How Stablecoins Hold Value

While they are one of the fastest growing families of crypto assets, their peg is fragile as there's not one but three fundamentally different ways a stablecoin can hold a value - and each holds that peg in a different way, relying on a different mechanism that can ultimately fail.

The Three Designs of Stablecoins

Three distinct designs underpin nearly all stablecoin issuance today.

Fiat-backed stablecoins are the most common. These are tokens that can be redeemed 1:1 for fiat currency, which explains the name. The issuer holds reserves of fiat, usually treasury bills and short-dating government securities. Case in point: USDC is described by an academic paper as a fiat-backed stablecoin because it is collateralized by cash and government debt.

Crypto-collateralized stablecoins are backed by yielding crypto assets. Most commonly, more assets are collateralized than are minted into stablecoins, meaning the borrower or stablecoin issuer creates more than the value of the assets they lock up.

Algorithmic stablecoins use minting and burning of additional value units with sets of algorithms, keeping an asset's price pegged through supply and demand.

What Keeps a Peg

The value these designs peg to is maintained in reality - and only in reality - by market forces and rules of the contract, not technology. Fiat-backed tokens must be backed by reserves, a reflection of the claim backing. Redemption must be available to all issuers at any time, and should the reserves become discouraged, a stablecoin can lose its peg and collapse.

For crypto-collateralized coins, a stablecoin must be over-collateralized: the collateral value of a borrower exceeds the value of the stablecoin tokens issued, which keeps the stablecoin issuance legitimate.

Despite their inherently misleading name, for algorithmic coins, it's the economic rules and supply controls, not the technology itself, that maintains a one-to-one ratio, see the Hong Kong Monetary Authority post-mortem report on Terra in 2022. Arbitrage traditionally stabilises a peg, with traders buying at a discount and redeeming at par. But for algorithmic stablecoins, the only arbitrage opportunity is profitably minting and redeeming between the collateral and stablecoin.

Fiat-Backed or -Collateralized Designs

Fiat-backed stablecoins require trust that reserves are 1:1 with their supply to maintain their value, as well as redemption rights to enable burning. For crypto-collateralized stablecoins, over-collateralized collateral and implementation of a liquidation module are essential. Without these, a stablecoin becomes untrustworthy.

The solvency of the issuer and reserve attestations are crucial, because they underpin a stablecoin's valuation viability. In fiat-backed tokens, the issuer must always be able to provide a 1:1 fiat backing for each token, much like an open bank account.

In crypto-collateralized tokens, the holder's collateralization ratio is always more than 1, so even if the value of the collateral fluctuates, the issuer remains underwater on the deal, and the stablecoin's value holds. But if collateral itself drops over a certain value, stablecoin issuance capacity must ratchet down.

Conveniently for these stablecoins, the opposite happens when the collateral's price rises: the system can collateralize more stablecoins at a set collateralization ratio limit.

The high collateralization ratio does offer some insight into a fifth design - one which the survey found had no marketplace adoption. That would be a design that was under-collateralized, where the collateral backing was worth less than the stablecoin value issued, meaning even modest volatility in the collateral's value would lead to stablecoin insolvency, potentially before the stablecoin delivers real value to market participants.

Algorithmically-Backed Designs

Algorithmic designs operate similarly, but change minting supply in response to market movements, deviating more from the fractional fiat or fractional crypto collateral. Supply increases when collateral becomes scarce, decreasing the quantity liquid and thus expanding the stablecoin's value, and vice versa. See the Federal Reserve Bank of Richmond on the Terra system in 2022.

How do these stablecoins implode? Analysts suggest that algorithmic stablecoins can enter a "death spiral" when the stablecoin's price falls below its peg. Traders redeem tokens for the reserve collateral, which creates an excess supply of stablecoins, further deflating their price and causing redemption to accelerate.

That's a different failure mode than fiat-collateralized tokens, which depend highly on the issuer since reserves are typically locked, centralized, private, and supplied by economic capital, not cryptocurrency.

Threats to Arbitrage

In each of these three designs, arbitrage traders serve as quality assurers, maintaining the balance, exchange rate and value in the system. But this breaks in several key scenarios, each of which causes the system to lose its stability and function.

Liquidity crises: During a fiat-reserve-backed stablecoin crisis, arbitrageurs may freeze the system, preventing successful arbitrage which would keep the value pegged. These opportunities are only available until the point at which central banking design forces them to close the arbitrage window. This is why fiat-backed stablecoin arbitrage opportunities are typically available earlier in the crisis than those backed by crypto collateral.

Fundamental market collapse: In the case of crypto-backed stablecoin's this is a major destabilizing force to the supply lines of fractional loans and stablecoins, see the analysis by in 2022. Another point of collapse can be a run by withdrawing large amounts in a short amount of time. This run minimizes liquidity, prompting a collapse, or liquidation module: if the value of the collateral drops below a certain threshold, a liquidation occurs, liquidating the collateral and burning the stablecoins.

Systemic shock: Algorithmic designs are at the mercy of the crypto-market itself, without a collateral asset base. As such, when the market collapses, demand for stability surges, reminding arbitrageurs to sell stablecoins to capture the discount, reducing their leverage.

Liquidity and Control

Fiat-backed stablecoins remain the most popular stablecoin design by market capitalization, because they allow for regulated redemption into fiat at a set exchange rate. Due to fiat's heritage as a financial system, redemption is seen as easier and less expensive to fiat for fiat- denominated assets. While there's some hope that people will transfer fiat into crypto as it gains more legal tender methodology, it will take time and track record.

Issuers have these built-in redemptions, allowing fiat assets to be transferred through the stablecoin itself. This feature does make it a possibility for larger financial institutions to offer these coins, provided they have the legal capacity to actually do so. These companies and ex-intermediaries are able to mint these tokens, granted they have custody over the stablecoin assets. Standard AML/KYC practices apply, but with this, the system has the same protections as traditional financial entities.

Another decision to consider is the core stablecoin itself. do you want one that is permissioned, with centralized technology gatekeeping access, or one that is decentralized? Each has their own pros and cons, but for most of the above considering a permissioned stablecoin is likely the right choice: they have controls on what kind of assets can be used, which mitigates against investor safety, and they are able to offer additional support capabilities that a decentralized stablecoin cannot.

Some, not all, fiat-backed stablecoin issuers also offer freezing and blacklisting of imposed decisions, which may go against decentralized crypto principles.

Given that peg requirements over time are simply a promise and not a technical feature, the underlying assets behind that peg can break down, leading to price volatility and a weakening in the peg, and hence the value of the underlying stablecoin.