Cryptocurrencies are often associated with significant price fluctuations. Bitcoin and Ether, for example, can gain or lose a substantial part of their value in a short period. Stablecoins were developed to address this problem: they are digital assets designed to maintain a relatively stable value against a traditional currency or another reference asset.
The most widely used stablecoins seek to track the US dollar. In principle, a dollar-pegged stablecoin should therefore maintain a price close to $1. However, this mechanism does not eliminate risk. Stability depends on how the project operates, the quality of its reserves and, where applicable, the issuer’s ability to process redemptions.
What is a stablecoin?
A stablecoin is a digital token whose value is linked to a reference asset. In most cases, this is a currency such as the US dollar or the euro, but some tokens are linked to gold, baskets of assets or other underlying assets.
Unlike traditional currencies, stablecoins are generally issued and transferred through blockchain networks. They can therefore circulate outside conventional banking hours, although transaction times, costs and availability depend on the network and services being used.
USDT and USDC are among the best-known US dollar stablecoins. Other stablecoins, including DAI, use crypto assets and decentralised protocols as part of their collateral and management systems.
However, the word “stable” describes an objective rather than a guarantee. A stablecoin can move away from its reference value and, in more serious cases, permanently lose its peg.
How are stablecoins classified in the European Union?
“Stablecoin” is a term commonly used by the market, but it does not represent a single legal category under the European regulatory framework.
The Markets in Crypto-Assets Regulation, known as MiCA, mainly distinguishes between:
- e-money tokens (EMTs), which seek to maintain a stable value by referencing a single official currency, such as the US dollar or the euro;
- asset-referenced tokens (ARTs), which reference another asset, right or combination of assets, including one or more official currencies.
The classification therefore depends on the token’s specific structure and stabilisation mechanism, rather than simply on how it is described or marketed.
How does a dollar peg work?
Consider a stablecoin designed to be worth $1. Under the simplest model, the issuer receives traditional currency from users or authorised intermediaries and creates an equivalent number of tokens.
When those tokens are returned in exchange for traditional currency, they should be removed from circulation. In this way, the supply can increase or decrease according to demand.
Arbitrage can also help keep the market price close to its intended value. If the stablecoin falls below $1 and can be redeemed at its nominal value, market participants may buy it at a discount and request redemption. If it rises above $1, new tokens may be issued and sold on the market.
This system works only if market participants consider the redemption mechanism credible and the reserves sufficiently robust. If concerns emerge about the issuer or the availability of funds, the token can rapidly lose its stability.
Not all stablecoins, however, have a centralised issuer or offer direct redemption into traditional currency.
The main types of stablecoins
Stablecoins can be distinguished according to the mechanism used to support their value.
Fiat-backed stablecoins
Fiat-backed stablecoins claim to be supported by reserves denominated in the reference currency or by financial assets considered liquid.
If 100 million tokens are issued, the issuer should hold enough assets to meet the redemption requests anticipated under its operating model. The strength of the system depends on the composition, custody, liquidity and actual availability of those reserves.
It is therefore not enough to know that a stablecoin is described as “backed”. Users should examine which assets support the token, where they are held and how frequently the issuer publishes attestations, reports or independent assessments.
Crypto-backed stablecoins
Some tokens use other crypto assets as collateral. Because these assets can be highly volatile, the system usually requires overcollateralisation. Generating $100 worth of stablecoins may, for example, require depositing crypto assets worth more than $100.
If the value of the collateral falls below certain thresholds, the protocol may automatically liquidate it. This model can reduce reliance on a single issuer, but it introduces risks related to smart contracts, liquidations and the volatility of the underlying collateral.
Algorithmic stablecoins
Algorithmic stablecoins seek to maintain their peg through economic incentives and automatic changes to supply, without necessarily holding an equivalent amount of immediately redeemable reserves.
They can be particularly risky because their stability may depend on market demand and confidence in the mechanism. If that confidence disappears, the incentives may cease to work and trigger a rapid loss in value.
The collapse of TerraUSD in 2022 demonstrated how vulnerable this type of structure can become when the system enters a spiral of selling and new token issuance.
Tokens linked to other assets
Some tokens are designed to track the value of gold or other assets. Although they are sometimes included within the broad stablecoin category, they are not necessarily stable in monetary terms: their price continues to follow the value of the underlying asset.
What are stablecoins used for?
Stablecoins represent one of the main links between the traditional financial system and the blockchain-based economy.
In trading, they allow users to move value temporarily from a volatile cryptocurrency into a digital asset designed to be more stable, without immediately converting their funds into bank-issued currency. They are also used as units of account on crypto platforms and within decentralised finance protocols.
