How secure are stablecoins?

Considered by some to be the “killer app” of the cryptocurrency space, stablecoin adoption continues to gain momentum. According to a study published in September of 2024:

• The overall supply of stablecoins has grown rapidly since 2017, from under $1 billion to its peak of $192 billion in March 2022.
• Stablecoins settled over $2.6 trillion dollars worth of value in H1 of 2024.
• There are currently over 20 million addresses that make a stablecoin transaction every month. 

But how secure are stablecoins? This article will examine their vulnerabilities, reflecting on the different types of stablecoins, the impact of regulation and the degree to which the issuers are transparent.

Stablecoins can be used in many ways but have one critical function, which is to maintain a stable peg to the underlying asset. In the simplest terms, stablecoin security relates to all measures taken to ensure the 1:1 peg remains intact. Further, it relates to contingencies in place to restore the peg should it be lost. 

Therefore, the degree to which a stablecoin is secure depends on the type of stablecoin being examined, as they all operate in slightly different ways. The following section examines how different stablecoins endeavour to remain secure.

Companies that issue fiat-backed stablecoins have a variety of different measures in place to help maintain the peg:

• By influencing supply and demand by issuing new tokens or buying them back. Arbitrage traders also have a role to play here by buying the coins at a discount then selling them when the peg is restored. 
• Through regular audits of their reserves by independent auditors. For fiat-backed stablecoins, companies are often expected - but not necessarily required - to publish regular audits of their reserves, clearly demonstrating that they have the assets to cover their liabilities. Note that the way in which stablecoins are regulated depends on geographical region. The EU recently introduced the Markets in Crypto-Assets Regulation (MiCA) which provides comprehensive rules for crypto-assets, including stablecoins. In the US, however, there is no comprehensive, nationwide regulatory framework for stablecoins. You should be able to find evidence of any audits on the issuers website (Tether publishes quarterly reports by BDO, Circle publishes monthly audits by Deloitte).
• By carefully considering which chains to integrate with their stablecoin. If users are unable to easily transact with a coin because a chain is halted or attacked, this has severe consequences as was the case when Solana experienced an outage earlier this year. 
• By complying with regulators, companies arguably minimize the likelihood of draconian punishment or policy. If a large developed nation elected to ban a particular stablecoin due a lack of adherence to local legislation, this could severely damage credibility and discourage investors from using it. 
• By ensuring that there’s always sufficient reserves in place to cover redemptions. If this is not the case, users may quickly lose confidence in the stablecoin, which could in turn jeopardize the peg.

Crypto-backed stablecoins have a unique set of challenges to maintain their peg: how do you collateralize a coin using smart contracts and assets that are themselves inherently volatile?

• By enforcing over-collateralization. To ensure the stability of the peg and protect users from liquidation, loans are over-collateralized. To use MakerDAO’s (now known as “Sky”) DAI as an example, if you want to borrow $1,000 worth of DAI, you will need to put $1,220 worth of Ethereum (ETH) as collateral (accurate at press time). 
• By having independently audited smart contracts. While this by no means eradicates the chance of an exploit, platforms may help inspire confidence by demonstrating that their code has been vetted by a third party.

Algorithmic stable coins represent the minority category, with relatively few in existence, perhaps in part due to investors' reticence to deploy capital into them. 

These stablecoins are not backed by any assets, real-world or otherwise. Therefore, maintaining the peg relates solely down to managing supply and demand, which is managed by:

• A rebasing mechanism, which monitors and responds to changes in supply and demand, burning or minting new coins where necessary. 
• Ensuring smart contract security. This is particularly important for algorithmic stablecoins, which depend on a fully functioning smart contract to maintain the peg. As evidenced by Terra UST, exposing a critical design flaw can be fatal. Independent audits of smart contracts can offer some degree of confidence, but are not entirely foolproof.

Stablecoins are vulnerable in a variety of ways, and many different factors impact on the likelihood and severity of a depeg event. 

The following list outlines common causes for stablecoin instability, derived from a report by S&P Global:

• Market volatility, which can impact supply and demand dynamics.
• Variable liquidity across different platforms, which can temporarily affect stability.
• Impairment of reserves, resulting in under collateralization.
• Mismanagement of reserves, resulting in under collateralization.
• Supply and demand shifts can drive price above or below the peg
• Lack of transparency and loss of confidence.
• Counterparty performance, impacted by financial, operational, legal or regulatory issues
• Technological and design flaws as evidenced by TerraUSD.
• Vulnerability to hacking schemes.
• Operational risk due to network issues can disrupt transactional flow.
• Regulatory uncertainty or legal action, leading to a loss of confidence.
• Wider financial market events can create a contagion effect, spilling over into the stablecoin ecosystem.

