TLDR: Stablecoins are not without their risks. While designed to maintain a stable value, they are still prone to operational, liquidity, and settlement risks. These risks can cause peg instability and loss of value.
Stablecoins play a significant role within the DeFi ecosystem because they are fiat-referenced crypto assets on blockchains. They act as a bridge between traditional currencies and digital currencies.
While they are designed to be as stable as the asset they are pegged to, stablecoins are not without risks. In this piece, we’ll go into an in-depth analysis of stablecoin risks.
Stablecoins are designed to maintain a stable value relative to a specific asset or store of value outside the crypto ecosystem. These underlying assets are usually fiat (national) currencies like the U.S. Dollar (USD) or commodities like gold.
To maintain this stable value, stablecoins usually employ a pegging or collateral mechanism that maintains its ratio to the reference assets. Here is a simple analogy to help you understand that better.
USDC is pegged to the U.S. dollar (USD) at a ratio of 1:1. This means that every time, 1 USDC should be equal to 1 USD more or less. So, if you buy 1000 USDC with $1000 now, at the end of the year, you should get $1000 if you sell your USDC. USDC uses a collateral mechanism to achieve this peg by maintaining a reserve of USD. So, for every issued USDC token, some U.S. dollars are deposited into the reserve.
Note that although stablecoins are pegged to fiat currency, they differ from fiat currencies in several ways. First, they are cryptocurrencies, i.e., they are secure with cryptography. Second, they are built on blockchains, i.e., all transactions are recorded and stored on blockchains.
These differences position stablecoins to support innovative and emerging financial markets like DeFi, where traditional currencies don’t work.
The total stablecoin supply is currently capped at around $130 billion, as shown in the chart below. Notice that at the peak, the total stablecoin supply was at $182 billion, over 16% of the entire crypto ecosystem.
Stablecoins are so crucial that “more than 75% of the trading on large crypto exchanges in 2022 involved a stablecoin,” according to data from Theblock.coand The Reserve Bank of Australia (RBA).
Stablecoins play an essential role within the crypto and DeFi ecosystem. Most importantly, they act as an onramp (bridge) between traditional currency and other digital tokens. This is important because most exchanges don’t allow users to convert their crypto assets into fiat currency for holdings.
Due to their stable nature, stablecoins can be a safe haven for investors during a market. In fact, according to data from Federal Reserve Board, stablecoins might appreciate more during market distress. The Image below shows instances of stablecoins appreciating when Bitcoin and Ethereum prices were falling.
However, stablecoins are not only important as a safe haven for investors. Stablecoins are also an important part of the DeFi ecosystem. DeFi protocols depend on stablecoins to facilitate lending, borrowing, yield farming, and other DeFi services. Due to their less volatile prices, they are useful for
Borrowers as collateral because they maintain stable value, so borrowers don’t have to worry about losing their position due to a reduction in market price
Liquidity providers/lenders to avoid impermanent losses
Although stablecoins are designed to maintain stability, they are not without risks for both investors and users. Stablecoin risks vary based on the collateralization type of stablecoin and their pegging mechanism. Generally, stablecoins are group into three main groups:
Fiat-backed stablecoins (off-chain, fiat-collateralized stablecoins)
Crypto-backed stablecoins (on-chain, cryptocurrency-collateralized stablecoins)
Algorithmic stablecoins (non-collateralized stablecoins)
Fiat-backed stablecoins maintain a reserve of cash, cash equivalent, Treasury bills, corporate bonds, and commercial papers as collateral to back issued coins. Fiat-backed stablecoins are also called off-chain collateralized stablecoins because the collateral reserve consists of assets that off blockchains.
The fiat reserve is maintained on a one-to-one basis with issued coins. So, for every unit of the stablecoin issued/minted, a unit of fiat currency is deposited in the reserve.
