4.1 Stablecoin Overview
Stablecoins bridge traditional finance and crypto by providing price stability in an otherwise volatile market. With over $150 billion in circulation, they have become the backbone of crypto trading, DeFi, and increasingly, cross-border payments.
Why Stablecoins Matter
- Trading pairs: Most crypto trading uses stablecoins as the quote currency (BTC/USDT)
- DeFi foundation: Lending, borrowing, and liquidity pools rely on stable value
- Remittances: Cross-border transfers without forex conversion delays
- Inflation hedge: Access to dollar stability in countries with currency instability
- Payment rails: Fast settlement compared to traditional banking
Stablecoin Market Landscape
| Stablecoin | Type | Market Cap | Issuer |
|---|---|---|---|
| USDT (Tether) | Fiat-backed | ~$95B | Tether Limited |
| USDC | Fiat-backed | ~$35B | Circle |
| DAI | Crypto-collateralized | ~$5B | MakerDAO |
| FDUSD | Fiat-backed | ~$3B | First Digital |
| FRAX | Fractional-algorithmic | ~$1B | Frax Finance |
Stablecoins face tradeoffs between: (1) Price Stability - maintaining the peg, (2) Capital Efficiency - minimizing collateral requirements, (3) Decentralization - avoiding central points of failure. No design perfectly optimizes all three.
4.2 Fiat-Backed Stablecoins
Fiat-backed stablecoins are the simplest model: for every token in circulation, the issuer holds an equivalent amount of fiat currency (or equivalent assets) in reserve. This provides strong peg stability but requires trust in the issuer.
USDT (Tether)
The first and largest stablecoin, USDT has maintained its peg since 2014 despite significant controversy:
- Multi-chain: Issued on Ethereum, Tron, Solana, and many other chains
- Reserve composition: Cash, T-bills, commercial paper, secured loans
- Attestations: Quarterly reports from accounting firm (not full audits)
- Controversies: Reserve opacity, $18.5M NYAG settlement (2021)
Tether has never completed a full third-party audit. Reserve composition has historically included commercial paper and loans. While attestations show sufficient backing, the quality and liquidity of reserves remains a concern for some analysts.
USDC (Circle)
USDC positions itself as the "regulated" alternative with greater transparency:
- Issuers: Circle (primary) and Coinbase (consortium member)
- Reserves: Cash and short-dated US Treasuries only
- Attestations: Monthly attestations from Big Four firm (Deloitte)
- Regulatory: Money transmitter licenses, working toward bank charter
March 2023 De-peg Event
USDC briefly traded at $0.87 when Circle disclosed $3.3B exposure to failed Silicon Valley Bank:
How Fiat-Backed Stablecoins Work
Minting
- User sends USD to issuer's bank
- Issuer mints equivalent tokens
- Tokens sent to user's wallet
- KYC/AML required for direct minting
Redemption
- User sends tokens to issuer
- Issuer burns the tokens
- USD wired to user's bank
- Minimum amounts often apply
Secondary Market
- Most users trade on exchanges
- Arbitrageurs maintain peg
- If price < $1: buy, redeem for profit
- If price > $1: mint, sell for profit
4.3 Crypto-Collateralized Stablecoins
Crypto-backed stablecoins use cryptocurrency as collateral instead of fiat. Since crypto is volatile, these require over-collateralization - typically 150% or more. The flagship example is DAI from MakerDAO.
DAI & MakerDAO
How DAI Works
- Deposit collateral: User locks ETH, WBTC, or other approved assets in a Vault (formerly CDP)
- Generate DAI: User can borrow DAI up to the collateral limit (e.g., 66% for ETH)
- Pay stability fee: Interest accrues on the DAI debt (currently ~5-8% APY)
- Repay and withdraw: User repays DAI + fees to unlock collateral
Liquidation Mechanism
If collateral value falls below the liquidation ratio (typically 150%), anyone can trigger liquidation:
- Collateral is auctioned to repay DAI debt
- Liquidation penalty (13% for ETH) incentivizes proper collateralization
- Excess collateral returned to original owner
- If auction fails, MKR token holders absorb losses
MKR holders govern MakerDAO: setting interest rates, collateral types, and risk parameters. MKR is also the backstop - if the system becomes under-collateralized, new MKR is minted and sold to recapitalize, diluting existing holders.
DAI Peg Stability
| Scenario | Mechanism |
|---|---|
| DAI > $1 | Lower stability fee - incentivizes minting more DAI |
| DAI < $1 | Raise stability fee - incentivizes repaying DAI debt |
| Emergency | Global Settlement - all DAI redeemable for collateral |
Evolution: Multi-Collateral DAI
Originally backed only by ETH (Single-Collateral DAI), MakerDAO evolved to accept multiple collateral types:
- Crypto: ETH, WBTC, LINK, YFI, and many others
- Real World Assets (RWA): US Treasuries, tokenized real estate
- Stablecoins: USDC (controversial - introduces centralization)
~40% of DAI was backed by USDC at its peak, creating dependency on Circle. The March 2023 USDC de-peg caused DAI to also break below $1. MakerDAO has since reduced USDC exposure and increased Treasury holdings.
