Stablecoins Are Not Risk-Free: Three Structural Gaps Every Crypto User Should Understand

In day-to-day crypto use, stablecoins feel simple: one token is worth roughly one US dollar, one euro or one unit of another reference currency. They sit in wallets, appear in trading pairs and flow through payment rails with little drama—until something goes wrong. When that happens, the crucial question is not just whether the coin is backed, but how it is backed and who legally owns the assets behind it.

This guide explores three structural gaps that can affect different families of stablecoins. It is written for readers who already use stablecoins but want to evaluate them more carefully, as well as for newcomers trying to make sense of the alphabet soup of tickers and designs.

1. Asset or IOU? The Ownership Question at the Heart of Stablecoins

At a high level, most stablecoins fall into one of two economic categories:

• Asset-style designs. Here, the backing assets are held in segregated accounts for the benefit of token holders. In an ideal structure, users have a clear legal claim on a pool of cash or securities, and the issuer acts more like a trustee or custodian.
• IOU-style designs. In this case, the stablecoin functions more like a promise from the issuer. The user holds a claim against the company, not directly against a pool of assets. If the issuer runs into trouble, token holders may have to line up with other creditors.

On a blockchain explorer, both types look identical: a balance of tokens in a wallet. The divergence only becomes visible in the legal documentation, the way reserves are held and the stress scenarios the system has been built to handle.

To see how that plays out in practice, let us look at three very different episodes in the history of stablecoins.

2. Case Study One – Fiat-Backed Stablecoins and the Old Banking System

2.1 What Went Right—and Wrong—for a Major Dollar Stablecoin

Fiat-backed stablecoins such as USD-denominated tokens hold reserves in traditional financial instruments: bank deposits, short-dated government securities and similar assets. On paper, this appears straightforward and conservative. The reserves are usually denominated in the same currency as the token, and professional custodians handle the cash.

However, those reserves still live inside the legacy banking system, with all its strengths and weaknesses. In March 2023, several regional banks in the United States entered distress. One well-known stablecoin issuer disclosed that a portion of its reserves—around 3.3 billion US dollars—was held at a bank that had just been placed into receivership.

From a balance-sheet perspective, nothing had changed for token holders at that moment. Government authorities later made all depositors whole. But markets trade on perception and timing. For a weekend, users were not sure how quickly the frozen funds would be available. On exchanges, the stablecoin briefly traded below one dollar, reaching roughly 0.89 USD at the lows before recovering once clarity emerged.

2.2 Lessons from the Banking Stress Episode

This incident highlighted several points that are easy to overlook in calm conditions:

• Fiat backing does not isolate a token from banking risk. Even a portfolio of conservative assets can be exposed to operational or counterparty issues at the institutions that custody those assets.
• Transparency helps but does not remove volatility. The issuer in this case communicated quickly about the size and location of the affected reserves. That transparency probably shortened the disruption, but it did not prevent a temporary deviation from the target price.
• Legal structure matters. Users benefit when reserve accounts are clearly segregated from the issuer’s own funds and are protected under applicable regulation. Reading the offering documents and attestation reports can reveal how robust that segregation is.

The key takeaway is that fiat-backed stablecoins inherit the strengths and weaknesses of the financial institutions they rely on. They can be relatively robust, but they are not as simple as holding physical cash in a personal safe.

3. Case Study Two – Algorithmic Stablecoins and the Limits of Self-Referential Design

3.1 The Promise of a Purely On-Chain Dollar

Algorithmic stablecoins take a very different approach. Instead of holding a large pool of traditional assets, they aim to maintain their value through programmatic supply adjustments and incentives. In one of the most well-known designs, a stablecoin was kept near one US dollar primarily by offering high yields to participants who helped stabilise its price and by pairing it with a separate volatile token that absorbed shocks.

For a time, this system appeared to work. The protocol attracted billions of dollars in deposits, and the high advertised yields drew a global user base. Many observers saw it as a glimpse of a fully on-chain alternative to traditional banking, where algorithms would replace balance sheets and credit committees.

3.2 What Happened During the Breakdown

The model relied on two fragile pillars: continued demand for the stablecoin and market confidence in the associated volatile token. When sentiment turned and a large volume of funds exited the system in May 2022, those pillars weakened simultaneously. To defend the stablecoin’s peg, the protocol issued massive quantities of the volatile token. Instead of restoring confidence, this influx pushed its price lower, which further eroded trust. A feedback loop set in: declining confidence required more issuance, which caused further declines.

