Stablecoins and the Fine Art of Not Imploding: A Game Theory Deep Dive | by Basil Gilbert | The Capital | Apr, 2025

Few things in life are certain: death, taxes, and the inevitable collapse of a poorly designed algorithmic stablecoin. In the high-stakes world of decentralized finance (DeFi), stablecoins have positioned themselves as the backbone of digital transactions. They promise the impossible — a cryptocurrency that doesn’t throw a tantrum every time Elon Musk tweets.

Yet, despite their noble aspirations, we’ve seen some of these so-called “stable” assets collapse in spectacular fashion. TerraUSD (UST) took an express train to oblivion, while others, like USDC and DAI, have managed to stay upright — even if a little wobbly at times. So, what separates the survivors from the cautionary tales? To answer that, we turn to game theory, the strategic playbook that explains why people, markets, and occasionally entire financial ecosystems make (or break) rational decisions.

Stablecoins operate in a dynamic ecosystem where every player — issuers, traders, investors, and regulators — has skin in the game. Their interactions, incentives, and occasional panic-driven stampedes dictate whether a stablecoin maintains its peg or crashes harder than an overleveraged hedge fund.

• Issuers: The central bankers of crypto, deciding how reserves are managed and whether transparency is a feature or an afterthought.
• Arbitrageurs: The unsung heroes (or villains) who restore stability by exploiting price gaps — until they suddenly can’t.
• Holders & Speculators: Some are in it for payments, others for savings, and a few just enjoy the thrill of financial brinkmanship.
• Regulators: The ever-looming force that can turn a stablecoin into a legal juggernaut or a forbidden fruit overnight.

The goal? Keep incentives aligned so that no rational player has a reason to bolt. The moment one group loses confidence, the whole system risks a death spiral. And that brings us to the fundamental dilemma of stablecoin design.

Much like the classic “Good, Fast, Cheap — Pick Two” paradox, stablecoins juggle their own impossible triangle:

1. Stability (peg retention under all conditions)
2. Decentralization (freedom from central control and single points of failure)
3. Capital Efficiency (not requiring every dollar to be backed by a small mountain of collateral)

Fiat-backed stablecoins like USDC are incredibly stable but lean on centralized reserves, making them easy regulatory targets. Crypto-backed stablecoins like DAI maintain decentralization but demand heavy overcollateralization, making them inefficient. Algorithmic stablecoins like the late UST? They claimed efficiency and decentralization but ultimately proved as sturdy as a house of cards in a hurricane.

Game theory tells us that systems survive when incentives align under all conditions — not just when the market is feeling particularly optimistic. And that’s precisely where some models have faltered.

TerraUSD (UST) was the financial equivalent of a reality show contestant — exciting, a little reckless, and doomed from the start.

It maintained its peg through an arbitrage relationship with LUNA, its sister token. The idea was that traders would swap between the two to stabilize prices. As long as everyone played along, the system worked. But when doubt crept in? Well, let’s just say game theory has a term for that: bank run dynamics.

• Moral Hazard: Early investors were showered with absurdly high yields (20% APY) via Terra’s Anchor Protocol, luring in capital that had no fundamental backing.
• Prisoner’s Dilemma: When the peg wobbled, rational investors had two choices: (1) trust the system, or (2) get out before everyone else did. Naturally, they chose the latter.
• Nash Equilibrium Breakdown: In a healthy system, no participant benefits from abandoning the game. In Terra’s case, the moment confidence cracked, everyone rushed for the exits, triggering a collapse that was both brutal and entirely predictable.

Not all stablecoins are doomed to spectacular failure. USDC and DAI have endured where others crumbled. Why?

USDC: The Traditionalist

• Fully backed by fiat reserves held at regulated institutions.
• Transparent audits that (mostly) prevent any “trust me, bro” accounting practices.
• Low depegging risk because every issued coin has an actual dollar in a bank somewhere.

From a game-theoretic lens, USDC operates in a stable Nash equilibrium — there’s no incentive for rational actors to abandon it unless the entire banking system collapses (which, to be fair, isn’t off the table).

DAI: The Decentralized Veteran

• Over-collateralized by crypto assets to prevent sudden liquidity crunches.
• Smart contract-based governance minimizes human mismanagement.
• Proactive stability mechanisms (like liquidation penalties) deter reckless leverage.

Unlike Terra, DAI’s design accounts for worst-case scenarios, forcing users to behave conservatively. It’s like an overprotective parent — strict, sometimes annoying, but ultimately looking out for your best interests.

Just when stablecoins thought they had their models figured out, regulators entered the chat. And they’re not here to play.

• Regulatory Arbitrage: Some issuers hop jurisdictions like digital nomads, looking for the friendliest laws. That works — until it doesn’t.
• CBDCs (Central Bank Digital Currencies): Governments might just launch their own stablecoins, rendering private ones obsolete.
• Compliance vs. Decentralization: The fundamental question: Can a stablecoin be both legally compliant and true to crypto’s ethos? So far, it’s an ongoing debate.

One thing is clear: regulation will redefine the incentive landscape. The stablecoins that survive will be the ones that adapt without losing their core value proposition.

The next generation of stablecoins will need to learn from past failures. Expect innovations like:

• AI-Driven Risk Models: Real-time analysis to adjust peg mechanisms dynamically.
• Interoperability with CBDCs: Bridging the gap between TradFi and DeFi.
• Smarter Contracts, Stronger Governance: Better automation to prevent human and algorithmic overconfidence.

Stablecoin stability isn’t just about collateral or clever algorithms — it’s about incentives. If participants have reasons to jump ship at the first sign of trouble, the system is doomed.

The key to long-term success?

• Resilient arbitrage mechanisms that function even in crises.
• Properly aligned incentives among issuers, holders, and traders.
• Regulatory foresight that balances compliance and decentralization.

The stablecoins that will stand the test of time aren’t necessarily the ones with the flashiest tech or the boldest claims. They’re the ones that understand one simple truth: finance, at its core, is a game. And in any game, the winners are those who know how to play strategically — and, more importantly, how to keep others playing too.

Now, if only we could get the same level of game-theoretic sophistication in Twitter debates about crypto.