The largest stablecoins by market cap — Tether (USDT), USD Coin (USDC), and Binance USD (BUSD) are fiat-backed stablecoins. However, it’s important to note that both USDT and BUSD are heavily suspected to be under-collateralized (i.e., don’t have the proper reserves to warrant the tokens that have been minted on-chain — see the “Fiat Stablecoins” subsection in The State of Crypto Regulation in the US).
USDC has also exposed that fiat-backed stablecoins are particularly susceptible to the insolvency risk of the financial institutions that custody the stablecoin’s reserves (i.e., $3B of USDC’s reserve at collapsed Silicon Valley Bank).
USDC and BUSD tend towards maintaining a conservative reserve holding of cash, cash equivalents, and treasury bills. On the other hand, USDT reserves include more risky assets like commercial papers and corporate bonds.
Provided that traditional financial institutions are notoriously non-transparent, the assumed risk of fiat-backed stablecoins (i.e., custodian insolvency risk & rising federal interest rates of the fiat peg), it is not correct to assume that they are less risky than, at the least, crypto-backed stablecoins, which offer softer asset collateral with much higher transparency.
Crypto-backed stablecoins (on-chain collateralized) are backed by a reserve of other cryptocurrencies like Bitcoin and Ethereum. They are on-chain collateralized because they are supported by blockchain-based assets.
An example of a crypto-backed stablecoin is Marker’s DAI backed with USDC, ETH, WBTC, and others. The image below shows DAI’s total crypto assets used for its on-chain collateralization.
Crypto-backed stablecoins use an over-collateralization model to withstand the volatility of their reserve assets. However, crypto-collateralized stablecoin protocols are quickly diversifying their collateral into tokenized real-world assets as the regulatory risk (and economic burden) of using some weaker cryptocurrencies as collateral is beginning to threaten the protocol’s economic sustainability.
Algorithmic stablecoins depend on algorithms and smart contracts to maintain their peg. Algorithmic stablecoins may be partially collateralized or non-collateralized at all. They are non-collateralized stablecoins because they don’t depend on a reserve to maintain their peg even if they have a partial reserve. Rather they maintain their peg based on market demand and a minting/burning mechanism.
Algorithmic stablecoins are considered the least stable within the crypto ecosystem. This is because they are the most susceptible to runs caused by market sentiments and speculative attacks.
The effectiveness of the peg mechanism varies depending on its stabilization mechanisms. We have covered the effectiveness of each model in this section.
Fiat-backed stabilization mechanism works based on the confidence users have in the stablecoin to maintain its peg
However, this stabilization mechanism can break down if the market loses faith in the stablecoin's ability to maintain its peg. Several things can trigger a loss of confidence in the stablecoin:
A drop in the collateral reserve like the recent USDC and SVB event
Lack of confidence in the custodian or issuers
Market speculation that can lead to FUD among holders
According to the Federal Reserve Board:
“The incentives of stablecoin holders are similar to those of depositors who withdraw their real-world currency from an uninsured brick-and-mortar bank if they suspect it might fail, thus precipitating a run on such a bank.”
An example of this failure is the recent de-pegging of USDC. The stablecoin lost its peg after SVB (Silicon Valley Bank) suffered a bank run with over $3.3 billion of USDC’s reserve. As a result, investors and users were uncertain about the collateralization of the stablecoin.
Like fiat-backed stablecoins, the effectiveness of crypto-backed stablecoins also depend on the trust the holders have in the stablecoin. However, the integrity of this pegging mechanism is less than that of fiat-backed stablecoin because of their reserve's quality.
Crypto-backed stablecoins have to depend on on-chain assets as their collaterals which means other stablecoins and cryptocurrencies. Depending on cryptocurrencies like Bitcoin and Ethereum means that crypto-backed stablecoins have to use over-collateralization to maintain their peg.
The degree of over-collateralization must be large enough to cover any decline in the collateral assets’ value. In most cases, stablecoin protocols include provisions for reevaluating the ratio of collateral to issued stablecoins at regular intervals. This ensures that the ratio is always greater than the standard collateralization ratio.
