Risks of Holding Stablecoins: Depegging and Beyond

Depegging occurs when a stablecoin's market price significantly and persistently deviates from its intended peg, typically $1. This is the most direct threat to a stablecoin's core value proposition.

• Causes: Loss of collateral backing, loss of market confidence, or smart contract failures.
• Example: The collapse of TerraUSD (UST), which lost its peg due to a flawed algorithmic design and a bank run, erasing billions in value.
• Impact: Users face immediate capital loss and reduced utility for payments and trading.

This risk concerns the quality, transparency, and liquidity of the assets backing the stablecoin. Even fiat-backed coins are vulnerable if reserves are mismanaged.

• Types: Includes fiat, crypto, commodity, or algorithmic reserves, each with unique failure modes.
• Example: Doubts about Tether's (USDT) commercial paper holdings historically sparked concerns about its ability to honor redemptions.
• Consequence: If reserves are insufficient or illiquid, the issuer cannot redeem tokens at full value, breaking the peg.

The risk that the entity holding the underlying assets (the custodian or issuer) fails, acts maliciously, or becomes insolvent. This is central to centralized stablecoins.

• Centralization: Reliance on a single company's solvency and honesty.
• Example: If the bank holding a stablecoin's cash reserves fails, those funds could be frozen or lost.
• User Exposure: Loss of access to funds, frozen withdrawals, or total loss if the custodian is hacked or declares bankruptcy.

The vulnerability of the underlying blockchain code and infrastructure to bugs, exploits, or governance failures. This is a primary risk for decentralized and algorithmic stablecoins.

• Vectors: Code bugs, oracle failures (feeding incorrect price data), and governance attacks.
• Example: The hack of the Wormhole bridge in 2022, which temporarily compromised wrapped Ethereum (wETH) backing certain stablecoins.
• Effect: Can lead to catastrophic, instantaneous loss of funds through exploits or system failure, regardless of collateral health.

The threat of new laws or enforcement actions that could restrict a stablecoin's operation, deem it a security, or ban its use, impacting its liquidity and legality.

• Scope: Includes issuer licensing, reserve auditing requirements, and user KYC/AML rules.
• Example: The potential U.S. Stablecoin Act could restrict issuance to insured depository institutions, disrupting current models.
• Implication: Sudden regulatory action can cause panic selling, depegging, or render a stablecoin unusable in key jurisdictions.

The danger that the failure of one major stablecoin or its interconnected platform could trigger a cascade of failures across the broader crypto ecosystem and traditional finance.

• Interconnectedness: Stablecoins are deeply embedded in DeFi lending, trading, and as collateral.

• Example: A major depegging event can trigger mass liquidations in lending protocols, crashing asset prices and causing liquidity crunches.

• Significance: Amplifies losses beyond direct holders, threatening the stability of the entire digital asset market.

A depegging event occurs when a stablecoin's market value significantly and persistently deviates from its intended peg, such as $1. This is often triggered by a loss of confidence or a failure in the underlying collateral mechanism.

• Cascading liquidations in DeFi protocols can amplify the sell-off.
• Example: UST's collapse in 2022 demonstrated how an algorithmic design could fail catastrophically.
• For users, this means deposited collateral can be liquidated at a loss, and savings can evaporate overnight.

Regulatory intervention poses a major external threat, where governments may restrict stablecoin issuance, redemption, or treat them as securities. This can freeze operations and access to underlying reserves.

• Sudden compliance demands can force abrupt changes to a stablecoin's model.
• Example: Potential U.S. stablecoin legislation could reshape the entire market landscape.
• Users risk having assets trapped in non-compliant protocols or facing unexpected tax liabilities.

This risk involves the insolvency or illiquidity of the backing assets held in reserves. For fiat-collateralized stablecoins, this could be bank failure; for crypto-collateralized, it's volatile asset crashes.

• Opacity in reserves makes it hard to verify backing authenticity.
• Example: Concerns over the quality of commercial paper in some reserves have sparked audits.
• If reserves are insufficient, redemptions halt, rendering the stablecoin worthless.

Many stablecoins rely on centralized entities for minting, burning, and holding cash reserves. This creates single points of failure vulnerable to seizure, fraud, or operational collapse.

• Custodial risk if the entity holding the bank accounts fails.
• Example: The freezing of assets in sanctioned smart contracts shows regulatory reach.
• Users are exposed to traditional financial system risks, counter to crypto's decentralized ethos.

The code underlying the stablecoin protocol can contain bugs or be exploited. This is a systemic threat as many DeFi applications are interconnected, and a hack on one can ripple through the ecosystem.

• Flash loan attacks can manipulate oracle prices to trigger depegs.
• Example: The 2023 Euler Finance hack impacted multiple integrated stablecoins.
• Users can lose funds directly from exploits, even if the stablecoin's model is sound.

Broader financial market crises can spill over into crypto. A liquidity crunch, rising interest rates, or a major bank run can trigger a flight to safety, destabilizing even well-collateralized stablecoins.

• Correlated asset sell-offs drain liquidity from crypto markets.
• Example: The 2023 banking crisis temporarily broke USDC's peg due to Silicon Valley Bank exposure.
• This links crypto user risk directly to traditional market volatility they may seek to escape.