According to S&P Global’s Stablecoin Stability Assessment, there are three main factors that impact the quality of stablecoin assets. These include:
Credit Risk: Stablecoins are pegged in value to a fiat asset, and issuers must maintain reserves to allow buyers to liquidate tokens for equivalent assets. If the issuer doesn’t have enough reserves or the value of their reserves decreases, then the peg may be lost.
Market Risk: Different types of market movements can impact the value of a stablecoin and the strength of its peg. For example, a bank run could cause a stablecoin issuer to liquidate investments at unfavorable terms, hurting their reserves.
Custody Risk: Stablecoin issuers may need to hold various types of crypto in blockchain wallets. Whether they choose to use a custody provider and the strength of their private key security practices impact their risk exposure.
These and other risks, along with potential mitigating factors like overcollateralization and liquidation mechanisms, determine the base asset quality of a stablecoin. However, other factors can impact the overall stability of a stablecoin, downgrading it and making it a more risky investment.
Stablecoin Asset Quality Beyond the Basics
Two stablecoins may have identical asset qualities based on the various types of risks that they’re exposed to and the health of their reserves and liquidation mechanisms. However, one might be much more stable than the other due to additional factors. In S&P’s Stablecoin Stability Framework, the following factors are listed as ways in which the stablecoin’s stability may be downgraded from its asset quality score.
Stablecoin Governance
A stablecoin issuer’s governance has several potential impacts on the health of its peg. For example, investing too much of its reserves in illiquid assets could place it at risk if a sudden surge in redemption requests forces it to liquidate those assets at unfavorable terms. A governance system that is too centralized or too decentralized may also be vulnerable to attacks via social engineering or similar techniques.
Stablecoin issuers need to have well-defined governance processes in place and demonstrate transparency to their investors to engender trust and maintain the health of their peg. Otherwise, questions about whether the protocol has adequate reserves might trigger a bank run that could turn into a downward spiral and the end of the cryptocurrency.
Stablecoin Legal and Regulatory Framework
Stablecoins are increasingly accepted by governments and regulators as a promising technology that addresses the volatility risks of other cryptocurrencies. However, different jurisdictions have varying levels of support for the technology.
Stablecoin issuers need to ensure that they have the necessary frameworks in place to comply with the regulatory requirements in the areas where they wish to do business. For example, issuers may need to have a license in certain countries to be permitted to operate. Failing to achieve and maintain compliance with requirements could harm the health of the currency, especially if regulators take action and seize the issuer’s assets.
Stablecoin Redeemability and Liquidity
The ability to redeem stablecoins for the fiat asset backing them — or some equivalent — is essential for them to maintain their peg. If a stablecoin issuer can’t keep up with redemption requests, they risk triggering a bank run and a downward price spiral.
For this reason, it’s important to ensure that a stablecoin has adequate liquidity and infrastructure to meet redemption requests in the various markets where it operates. For multi-chain stablecoins, this may include forecasting demand and redemption requests to maintain sufficient liquidity on each platform, as well as having processes and rails in place to move funds rapidly in the event of large or frequent redemption requests in a particular market.
Stablecoin Third-Party Dependencies and Technology
Many stablecoins and other DeFi projects have a variety of third-party dependencies and deep supply chains. For example, an issuer might rely on a custody provider to hold private keys or handle redemption requests for fiat assets through a payment provider.
Stablecoins are also implemented as smart contracts, which have both internal and supply chain risks. Smart contract vulnerabilities in a token contract could expose it to attack, while dependence on an external oracle for price data may introduce risk if the oracle provides incorrect information due to errors or attacks.
Managing these risks — and their potential impacts on a stablecoin’s peg — requires identifying potential sources of third-party and technological risk and implementing contingency plans to manage these risks. For example, a platform may have a primary and backup redemption processing provider to ensure that it can continue to handle requests in the event of an outage.
Stablecoin Track Record
Finally, track record can play a major role in the reputation of a stablecoin and its overall stability. At a high level, a well-established stablecoin is likely to be more trusted and stable than a newly issued one since the older token has demonstrated its ability to survive for some time already.
Other elements of a stablecoin’s history and track record can also positively or negatively impact its track record and perceived stability. For example, if the stablecoin has experienced a breach, the magnitude of the incident and how it was handled can impact public perception. Additionally, factors like price discovery, ability to convert to different exchanges, and other elements of the stablecoin’s operations can also have an effect on stablecoin stability.
Conclusion
Stablecoin stability can be affected by a wide range of potential factors. In addition to various risks and the controls that the issuer has in place, factors such as legal and regulatory compliance and the strength of the stablecoin’s governance structure can have a significant impact.
In many cases, security plays a critical role in stablecoin stability assessments. Private key security is a key component of governance, and stablecoin issuers need controls and policies in place to manage the potential risks associated with third-party relationships and technological dependencies.
Halborn’s advisory services offer support to stablecoin issuers and other DeFi projects throughout their entire lifecycle, ensuring compliance with security best practices and regulatory requirements. To learn more about how Halborn can help your project to improve its security and stablecoin stability rating, get in touch.