Understanding How Stablecoin Works | by Nathaniel Adediran | Coinmonks | Feb, 2023


USDT reserves breakdown
  • Market and liquidity risks: Stablecoins can be susceptible to runs, which occur when a sudden increase in redemption requests is triggered by events such as a drop in price, rumors of instability, or concerns about the quality of the underlying assets. This can lead to a “fire sale” of the assets that support the stablecoin, potentially causing additional outflows as investors worry that the issuer may not be able to fulfill future redemption requests in their entirety. This can be seen in the case of TerraUST where investors started selling off when there were rumors of instability.
  • Smart contract risk: As most decentralized stablecoins live within smart contracts in protocols like Ethereum or Stellar, there’s a risk the algorithm which keeps the currency stable fails. Smart contracts could even be manipulated by a third party. Because “code is law”, updates to the network can have an impact on previous smart contracts — a huge hassle for decentralized projects.
  • Reliance on a central authority: One of the biggest concerns with stablecoins is their reliance on a central authority. This goes against the very ethos of cryptocurrencies, which are meant to be decentralized and free from third-party control. With most stablecoins, a central entity holds the fiat or cryptocurrency reserves that back the value of the stablecoin. This means that there is a central point of control and failure. If the central entity collapses or is hacked, the stablecoin could lose its value completely.
  • Lack of transparency: There are some issuers of stablecoins who don’t provide proof or information about their reserves, making it difficult to determine if they are adequately supporting their stablecoins. Since there are no industry requirements for audits or reporting, there is concern that these tokens may fail.
  • Lack of precision: Stablecoins often deviate in value from their underlying pegs which can undermine confidence in their usefulness. This can be seen in Stablecoins like USDT, USDC frequently ranging between $0.98 — $1.02.
  • Regulatory Risk: The lack of clear regulations for stablecoins creates significant uncertainty for both investors and issuers. As different jurisdictions treat stablecoins differently, it can lead to a patchwork of rules and guidelines. This regulatory inconsistency can make it difficult for stablecoin issuers to comply with various requirements in different jurisdictions, leading to increased risk.

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