Stablecoins aim to maintain a fixed value against a reference, typically a currency. The mechanisms used differ substantially and so do the risks.
This describes the categories rather than commenting on any specific instrument. These are high-risk assets, regulatory treatment varies, and losses can be total.
Asset-backed
The most common structure.
The issuer holds reserves intended to back the tokens in issue, and commits to redeeming at the reference value.
Which makes the relevant questions what the reserves consist of, whether they are sufficient, whether they are segregated, and who verifies it.
Reserve composition varies. Cash and short-term government securities are the most liquid; commercial paper, corporate debt and other instruments carry more risk and were the subject of substantial scrutiny in several cases.
Attestations by accounting firms are common and differ from full audits, which is a distinction worth understanding when assessing a claim about reserves.
Crypto-collateralised
A different structure with different exposures.
Tokens are backed by other cryptoassets held in smart contracts, generally over-collateralised because the backing is itself volatile.
Which means the mechanism depends on the collateral maintaining sufficient value and on the liquidation processes functioning during stress.
Rapid falls in collateral value can trigger cascading liquidations, and this has occurred.
Algorithmic
The category with the worst record.
Value is maintained through mechanisms adjusting supply, without full backing by reserves.
Several such designs have failed, in some cases catastrophically and rapidly, with the collapse of one large instrument producing substantial losses and contributing to wider disruption in the sector.
The failure mode is a loss of confidence producing redemptions that the mechanism cannot absorb, which becomes self-reinforcing.
Regulators have paid particular attention to this category as a result.
Depegging
The event these instruments are designed to avoid.
A stablecoin trading below its reference value indicates the market doubts redemption at par, whether because of reserve concerns, liquidity constraints, or a failure of the stabilising mechanism.
Brief deviations occur and generally resolve. Sustained deviations have preceded failures.
Which means the trading price relative to the peg is an observable and useful signal, and it is publicly visible.
The regulatory position
Which has been developing quickly.
Several jurisdictions have introduced or proposed frameworks specifically for these instruments, addressing reserve requirements, redemption rights, disclosure and authorisation.
The direction has been toward requiring high-quality liquid reserves, segregation, regular reporting and a clear redemption right.
Which is a meaningful improvement where it applies and does not apply everywhere, and instruments issued outside such frameworks are not subject to those requirements.
What they are not
Worth stating plainly since the naming implies otherwise.
They are not bank deposits and are not covered by deposit guarantee schemes in most jurisdictions.
Stability is a design objective rather than a guarantee, and several designs have failed to achieve it.
And a redemption right depends on the issuer's solvency and willingness, which is a credit exposure to a private company.
What to establish before holding one
The questions that follow from the above.
What backs it, specifically, and what proportion is in high-quality liquid assets.
Who verifies the reserves, how often, and whether it is an audit or an attestation.
Whether a redemption right exists, for whom, and on what terms.
What regulatory framework, if any, the issuer operates under.
And whether the instrument has maintained its peg historically, which is publicly observable.
Those five questions are answerable from public information for most significant instruments, and the willingness of an issuer to answer them is itself informative.
The redemption question in practice
Worth separating from the theoretical right.
Direct redemption with an issuer is frequently available only to institutional counterparties above a minimum size, with retail holders relying on secondary market liquidity instead.
Which means the redemption mechanism supporting the peg may not be accessible to an individual holder at all.
The practical consequence is that a retail holder's exit is through an exchange at whatever price prevails, which under stress may be below the peg.
Use in payments
Where much of the regulatory interest is concentrated.
Proposals to use these instruments for payments raise questions distinct from those about holding them, including settlement finality, consumer protection and financial stability if usage became large.
Which is why several jurisdictions have addressed payment use specifically in their frameworks, sometimes with stricter requirements than for other cryptoassets.
For an individual, the relevant point is that a payment made in such an instrument generally carries none of the protections that apply to card or bank payments, including chargeback rights.
Yield offerings
A category that warrants particular caution.
Arrangements offering a return on stablecoin holdings generally involve lending them to somebody, which introduces credit risk entirely separate from the peg.
Several such programmes have failed, with holders becoming unsecured creditors of the platform.
A return above prevailing risk-free rates reflects risk being taken somewhere, and identifying where it sits is the relevant question.
Regulators in several jurisdictions have acted specifically against such offerings being marketed without appropriate authorisation or disclosure.