Everyone in (and outside) cryptocurrency felt the collapse of Terra's UST stablecoin when it died, and the consequences were so devastating it took down multiple crypto lending platforms, a multi-billion dollar hedge fund, dozens of projects that were built on Terra's blockchain, and $18B of people's money plus $60B from the crypto market. While people are now skeptical of crypto and stablecoins because of this tragic event, it is actually a specific type of stablecoin that collapses in this fashion.
Stablecoins are cryptocurrencies stable to the dollar and are fundamentally different from digital currency. Cryptocurrency exchanges have a long history of losing people's crypto and money due to hacks or managerial incompetence, so stablecoins were created to avoid holding digital currency in an exchange account. As long as cryptocurrencies/stablecoins are withdrawn from an exchange, they are safe from exchange issues. Today, stablecoins are the life-blood of Decentralized Finance (DeFi), an industry that uses blockchain smart contracts to recreate financial services for cryptocurrencies, and knowing which ones to trust is vital to preserving wealth.
While all stablecoins have a possibility for collapsing, the reason and likelihood for this depends upon the stablecoin's variant. 101 Blockchains discusses the three (plus one) types of stablecoins: fiat-backed, crypto-backed, and algorithmic (plus commodity-backed). Fiat-backed stablecoins (USDT, USDC) are backed by cash or "cash equivalents" held in a bank account, and are the most stable. Crypto-backed stablecoins (DAI) are backed by "collateralized debt positions", cryptocurrency deposits used as collateral to borrow the stablecoin, and are less stable than fiat-backed stablecoins. Finally, algorithmic stablecoins (UST) are backed by an algorithm that creates or destroys tokens to maintain their peg, and are the least stable. There also exists commodity-backed stablecoins, which are similar to fiat-backed but are pegged to a commodity instead. Keep in mind that stablecoins are vastly different from digital currencies, and digital dollars won't have the same problems or advantages as stablecoins.
What Causes Stablecoins To Collapse?
All stablecoins have some amount of healthy volatility, often fluctuating around 0.01% of $1.00 due to buying and selling behavior on the open market. They all have the potential to become "de-pegged" from the dollar during extreme volatility, which happens when their market value drops or rises by more than 1%, but most can reclaim their peg. However, some can enter a "death spiral", which happens when holders lose faith in the stablecoin's value and rush to cash out their crypto in a panicked frenzy, collapsing the price to zero. Out of the three variants, algorithmic stablecoins are almost guaranteed to eventually suffer a death spiral, due to having no backing assets that can be redeemed during high volatility, and to date nobody has discovered an algorithm which is immune to mass-panic.
Often, a simple search on CoinMarketCap or CoinGecko will reveal if a stablecoin is fiat-backed, crypto-backed, or algorithmic. If it doesn't say in the token's description, then following the website link and looking around on its official website will yield the answer. If it's a company who holds cash in a bank account and publishes reports on their asset reserves, such as Tether's USDT or Circle's USDC, then it's a fiat-backed stablecoin and will only collapse if the company turns out to be lying about their reserves (which regulatory oversight protects against). If it's a DeFi application that lets users borrow stablecoins against their cryptocurrency holdings, like Maker Protocol's DAI or Aave's new GHO stablecoin, then it's a crypto-backed stablecoin and will only fail under a perfect storm of specific and unlikely fringe conditions. If it's too complicated to understand and doesn't involve any cash reserves or collateralized cryptocurrency deposits, then it's most likely an algorithmic stablecoin and should be avoided.
Avoiding a stablecoin death spiral is pretty easy if its variant is known. While this is a massive over-simplification of how stablecoins work and why they fail, it is useful for avoiding heavy losses from death spirals. In summary, fiat-backed stablecoins are the most stable and durable and are practically invulnerable, crypto-backed stablecoins are more volatile but still highly durable, and algorithmic stablecoins will collapse when everyone panic-sells their holdings.
Source: 101 Blockchains, CoinMarketCap, CoinGecko