, code, number or token (not being Indian or foreign currency), generated through cryptographic means or otherwise, that provides a digital representation of value, functions as a store of value or unit of account, and can be transferred, stored or traded electronically (Memorandum explaining the Finance Bill 2022). A dollar stablecoin is a token, not foreign currency, so it falls within this definition.

How VDA gains are taxed

The rules set out in the 2022 memorandum are strict:

30% tax on income from transferring a VDA, regardless of your income slab or how long you held it.
No deductions other than the cost of acquisition. Exchange fees and other expenses are not deductible.
No set-off of losses. A loss on one VDA cannot be set off against any other income, and VDA losses cannot be carried forward.
1% TDS on payments for the transfer of a VDA to a resident, above annual thresholds of ₹50,000 for "specified persons" (broadly, individuals and HUFs without large business turnover) and ₹10,000 for others. The TDS provision took effect on 1 July 2022.
Crypto-to-crypto swaps count. The memorandum covers payment in kind or in exchange for another VDA, so converting a stablecoin into another token is a transfer.
Gifts of VDAs can be taxable in the hands of the recipient.

One practical consequence: because a stablecoin is designed not to move, your "gain" may be tiny, but swapping it in and out of other tokens creates a stream of taxable transfers, each potentially subject to TDS, while losses on the other tokens give no relief.

Under the Income-tax Act, 2025

The Income-tax Act, 2025 replaced the 1961 Act from 1 April 2026 and introduced the single "tax year" in place of "previous year" and "assessment year". The government's explainer states that the rewrite made no modifications of tax rates (PIB, The Income Tax Act, 2025: Reshaping Tax Framework). The Finance Bill 2026 memorandum continues to refer to tax deducted on the transfer of a virtual digital asset under the new Act, which indicates the VDA regime has carried over, with new section numbers (Memorandum explaining the Finance Bill 2026).

Anti-money-laundering registration

VDA service providers operating in India are expected to register with the Financial Intelligence Unit, India (FIU-IND) as reporting entities; FIU-IND's website carries a notice on the registration of virtual digital asset service providers as reporting entities (FIU-IND). Before using a platform, check whether it appears in FIU-IND's communications as registered or non-compliant.

A checklist before you hold a stablecoin

Know why you want it. Parking money between crypto trades is a different need from saving, and a stablecoin is not a bank deposit.
Read the issuer's reserve disclosures and note who audits or attests them, how often and what assets they hold.
Check redemption terms. If you cannot redeem directly, your exit depends on exchange liquidity.
Treat high advertised yields as a warning sign, and ask exactly how the yield is generated and who bears the loss if it fails.
Check the platform, including its FIU-IND status, and avoid leaving large balances on any exchange.
Keep records of every transfer and swap for tax, including the rupee value at the time and the TDS deducted.

If you are considering crypto as a small long-term slice of a portfolio rather than as a cash substitute, our guide to automated crypto index portfolios covers position sizing and security in more detail.

The bottom line

A stablecoin is a private promise to be worth one unit of currency, backed by an issuer's reserves and its willingness to redeem. Fiat-backed designs are the most common, but direct redemption is limited to large customers, reserve claims have been wrong in the past, and algorithmic designs have failed outright. In India, stablecoins are virtual digital assets: every sale or swap is a taxable transfer at 30% with no loss set-off, and 1% TDS often applies. Treat them as a crypto tool, not as a safe place for savings.

Frequently asked questions

Is a stablecoin the same as a digital rupee?

No. A stablecoin such as USDT or USDC is issued by a private company and is a claim on that issuer, not on any central bank. A dollar stablecoin falls within India's definition of a virtual digital asset for tax.

Can a stablecoin lose its value?

Yes. TerraUSD fell to close to zero in May 2022, and the BIS notes several instances of stablecoins failing to hold parity. Fiat-backed coins are generally more robust, but they still depend on the issuer and its reserves.

Do I pay tax if I swap USDT for another crypto?

Under the VDA rules introduced in 2022, an exchange of one VDA for another is a transfer, so any gain is taxed at 30% and TDS provisions can apply. A Chartered Accountant can help you work out the rupee value of each swap.

Can I set off a loss on another token against a stablecoin gain?

No. The VDA rules allow no deduction other than cost of acquisition and no set-off of losses, so each gain is taxed on its own and losses cannot be carried forward.

Are stablecoins insured like bank deposits?

No. They are not bank deposits, and Circle's own terms say USDC held in its accounts is not subject to deposit insurance protection.

Sources

Annual Economic Report 2025, Chapter III: The next-generation monetary and financial system, Bank for International Settlements, 2025.
USDC Terms, Circle, accessed 2026.
Fees, Tether, accessed 2026.
Attorney General James Ends Virtual Currency Trading Platform Bitfinex's Illegal Activities in New York, New York State Office of the Attorney General, 2021.
SEC Charges Terraform and CEO Do Kwon with Defrauding Investors in Crypto Schemes, US Securities and Exchange Commission, 2023.
High-level Recommendations for the Regulation, Supervision and Oversight of Global Stablecoin Arrangements: Final report, Financial Stability Board, 2023.
Markets in Crypto-Assets Regulation (MiCA), European Securities and Markets Authority, accessed 2026.
Fact Sheet: President Donald J. Trump Signs GENIUS Act into Law, The White House, 2025.
Memorandum Explaining the Provisions in the Finance Bill, 2022, Ministry of Finance, Government of India, 2022.
Memorandum Explaining the Provisions in the Finance Bill, 2026, Ministry of Finance, Government of India, 2026.
The Income Tax Act, 2025: Reshaping Tax Framework, Press Information Bureau, 2025.
Financial Intelligence Unit, India, FIU-IND, accessed 2026.