STABLECOINS EXPLAINED: TYPES, RISKS AND REGULATION

What Are Stablecoins?

Stablecoins are a category of cryptocurrencies designed to minimise price volatility by pegging their value to a reference asset, typically a fiat currency like the US dollar or the euro. Unlike conventional cryptos such as Bitcoin or Ethereum, whose prices can fluctuate dramatically, stablecoins aim to offer people the reliability of traditional money with the utility of blockchain-based assets.

The core idea behind stablecoins is to provide a medium of exchange and store of value within the digital ecosystem while avoiding the wild price swings that have characterised the broader crypto market. This makes stablecoins an attractive option for trading, remittances, decentralised finance (DeFi), and as an on-ramp for digital currencies.

For example, a stablecoin pegged 1:1 with the US dollar maintains a valuation of approximately $1, no matter how the wider cryptocurrency markets behave. To maintain that stability, issuers use a range of mechanisms—such as holding reserves, using smart contracts, or employing algorithmic models—that adjust supply or demand.

Popular implementations of stablecoins include:

• USDT (Tether): One of the oldest and most widely used stablecoins, supposedly backed by dollar-equivalent reserves.
• USDC (USD Coin): Issued by Circle and Coinbase, this coin is fully backed by cash and equivalent reserves and is regularly audited.
• DAI: A decentralised stablecoin managed through a smart contract system on the Ethereum blockchain, backed by collateral.

Although they offer a solution to volatility, stablecoins themselves have not been devoid of scrutiny and operational challenges. Issues related to transparency, reserve backing, regulatory frameworks, and governance have highlighted that "stability" in stablecoins is not always guaranteed.

As the digital asset ecosystem matures, stablecoins are increasingly viewed as a bridge between traditional finance and decentralised networks. Their usability—from payments to programmable money—has created new opportunities while also raising important concerns about systemic risks, depegging events, and safe implementation practices.

Types of Stablecoins Explained

Stablecoins are not all structured the same way. They vary significantly based on the mechanism used to keep their value stable. Broadly, they can be classified into three primary types: fiat-collateralised, crypto-collateralised, and algorithmic stablecoins. Each comes with its own set of advantages and vulnerabilities.

Fiat-Collateralised Stablecoins

These are the most prevalent form of stablecoins in the cryptocurrency ecosystem. Fiat-collateralised stablecoins are backed 1:1 by reserves held in a trusted institution, such as a bank. For every stablecoin issued, an equal amount in traditional currency is kept in reserve. This backing ensures that the coins can be redeemed at any time for the pegged currency, maintaining price stability.

Examples:

• USDC (USD Coin): Fully backed by cash and short-term US government bonds. Issued by Circle and subject to monthly attestations by certified auditors.
• USDT (Tether): Claims to be backed by various financial reserves including cash, securities, and commercial paper. Market concerns over transparency have persisted.

Advantages:

• Predictable and generally less volatile.
• Easy to understand and adopt.
• Traditionally tied to established financial infrastructure.

Drawbacks:

• Requires trusting a centralised issuer.
• Lack of transparency in reserve management can be problematic.

Crypto-Collateralised Stablecoins

These stablecoins are backed by other cryptocurrencies rather than fiat. Due to crypto’s inherent volatility, they are often over-collateralised to protect against fluctuations in collateral value. They rely heavily on smart contracts and decentralised governance models.

Example: DAI – Maintained by the MakerDAO protocol. Users lock crypto assets into a smart contract to mint new DAI tokens, with a collateralisation ratio typically exceeding 150%.

Advantages:

• More decentralised and autonomous in structure.
• No need for a central issuer or bank-held reserves.

Risks:

• Complex mechanism prone to collateral shortfalls during sharp market downturns.
• High reliance on oracles and smart contract integrity.

Algorithmic Stablecoins

These use software algorithms and automated economic policies to maintain the coin’s peg. They are not backed by any collateral, but rather rely on market incentives, minting, and burning to regulate supply.