Throughout the crypto industry’s brief history, several high profile stablecoin projects have faced challenges in maintaining their pegs to their underlying assets.

USDC ($USDC), 10th March 2023: When it emerged that Circle was waiting for $3.3 billion worth of reserves to be returned by the failing Silicon Valley Bank, USDC depegged down to 90 cents per coin. After the FDIC made an exception to waive the standard insurance limit, the stablecoin quickly restored its peg. The same event also caused the crypto-backed stablecoin DAI to depeg, as 40% of its collateral was in USDC at the time. 

Terra UST, May 2022: The overnight failure of this algorithmic stablecoin resulted in $20 billion of losses. A small number of players identified and exploited vulnerabilities relating to the ‘...relatively shallow liquidity of the Curve pools securing TerraUSD (UST)’s peg to other stablecoins.’ The UST meltdown also had a knock-on effect. Shortly after, many investors sought redemptions for Tether (USDT), resulting in a temporary depeg. 

Tether (USDT), various dates: One researcher at Kaiko once wrote that “USDT has a peg stability problem,” and it’s true that Tether has depegged to varying degrees on several occasions, often due to liquidity. Perhaps the two most significant recent examples resulted from the FTX exchange’s collapse in November 2022 that contributed to a 1% depeg and the Curve liquidity pool imbalance in June 2023, and saw Tether drop to $0.9972.

In December 2023, S&P Global published its “Stablecoin Stability Assessment,” where it rated several prominent stablecoins, examining factors such as quality risks, collateralization, legal and regulatory framework, and redeemability to name a few. 

The findings of the report made the following stability assessments of the major stablecoins, from strongest to weakest:

• USDC: 2 (strong)
• Gemini Dollar: 2 (strong)
• Pax Dollar: 2 (strong)
• Dai: 4 (constrained)
• First Digital USD: 4 (constrained)
• Tether: 4 (constrained)
• Frax: 5 (weak)
• TrueUSD: 5 (weak)

As stated previously, the degree to which stablecoins are regulated and required to be transparent depends on jurisdiction. In the United States, the regulatory framework for fiat-backed stablecoins is still evolving, but what is clear is that:

• “...most stablecoin issuers are not subject to federal regulations and protections designed to instill faith in those liabilities, such as deposit insurance and portfolio restrictions.”
• “The regulations governing a stablecoin issuer depend in part on the issuer’s legal form”, and net-worth requirements vary markedly between states. 
• Stablecoin issuers are also subject to certain federal regulations, such as anti-money laundering requirements in the Bank Secrecy Act.
• Some stablecoins may qualify as “securities” under federal law, something that comes with registration and reporting requirements. 

To use Tether as a case study, the company was previously fined by the CFTC, is registered with and subject to FinCEN anti-money laundering regulations, has frozen assets belonging to individuals on OFAC's Specially Designated Nationals (SDN) List and is currently being investigated by the Department of Justice for potential violations of sanctions and anti-money-laundering regulations.

It remains unknown to what extent regulators might step in to protect users of fiat-backed stablecoins were a company to experience a major systemic failure. The Clarity for Payment Stablecoins Act of 2023 will endeavour to regulate stablecoins depending on the status of the issuer, and may offer some clarity in the future.

If you are considering using a stablecoin, the following guide may help you decide on which coin is suitable for you:

1. First, remember that no stablecoin is 100% secure, all have experienced some form of depeg since inception, and brief periods of instability do not necessarily represent an existential threat. 
2. If you are looking to use a fiat-backed stablecoin, examine the issuing company’s reputation, transparency and reserves. Some traders may also decide to consider the degree to which they have complied with regulators in the past, and any current scrutiny. Look at how the company has managed instability and what contingencies it has in place for future challenges. 
3. If you are looking to use a crypto-backed or algorithmic stablecoin, look closely into its track record. Some questions you might want to ask are: How did the stablecoin fare in periods of historical difficulty? What new processes were put in place after vulnerabilities were identified? Are the smart contracts regularly audited by reputable third parties? What is the coin's track record in terms of priec stability; how often does it depeg and to what extent?

In summary, while stablecoins have endured many challenges over the years, they remain an important part of the wider cryptocurrency ecosystem. 

Many factors contribute to stablecoin security, ranging from regulatory compliance to smart contract auditing and depend largely on the type of coin in question. While major depeg events are rare in the larger stablecoins, and a certain amount of instability is to be expected, exposure of major design flaws can be fatal. 

Investors deploying capital into a stablecoin asset should conduct their own research into the many factors that contribute to its security and decide whether it’s suitable. 

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