Stablecoins can also be used to:
- transfer value between wallets and platforms;
- make international payments;
- settle blockchain transactions;
- send remittances;
- provide liquidity to decentralised protocols;
- supply collateral for loans and other financial transactions;
- automate payments through smart contracts.
Transaction costs and processing times still depend on the blockchain, network conditions and any intermediaries involved.
Is a stablecoin the same as a digital dollar?
Not exactly.
A dollar held in a bank account, a stablecoin issued by a private organisation and a digital currency issued by a central bank are different instruments.
When a stablecoin is issued by a centralised organisation, the token may give its holder certain rights against the issuer, depending on the product’s structure, the applicable regulations and its terms and conditions. However, redemption arrangements are not the same for every stablecoin.
A stablecoin is not automatically equivalent to a bank deposit and may not benefit from the same protections. Access to direct redemption may also depend on the user’s identity, jurisdiction and the issuer’s conditions.
Someone who purchases a token through an exchange may therefore have to sell it on the market rather than redeem it directly with the issuer.
What are the main risks?
Apparent stability should not be confused with an absence of risk.
Loss of the peg
The market price can fall below the reference value. A small deviation may be temporary, but a loss of confidence can cause a more severe and prolonged decline.
Reserve risk
The assets used to support a stablecoin may be insufficient, illiquid or exposed to losses. If many holders request redemptions simultaneously, the issuer may encounter difficulties converting its reserves into cash quickly enough.
Issuer and custody risk
Users may depend on the organisation issuing the token, the banks holding the reserves and other entities involved in their custody.
Regulatory risk
Stablecoins are subject to requirements that may vary according to the country, issuer and structure of the product. New regulations, measures introduced by authorities or operational restrictions can affect the availability of a token and the services offered by platforms.
The presence of a stablecoin on a platform does not automatically mean that it can be offered, promoted or used in the same way in every country. Within the European Union, issuers and service providers must comply with MiCA and other applicable regulations.
Technology risk
Smart contract vulnerabilities, cyberattacks, network congestion and transfer errors can all cause losses. A transaction sent to the wrong address or through an unsupported network may be difficult or impossible to recover.
Platform risk
Holding stablecoins on an exchange also exposes users to the platform’s operational and financial risks. The token maintaining its value does not protect the holder from suspended withdrawals, a cyberattack or the insolvency of an intermediary.
Address freezing
Some issuers can freeze particular wallet addresses or prevent tokens from being transferred under circumstances established by their terms and applicable laws. Not all stablecoins are therefore decentralised or resistant to censorship.
How to evaluate a stablecoin
Before using a stablecoin, it is worth examining several fundamental factors:
- the identity, location and reliability of the issuer;
- the token’s legal structure;
- the composition and liquidity of its reserves;
- the frequency and quality of available attestations;
- redemption rights and conditions;
- its historical performance against the reference value;
- its market capitalisation and liquidity;
- the blockchain networks on which it is issued;
- any freezing or modification powers;
- smart contract risks;
- the rules that apply in the user’s country.
It is also important to verify the token’s official smart contract address. Fraudulent tokens can use the same name or ticker symbol as a well-known stablecoin.
Are stablecoins an investment?
A stablecoin pegged to the US dollar is generally not designed to appreciate against the dollar. Its main purpose is to represent dollar-denominated value digitally and make it easier to transfer.
Any returns offered by exchanges, DeFi protocols or lending services do not result from simply holding the token. They are compensation for additional financial activities and involve further risks, including counterparty default, liquidity problems and smart contract vulnerabilities.
A dollar-denominated stablecoin also creates currency risk for someone whose reference currency is the euro. Even if the token remains close to $1, its value in euros can rise or fall as the exchange rate between the two currencies changes.
The role of stablecoins in digital finance
Stablecoins have transformed the way crypto markets operate by providing a digital means of exchange designed to be less volatile than conventional cryptocurrencies. Their use is also expanding into international payments, tokenisation and programmable financial services.
Their usefulness, however, depends on the strength of the mechanism supporting the peg. Two tokens that are both designed to be worth $1 can have very different structures and risk profiles.
The most important question is therefore not only whether a stablecoin currently maintains its intended price, but what enables it to do so and what could happen under stressed market conditions.
Disclaimer: This content is provided for informational and educational purposes only. It does not constitute financial, legal or tax advice, or a recommendation to buy, sell or hold crypto assets.
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This article is provided for informational and educational purposes only and does not constitute financial, investment or legal advice, nor a recommendation or endorsement of any platform. Crypto-assets are highly volatile and involve a risk of partial or total loss.
