Stablecoins have emerged as a popular asset for traditional financial (TradFi) institutions as a means to leverage the benefits of blockchain technology within a clearer regulatory framework. Laws like the GENIUS Act in the U.S. define rules for creating stablecoins, and regulators tend to view these tokens more favorably because they are tied to fiat assets and exhibit less volatility than Bitcoin, Ether, and other traditional cryptocurrencies.
However, not all stablecoins are created equal, and stablecoins have failed in the past by losing their peg. One of the top risks to stablecoin asset quality is weak redeemability and liquidity.
The Role of Redeemability and Liquidity for Stablecoins
Stablecoins are pegged in value to a fiat asset. This peg defines the value of the stablecoin, unlike traditional cryptocurrencies, which are valued by the market. Losing this peg can be disastrous for a stablecoin, triggering a downward spiral toward worthlessness.
One of the most important ways that a stablecoin maintains its peg is by supporting redeemability. If users can swap their stablecoins for the backing fiat currency at a 1:1 ratio, then the stablecoin’s value matches that of the fiat asset.
An asset’s peg and value may also be determined by secondary markets and how well it can be traded for other assets. If liquidity is insufficient, it may be infeasible to buy or sell at the pegged value in these markets. If this is the case, then the value of the stablecoin may move away from the peg even if it is redeemable 1:1 in primary markets.
Where Redeemability Can Fall Short
Redeemability is vital to trust in a stablecoin and its ability to maintain a peg with the fiat asset backing it. Without 1:1 redemption, a stablecoin is valued below a peg, which can cause a continuous fall in value.
Some of the main ways that redeemability can go wrong include:
Inadequate or Opaque Reserves: Ideally, a stablecoin issuer will maintain reserves equal in value to the stablecoins that have been issued, ensuring that all users can redeem their tokens at a 1:1 valuation. If a stablecoin issuer doesn’t hold adequate reserves or if its users don’t believe that the reserves are adequate due to a lack of transparency, this can undermine faith in the cryptocurrency.
Credit and Liquidity Risks: Often, stablecoin issuers will hold their reserves in various assets, such as bank deposits or bonds. However, if these holdings lose value or are insufficiently liquid to meet redemption requests, then users may lose faith in the redeemability of the stablecoin.
Both of these issues can create the risk of a bank run, where users attempt to redeem their stablecoins for the underlying asset before the issuer’s reserves run out. This can be problematic for the currency and create a downward spiral, especially if some reserves are held as assets that must be liquidated at unfavorable terms to meet redemption demands. The loss of reserve value due to unfavorable sales could weaken the issuer’s reserves, further decreasing faith in the currency and incentivizing more users to liquidate their holdings.
Secondary Markets and Stablecoin Pegs
While primary markets and redeemability are the main ways that a stablecoin issuer can control an asset’s peg, they aren’t the only factors that impact it. Secondary markets play a critical role as well, and insufficient liquidity can have several potential impacts on a stablecoin’s value, including:
Unstable Pricing: While stablecoins are valued based on their pegs, their actual market value can move around that peg. If liquidity is insufficient in secondary markets, a stablecoin can experience wider spreads, greater slippage, and higher volatility. This can harm a stablecoin’s ability to perform its primary role, which is to act as a stable means of exchange or store of value.
Decreased Market Efficiency: Without adequate liquidity, stablecoins are more vulnerable to price manipulation attacks, which can negatively impact the stablecoin’s reliability and security in users’ eyes. Additionally, a certain level of liquidity is necessary for a stablecoin to play a useful role in DeFi.
Stablecoin Weaknesses and Payment Rails
Stablecoins have become increasingly popular due to their ability to create on-chain payment rails for transfers of fiat assets. If a stablecoin maintains its peg, then value can be quickly transferred domestically or internationally via a simple blockchain transaction.
However, if stablecoins have weak redeemability or liquidity, this can negatively impact payment rails in several ways, including:
Inefficient Transfers: On-chain payment rails using stablecoins rely on the redeemability of the underlying assets. If assets can’t be quickly redeemed at a 1:1 ratio, then settlements may be delayed or fail entirely.
Reduced Acceptance: Stablecoin adoption for payment rails depends on acceptance by financial institutions, merchants, and users. If users are afraid of liquidity shortages or an inability to redeem their stablecoins for fiat at a 1:1 ratio, then they will be slow to adopt the technology.
Bank and Liquidity Coverage Effects: Stablecoin issuers or customers may deposit funds with financial institutions. If a bank is holding an unstable stablecoin, this may negatively impact its ability to provide certain services to its customers.
Managing the Redeemability and Liquidity Risks of Stablecoins
Stablecoins face various risks, but a lack of adequate liquidity and redeemability infrastructure is one of the most significant. These have a direct impact on a stablecoin’s peg strength and its perceived value in the eyes of investors.
While redeemability and liquidity can be weakened by poor design decisions, security also plays a significant role in protecting these key features. If an attacker compromises a vulnerable smart contract, critical private key, or other important part of a stablecoin issuer’s infrastructure, they may be able to steal assets or perform unauthorized mints, leaving the issuer with inadequate reserves to cover issued tokens.
Halborn offers advisory services to support stablecoin issuers throughout their projects' lifecycles, from initial design to on-chain deployment. To learn more about how Halborn can help your organization manage the risks associated with stablecoins, get in touch.