Stablecoin

A reserve-backed stablecoin functions much like a narrow bank or a money market fund with a token as its share class. The issuer receives fiat, mints tokens one-for-one, and invests the proceeds in cash deposits, Treasury bills, and repurchase agreements. The peg holds because authorised parties can redeem tokens at par: if the token trades below one dollar in the secondary market, arbitrageurs buy it cheaply and redeem at face value, retiring supply until the discount closes. The credibility of the peg therefore rests on the quality and liquidity of the reserves and on the reliability of redemption access.

Algorithmic designs replace reserves with rules. Supply expands when the token trades above the target and contracts when it trades below, typically by allowing holders to swap into or out of a companion volatile token. The mechanism is reflexive: contraction requires demand for the absorbing asset, and that demand tends to evaporate precisely when confidence in the peg fails, producing a self-reinforcing spiral rather than a stabilising correction.

Stablecoins are the dominant quote currency on crypto exchanges, so most trading volume in bitcoin and other tokens is denominated in them rather than in fiat. They serve as margin and collateral for perpetual futures, as the borrowing and lending unit in decentralised finance protocols, and as the settlement leg for tokenised assets, where cash-on-chain allows delivery versus payment without a correspondent bank. They are also used for cross-border transfers in jurisdictions with capital controls or weak local currencies, where dollar exposure that settles in minutes competes with slow, expensive remittance corridors.

Because the large issuers hold sizeable portfolios of short-dated Treasuries and repo, they have become visible participants in US money markets. This creates a two-way linkage: stress in the token market forces reserve liquidation into bill markets, while stress in the banking system, where some reserves sit as uninsured deposits, transmits straight back into the peg.

Treat a stablecoin as a credit and liquidity instrument, not as currency. The relevant exposures are issuer credit risk, custody and bank counterparty risk on the cash leg, market and duration risk in the reserve portfolio, redemption gating risk when terms allow the issuer to suspend or fee redemptions, and run risk arising from the mismatch between instant-settling liabilities and reserves that must be sold in a market. Smart-contract failure, blacklisting powers, and the possibility that the token exists on multiple chains via bridges add operational layers absent from a bank deposit.

Disclosure quality varies. Some issuers publish monthly attestations of reserve composition by an accounting firm; these are point-in-time procedures, not full audits, and they say nothing about intraday liquidity. Regulatory frameworks are converging on reserve segregation, high-quality liquid asset requirements, and redemption rights at par, with the European Union's MiCA regime and dedicated US payment stablecoin legislation as the leading examples.

You should be able to classify a stablecoin by its collateral model, fiat-reserve, crypto-overcollateralised, or algorithmic, and explain in words why each model breaks under stress. For the reserve model, describe the arbitrage loop that closes a discount and identify what interrupts it: frozen redemptions, an issuer whose bank is closed, or reserves that cannot be sold at carrying value. For the algorithmic model, articulate the reflexivity that turns a small discount into a collapse.

Expect stablecoins to appear in the digital assets material as an illustration of why tokens are not homogeneous, and in comparisons with money market funds, where the parallels of maturity transformation and par-value expectations are direct. You should also be able to state the investment use case, transfer and settlement efficiency plus continuous market access, without conceding that a peg equals principal safety, and to discuss depegs as measurable credit events rather than technical glitches.