Stablecoin Mechanics and Risks

Stablecoins aim to maintain a stable value against a fiat currency like the US dollar. We categorize them by their backing mechanism and reserve audit status. Understanding these structures is essential because failure modes vary significantly between types.

Fiat-Backed Stablecoins

These tokens are redeemable for fiat currency held in bank accounts or custodial reserves. Issuers like Tether or Circle claim each token is backed 1:1 with cash or equivalent assets. The primary risk lies in the issuer's solvency and banking partner access. If the bank fails or regulators freeze funds, the peg is at risk. I view these as the simplest instruments, but they require trust in centralized entities.

Crypto-Backed Stablecoins

These rely on other cryptocurrencies locked in smart contracts as collateral. Because crypto is volatile, users must deposit more value than they borrow, often at 150% or higher. This mechanism is transparent and on-chain but relies on smart contract security. If the underlying collateral crashes too quickly, the stablecoin may lose its peg. liquidation cascades are a specific attack vector here.

Algorithmic Stablecoins

These attempt to maintain the peg through algorithms that expand or contract token supply. They are not backed by external assets but rely on market incentives and secondary tokens. I consider these high-risk structures. They are prone to "death spirals" where confidence drops and the price collapses irrecoverably. If the code or incentive structure fails, there is no underlying asset to recover.

Depeg Events and Liquidity

A depeg occurs when the market price diverges significantly from the target value, usually below $1.00. This happens when liquidity dries up or holders lose confidence in reserves. On an exchange, you might see the price drop, but redemption via the issuer is often paused during these events. Your ability to exit determines your actual loss. Slippage can be extreme during a crash.

Reserves and Transparency

We look for proof of reserves to verify that assets actually exist. Be aware that "attestations" are not the same as full financial audits. Some issuers include commercial paper or non-liquid assets in their reserves. This creates liquidity risk during a bank run scenario. I prefer stablecoins that hold strictly cash and short-term government bonds.

Practical Stablecoin Checklist

• Verify the backing mechanism (fiat, crypto, or algorithmic).
• Check for regular third-party reserve attestations.
• Avoid storing savings in algorithmic stablecoins.
• Monitor the trading volume; low volume increases exit risk.
• Confirm that the exchange supports withdrawal of the specific token.

Counterparty Risk

Holding stablecoins on an exchange introduces two layers of risk: the stablecoin issuer and the exchange itself. If the exchange halts withdrawals, you cannot redeem your coins for fiat regardless of the issuer's status. I treat stablecoins as a temporary trading tool, not a long-term store of value. Diversify counterparty exposure where possible.

Verify the reserves of the stablecoin you use most frequently.