In a market where asset prices can change sharply in a short period of time, stablecoins are often viewed as a relatively stable intermediary asset. Users can transfer stablecoins between wallets, use them on exchanges, or put them into decentralized finance applications without constantly facing the level of volatility associated with holding cryptocurrencies whose prices fluctuate freely. However, the name “stablecoin” does not mean that its value is absolutely guaranteed. The stability this type of asset aims for is the result of a mechanism for issuance, backing, and maintaining liquidity, rather than an inherent characteristic.
To understand stablecoins, it is necessary to distinguish three issues that are often conflated. The first is what unit the asset is pegged to, such as a fiat currency or another reference asset. The second is what resources the issuer or protocol relies on to guarantee redeemability. The third is how the market will respond when many people want to sell or exchange stablecoins within a short period of time. A stablecoin may function well under normal conditions but still reveal weaknesses when liquidity declines, backing assets lose value, or confidence is affected.
What mechanism gives stablecoins a sense of stability?
Most popular stablecoins attempt to maintain a reference value close to one unit of fiat currency. The simplest mechanism is to issue tokens based on a corresponding amount of reserve assets. When users deposit assets into the system according to the issuer’s procedures, a certain amount of stablecoins can be created. When users want to reverse the exchange, the stablecoins are returned to the system and may be destroyed, while the reference assets are returned under the applicable conditions.
In practice, the backing structure can be more complex. Reserve assets may include cash, deposits, short-term debt instruments, or other liquid assets. The value, maturity, and convertibility of each type of asset all affect the system’s level of safety. If reserve assets are difficult to sell quickly, meeting simultaneous redemption requests from many users will become more difficult, even if the total value of the assets on paper remains large enough.
Another group uses digital assets as collateral. Users lock assets in a smart contract to create stablecoins worth less than the value of the assets deposited. This difference is intended to create a buffer when the collateral fluctuates. If the asset’s value falls below a certain threshold, the system may liquidate the asset to reduce the risk that the stablecoins will no longer be sufficiently backed.
There are also models that attempt to maintain the peg through rules for adjusting supply, incentivizing trading, or combining multiple assets and governance mechanisms. These models do not necessarily hold reserve assets in the traditional manner. In return, they depend more heavily on economic design, participant behavior, and the ability to maintain confidence during periods of stress. The more difficult the mechanism is to understand, the more cautious users need to be when evaluating promises of stability.
A “price peg” is not an absolute guarantee
The price of a stablecoin can fluctuate around its reference level because it is still bought and sold on the market. When buying demand increases, the price may temporarily rise above the target level. When many people want to sell at the same time, the price may fall below it. Under normal conditions, arbitrage activity and the ability to redeem can help bring the price back close to the peg. But this mechanism only works effectively when participants believe that redemption is genuinely possible and the market still has sufficient liquidity.
The risk of losing the peg often begins with a small doubt about the quality of the backing assets or the issuer’s ability to pay. When a group of users withdraws money at the same time, the market may observe a discrepancy between the value of the reserve assets and the number of stablecoins in circulation, but there is not always enough information to verify this immediately. A lack of clarity can cause others to act defensively, creating a spiral of sell-offs and pushing the price further away from the reference level.
For stablecoins collateralized by digital assets, the risk may come from a sharp market decline. When collateral falls rapidly, positions may be liquidated almost simultaneously. If market liquidity is insufficient, the assets are sold at a lower price than expected, increasing pressure on the system. A design with a high collateralization ratio still does not completely eliminate risk, because prices can move faster than the protocol’s ability to update or process information.
For stablecoins that rely heavily on supply-and-demand adjustment mechanisms, the major risk lies in the assumption that participants will continue to believe in the system’s future value. When the economic incentives are no longer attractive enough or users believe that the mechanism cannot rebalance itself, the motivation to maintain the peg may weaken. This is why stablecoins should not be evaluated solely by their name, market capitalization, or popularity on trading platforms.
Factors to consider before using them
The first point is the structure of the backing assets. Users should find out what type of assets the stablecoin is backed by, who holds those assets, and how long it would take to convert them into cash or highly liquid assets. An asset with a high nominal value but that is difficult to sell during a period of market stress can still create liquidity risk.
The second point is the degree of transparency. Information about reserve assets, verification procedures, holders’ rights, and redemption conditions needs to be presented clearly enough for users to understand what they own. A report produced by a third party, if one exists, also needs to be read in the proper context. Confirming certain data at a particular point in time is not the same as guaranteeing that all future redemption requests will be fulfilled.
The third point is legal rights and counterparty risk. Token holders may not have the direct right to claim the reserve assets, and may instead have to depend on the issuer, custodian, or procedures specified in the contract. In the event of a dispute, suspension of operations, or regulatory changes, access to the assets may not be the same as users imagine when looking only at the trading price.
The fourth point is technical risk. Stablecoins circulating on blockchains may be affected by smart contract bugs, protocol failures, key-management issues, or attacks targeting related systems. Even if the off-chain backing assets still exist, an error at the technology layer can disrupt transfers or prevent users from using the tokens normally.
Finally, there is network risk. A stablecoin may exist on multiple blockchains, but transaction fees, processing speed, compatibility, and the level of support differ from one network to another. Sending tokens through a network that is not supported by the recipient may make the assets difficult to recover. Therefore, before each transaction, users need to check the exact token, network, and receiving address rather than relying only on the asset’s name.
When are stablecoins useful?
Stablecoins can help reduce the need for continual conversion between fiat currency and digital assets in trading activities. They can also be used to move value between platforms, serve as a unit of account in certain blockchain applications, or support transactions that need to limit volatility over a short period. For people working in the digital finance environment, stablecoins also provide a relatively convenient way to interact with services that operate continuously on blockchain networks.
However, “relatively stable” should not be understood as “risk-free.” Users may face depegging risk, platform risk, legal risk, network risk, and personal security risk all at the same time. If stablecoins are deposited into a protocol to earn yield, users must also assess the withdrawal conditions, the source of the returns, the liquidation mechanism, and the possibility that the operating organization may encounter problems. A stablecoin is only one component in a broader chain of risks, not an insurance layer for all digital-asset activity.
A cautious approach for users
Before using them, users should identify their specific purpose: short-term trading, transferring assets, making payments, or temporarily storing value. Each purpose requires a different level of liquidity, redeemability, and risk tolerance. Users should not keep all their assets in a single stablecoin or on a single platform merely because its price usually fluctuates little.
Monitoring the price across multiple markets is also meaningful. If the price begins to deviate from the reference level, users should look for the cause rather than hastily concluding that it is merely a short-term fluctuation. Questions to ask include: Is the discrepancy appearing on one platform or in multiple places, has redemption activity been restricted, has liquidity declined, and has information about the backing assets changed? Not every fluctuation leads to a crisis, but ignoring warning signals can reduce the available options for dealing with the situation later.
Stablecoins can play an important role in the digital-asset ecosystem because they connect the stability needs of traditional finance with the transferability of blockchain. Nevertheless, this stability always rests on a chain of assumptions about backing assets, technology, liquidity, and trust. Understanding how stablecoins maintain their value is also a way to recognize when that mechanism may come under pressure. Rather than viewing stablecoins as absolutely safe digital cash, users should regard them as financial instruments with their own structures, which need to be examined before use and managed in line with their individual risk tolerance.