Example: TerraUSD (UST) – One of the most prominent algorithmic stablecoins until its collapse in 2022, which caused major damage to the credibility of the model.

Advantages:

• No reserve assets, removing reliance on custodians.
• Fully decentralised in theory.

Disadvantages:

• Highly vulnerable to market sentiment and speculative attacks.
• Historical failures raise significant scepticism around design viability.

In short, while varying stablecoin models aim to offer a price-stable crypto asset, their underlying methodologies determine levels of decentralisation, security, and risk. Investors, developers and institutions must evaluate these distinctions before adopting or integrating stablecoins into platforms or portfolios.

Risks: Depegs, Reserves, Regulation

Despite their promise of stability, stablecoins face a myriad of risks that investors and users must understand clearly. Incidents ranging from depeggings to questionable reserves and a murky regulatory landscape have showcased that these assets are not devoid of systemic vulnerabilities.

Depegging Events

One of the most significant dangers associated with stablecoins is depegging—when the stablecoin fails to maintain its 1:1 parity with the reference asset. This may result from insufficient collateral, lack of market confidence, or technical breakdowns, leading to a price drop below the pegged value.

Notable Examples:

• UST Collapse: TerraUSD’s 2022 depeg was triggered by a mass sell-off, leading to a death spiral in the LUNA governance token, and culminating in billions lost in investor capital.
• USDC Depeg: In March 2023, USDC temporarily fell below $1.00 due to exposure to the collapse of Silicon Valley Bank, which held part of the USDC reserves. The peg restored after the government intervened to backstop deposits.

These events directly affect asset holders and often have cascading effects across DeFi markets and crypto exchanges that rely on stablecoin liquidity.

Reserve Risk and Transparency

Stablecoins, especially fiat-backed ones, claim to maintain full reserves. Yet, many issuers historically failed to provide comprehensive or real-time proof of those reserves. Questions around the composition—such as exposure to risky commercial paper or foreign bonds—can erode confidence.

USDT Reserve Issues: Tether has long been scrutinised due to its limited disclosures. Although it now publishes quarterly attestations, critics argue audits would be more reliable. Uncertainty around its backing remains a systemic concern given USDT’s vast presence in global digital asset markets.

Regulatory Risk

Governments and financial regulators are catching up with the rapid rise of stablecoins. These digital assets are increasingly seen as high-stakes tools that require oversight due to their growing role in cross-border payments, banking-system integration, and potential for misuse in illicit financial activities.

Global Approaches:

• United States: The SEC, Federal Reserve, and Treasury Department have proposed regulations concerning stablecoin reserve auditing, consumer protections, and potential issuance only by licensed entities.
• European Union: Under MiCA (Markets in Crypto-Assets Regulation), issuing stablecoins in the EU will soon require explicit authorisation, transparency around reserves, and capital controls.
• Singapore and Hong Kong: Both financial hubs are working toward licensing frameworks and operational guardrails for fiat-referenced digital tokens to ensure issuer accountability.

Institutions are increasingly wary of holding unregulated or unaudited stablecoins, and major payment systems have hesitated to integrate them fully due to inconsistent legal standing worldwide. This puts both investors and providers in a zone of conditional uncertainty.

Other Considerations

• Smart contract risk: Especially in algorithmic or decentralised models, coding flaws, governance attacks, or oracle manipulation can cause major disruptions.
• Market dependence: Stablecoins heavily utilised in DeFi protocols might collapse entire ecosystems if liquidity or confidence vanishes suddenly.
• Counterparty risk: In centralised models, trust must be placed in the issuer’s solvency, regulatory compliance, and technical competence.

While stablecoins offer vast utility, risk mitigation strategies including regulation, reserve audits, and technical upgrades are vital for sustainable growth. Investors need to weigh the apparent stability against the latent risks hidden in their architecture and issuance structures.