4.4 Algorithmic Stablecoins
Algorithmic stablecoins attempt to maintain their peg through supply/demand mechanisms without traditional collateral. This capital-efficient approach has repeatedly failed, most spectacularly with Terra/UST in May 2022.
Common Algorithmic Mechanisms
Rebase Model
- Wallet balances automatically adjust
- Price above peg: increase supply
- Price below peg: decrease supply
- Example: Ampleforth (AMPL)
Seigniorage Model
- Two-token system
- Stablecoin + volatile governance token
- Arbitrage between tokens maintains peg
- Example: Terra UST/LUNA
Fractional Model
- Partially collateralized
- Algorithmic portion adjusts with demand
- More stable than pure algo
- Example: FRAX
Case Study: Terra/LUNA Collapse (May 2022)
The $60 billion collapse of Terra's UST stablecoin is the largest failure in crypto history, destroying wealth, triggering contagion, and leading to criminal charges against founder Do Kwon.
How Terra/LUNA Worked
- Mint/Burn: 1 UST could always be exchanged for $1 worth of LUNA, and vice versa
- Anchor Protocol: Offered ~20% APY on UST deposits, driving massive adoption
- Reflexive: UST demand increased LUNA price, which attracted more UST minting
The Death Spiral
Key Lessons
- Reflexivity is dangerous: The same mechanism that drove growth accelerated collapse
- Unsustainable yields: 20% APY required constant new capital inflows (Ponzi dynamics)
- No collateral floor: Unlike DAI, there was no hard collateral to limit losses
- Confidence-based: Once confidence broke, nothing could stop the spiral
Pure algorithmic stablecoins have a 100% failure rate at scale. Even "improved" designs face the same fundamental problem: in a crisis, there's no collateral to backstop the peg. Treat any algorithmic stablecoin exposure as high-risk speculation.
4.5 Stablecoin Regulation
The systemic importance of stablecoins has attracted regulatory attention globally. The Terra collapse, combined with USDC's SVB exposure, demonstrated that stablecoin risks can propagate beyond crypto into traditional finance.
Regulatory Approaches
| Jurisdiction | Status | Key Requirements |
|---|---|---|
| United States | Proposed legislation | Bank-like regulation, reserve requirements, audits |
| European Union | MiCA enacted | E-money license required, 1:1 reserves, redemption rights |
| Singapore | Final framework | MAS regulation, reserve requirements, disclosure |
| UK | Consultation | Treating as regulated payment activity |
| India | No specific framework | Taxed as VDA; RBI concerns about rupee competition |
EU MiCA Framework
The Markets in Crypto-Assets Regulation (MiCA) is the most comprehensive stablecoin framework:
- E-money tokens: Stablecoins pegged to single fiat currency
- Asset-referenced tokens: Stablecoins backed by baskets of assets
- Authorization: Must be issued by licensed credit/e-money institution
- Reserves: 1:1 backing in high-quality liquid assets
- Redemption: Holders must be able to redeem at par at any time
- Significant stablecoins: Additional requirements for tokens exceeding thresholds
Indian Context
India has not enacted specific stablecoin regulation, but several considerations apply:
- RBI concerns: Stablecoins could undermine rupee and monetary policy
- VDA taxation: Stablecoins are taxable VDAs - even holding generates TDS obligations on transfers
- CBDC priority: RBI is piloting Digital Rupee (e-INR) as the preferred stable digital currency
- Potential restrictions: Future regulation may limit stablecoin use in favor of e-INR
When advising clients on stablecoin use, document the choice of stablecoin and rationale. Prefer fully-reserved, audited stablecoins (USDC, FDUSD) over less transparent options. Monitor regulatory developments as the landscape evolves rapidly.
Key Takeaways
- Stablecoins are critical crypto infrastructure - $150B+ in circulation, powering trading and DeFi
- Fiat-backed (USDT, USDC) offer best peg stability but require trust in centralized issuers
- Crypto-collateralized (DAI) are more decentralized but capital-inefficient (150%+ collateral)
- Algorithmic stablecoins have 100% failure rate at scale - Terra/LUNA destroyed $60B
- The stablecoin trilemma: Cannot optimize stability, capital efficiency, and decentralization simultaneously
- Regulatory frameworks emerging globally - EU MiCA requires bank-like reserves and redemption rights
- India taxes stablecoins as VDAs - TDS applies to transfers; specific regulation pending