Stablecoins: Promise and Perils in a Financial Crisis

Stablecoins have been around for over a decade, presenting a unique blend of the benefits of cryptocurrency with the stability of traditional currencies like the U.S. dollar. Ideally, a stablecoin should always maintain a value of $1. However, recent research highlights significant concerns regarding these digital assets, especially as their popularity soars, with their total value exceeding $250 billion as of August 2025. One of the main issues discovered is that the mechanisms used by stablecoins to maintain their dollar peg could also make them more vulnerable during financial crises, leading to what experts describe as “significant run risk.”

Understanding the Stability and Risk of Stablecoins

The previous administration placed a strong emphasis on developing stablecoin legislation, with hopes that these tokens could secure the U.S. dollar’s dominance on a global scale. However, a study by the National Bureau of Economic Research (NBER) sheds light on a critical flaw in the design of stablecoins. While it has generally been believed that more competition leads to greater stability, the findings suggest a trade-off exists. The measures that ensure stablecoin prices remain at $1 may inadvertently increase the risk of panic selling and financial runs.

The Structure of Stablecoins

Unlike traditional bank accounts, you can’t cash out most stablecoins directly with their issuers. There are two distinct markets for stablecoins:

1. Primary Market: Here, a small group of authorized dealers, known as arbitrageurs, can redeem stablecoins for cash straight from issuers like Tether or Circle.

2. Secondary Market: In this market, the general public trades stablecoins through exchanges, where prices may fluctuate depending on supply and demand.

What Triggers a Crisis?

Researchers identified various common triggers that could initiate a sell-off or financial crisis in stablecoins:

• Credit Downgrades: If reserve assets (like corporate bonds or bank deposits) lose their value, it can create panic.
• Interest Rate Changes: Shifts in interest rates can significantly affect the performance of bond portfolios.
• Regulatory Changes: Uncertainty in regulations can scare investors and lead to sell-offs.
• Market Stress: General market turmoil can create fears about asset liquidity.
• Bulk Redemption Requests: Large redemptions by institutional holders can trigger a domino effect.

Central Traders: The Key to Stability

Arbitrageurs play a crucial role, acting as intermediaries who help maintain the overall price stability of stablecoins at $1. However, the research reveals a surprising twist: having more arbitrageurs does not necessarily mean lower risk. In fact, in times of market panic, more intermediaries may amplify the risks they are meant to manage.

To illustrate this, consider two major stablecoins: Tether (USDT) and Circle (USDC).

1. Tether: With only six authorized dealers, if panic selling begins, there may not be enough dealers to manage the selling pressure. This could cause prices to plummet to around 95 cents, leading to further irrational selling as investors rush to liquidate their assets.

2. Circle: With 521 dealers, panic selling may cause a minimal price drop, perhaps only to 99 cents. However, the broader market panic could compel many investors to sell, fearing a larger calamity.

The Emergency Exit Analogy

Think of a building in an emergency situation. If there are too few exits (like with Tether), people may hesitate and cause a bottleneck, slowing down the evacuation. On the other hand, if there are many exits (like with Circle), while people can leave quickly, it can lead to a rush that may exacerbate the situation. This highlights a paradox: the very structure designed to prevent sell-offs in stablecoins could inadvertently trigger them.

Assessing the Risk

The research estimates the annual run probability for both Tether and Circle as around 3.3% to 3.9%. While this seems low, consider this: holding a stablecoin for ten years gives you about a one in three chance of facing significant problems. In contrast, traditional bank accounts insured by the Federal Deposit Insurance Corporation (FDIC) have a much lower risk at only 0.001%.

The Bottom Line

Understanding stablecoins is important, especially as they are integral to the larger $3.87 trillion crypto ecosystem. The findings reveal that these assets are far more precarious than their name suggests. The more market value stablecoins accumulate, the more dangerous their hidden instability becomes. As investors increasingly rely on these digital tokens, there’s a pressing need to recognize and address these potential risks.

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Original Text – https://www.investopedia.com/hidden-risks-of-widespread-adoption-of-stablecoin-11747043