Furthermore, the market for the collateral assets must have enough liquidity for selling the reserve in case of a run.
However, crypto-backed stablecoins are still more subjected to panic runs due to:
The market volatility of the biggest cryptocurrencies (Bitcoin and Ethereum)
a sudden change in regulation
panic resulting from other stablecoins run
Algorithmic stablecoins maintain their peg by using smart contracts preprogrammed with the set of rules that control the stablecoin. Typically, the smart contract dynamically match kgvbnmb the supply and demand of the stablecoin to maintain price stability.
Algorithmic peg stabilization is similar to the central banks’ system of expansion and contraction of money supply to control the economy. In this case, the smart contract mints (create new tokens) when the price exceeds $1. This increase supply and brings the price down. On the other hand, the system removes coins from circulation (burns tokens) when the price goes below $1. This reduces supply and brings the price up.
Algorithmic stablecoins can be categorized into two subgroups depending on the type of stabilization mechanism they adopt:
The rebase model
The coupon model
The rebase model maintains price stability by adjusting supply across all wallets that hold the coin proportional to the percentage of price increase or decrease. This model can only sustain the peg if holders believe the price will return to normal. In case where the holder thinks the price will keep falling, they will sell their holdings, causing a total depeg.
The coupon model, also the seigniorage model, maintains prices by adjusting supply to meet market demands. However, the coupon model gives stablecoin owners incentives/rewards to sell or buy more.
The problem with the coupon model is the same as with rebase model; the model can sustain its peg if enough holders believe that the stablecoin will revert to normal. Once holders think otherwise, they start to sell their holdings, generating a run that leads to de-pegging.
An example of algorithmic stablecoin failing is Terra USD losing its 1:1 peg to the U.S. dollar. UST maintained its peg with the coupon model; holders were rewarded with its sister coin Luna.
This section discusses some of the most significant risks stablecoins face.
A stablecoin loses its peg when it can no longer maintain its original ratio to the reference asset. This usually happens when there is a spike in redemption requests which is generally triggered by the following:
Price fall
Concerns about collateral reserve
market speculation
Two prominent examples of peg instability are USDC and UST. USDC lost its peg and regained it a few days after concerns about its reserves were resolved.
Payment system risk arises from a stablecoin transfer mechanism between issuance and redemption. Stablecoins also face the same basic risks as traditional payment systems, including
liquidity risk,
operational risk,
settlement risks, and
threats from ineffective or improper governance
When a stablecoin fails to manage these risks properly, it makes them less reliable and can lead to peg instability.
Liquidity risk arises from misalignment between the settlement timing and the stablecoin arrangement with other systems. For example, if the stablecoin operates 24/7 but the payment system for funding stablecoin issuance and redemption operates on regular business days and hours.
That can cause a shortage in stablecoins and fiat currency available to make payments. Liquidity risks make stablecoins vulnerable to market runs that the slightest rumor of instability can trigger. In practice, stablecoins usually limit their exposure to liquidity risk with over-collateralization.
Operational risk disrupts the user’s ability to make a payment or use the system, which in turn, disturbs the whole ecosystem. Operational risk results from:
deficiencies in information systems or internal processes
human errors
management failures
interruptions from external events
Settlement risks arise when a position’s settlement doesn’t occur when expected. Most stablecoins arrangements don’t clearly define the point where payment is final during redemption or issuance.
Stablecoins are not without risks, even though they are designed to be stable. Some factors that determine the stability include the effectiveness of the pegging mechanism. In this piece, we have covered the effectiveness of the different peg stability mechanism and their risk level.
At the end of the day, a stablecoin will remain stable as long as users trust in its peg stability. Therefore, there is a need to invest in risk-free assets. RWAs (Real-world assets) to mitigate these risks. Learn more about RWAs and how they can help with diversification and risk management here
At Umoja, we offer a risk gradient of tokenized real-world assets (RWAs). These RWAs help investors reduce their risk exposure while earning variable APYs.
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