Within days, the system had effectively broken down. The stablecoin traded far below one dollar and never fully recovered. The total market value associated with the ecosystem dropped by tens of billions of dollars, and the episode became a central reference point in discussions about how not to design a stabilisation mechanism.

3.3 What Algorithmic Designs Teach Us About Risk

Algorithmic stablecoins show that elegant mathematics is not a substitute for resilient collateral. Some key lessons from this case include:

• Reflexivity cuts both ways. Designs that depend on market confidence to sustain demand can enjoy rapid growth when conditions are favourable, but the same reflexive forces can accelerate declines when sentiment shifts.
• High yields deserve extra scrutiny. Very generous advertised returns often mean that users are being compensated for taking on complex, layered risk—liquidity risk, governance risk and model risk all at once.
• Stress scenarios should be part of the evaluation. A responsible assessment asks what happens if everyone tries to exit at once, or if the associated volatile token loses market interest for an extended period.

Algorithmic approaches continue to evolve, and not all such designs are identical. Still, the collapse of a major project in this category is a reminder that stability based solely on incentives and expectations can be fragile.

4. Case Study Three – Multi-Collateral Stablecoins and Technical Stress

4.1 A More Diversified Approach

Multi-collateral stablecoins, such as those issued by decentralised lending protocols, take yet another path. Instead of holding only cash and government securities, they accept a basket of digital assets—typically large-capitalisation cryptocurrencies and tokenised real-world instruments—as collateral. Users lock these assets in smart contracts and borrow a stablecoin against them, with automated rules determining when positions must be adjusted.

This architecture spreads risk across multiple types of backing, and it reduces reliance on a single bank. It also introduces new sensitivities, particularly in periods of rapid price movement or when the underlying blockchain becomes congested.

4.2 The March 2020 Stress Test

In March 2020, global markets sold off sharply as the scale of the COVID-19 pandemic became clear. Crypto assets fell alongside equities and other risk assets. On the Ethereum network, the combination of heavy trading and rising uncertainty led to severe congestion. Transaction fees spiked and it became difficult to adjust positions quickly.

Within one major decentralised stablecoin system, the automatic liquidation mechanism—designed to sell collateral when its value dropped below a threshold—struggled to function smoothly. In the chaos, some market participants were able to win liquidation auctions with extremely low bids because others could not submit competing transactions in time. The protocol later took steps to repair the shortfall, but the episode revealed that technical and liquidity constraints can matter as much as the headline collateral ratio.

4.3 Engineering Lessons from Multi-Collateral Designs

This stress event highlighted several dimensions of risk that are easy to underestimate:

• Blockchain performance is part of the risk model. A system that relies on timely liquidations must account for periods when the underlying network is congested or when transaction fees become temporarily prohibitive.
• Diversity of collateral is helpful but not a cure-all. Even with multiple backing assets, a sharp, broad-based market decline can pressure the system. Highly correlated assets may behave similarly under stress.
• Governance and emergency tools matter. Protocols that can adapt parameters, pause certain mechanisms or tap insurance funds transparently may navigate shocks more effectively than those with rigid rules.

Multi-collateral stablecoins remain an important part of the decentralised finance landscape, but their resilience depends not only on over-collateralisation, but also on the quality of their engineering and governance.

5. A Practical Checklist for Evaluating Any Stablecoin

Putting these case studies together, what should everyday users look for before treating a stablecoin as a safe parking place for funds? Below is a non-exhaustive checklist framed in plain language.

5.1 What Backs It—and Where?

• Is the backing primarily cash and short-term government securities, crypto collateral, or a hybrid?
• Where are those reserves held—at specific banks, in on-chain vaults, or with licensed trust companies?
• Are reserves segregated for the benefit of token holders, or do they sit in general corporate accounts?

5.2 Who Bears the Risk?

• In the event of a problem at a bank or a sharp market move, do token holders have a direct claim on assets, or are they general creditors of the issuer?
• Does the whitepaper or terms of service clearly describe the ranking of claims?
• Is there any form of insurance, guarantee fund or over-collateralisation that absorbs first losses?

5.3 How Transparent Is the System?

• Are there regular attestations or audits from independent firms describing the reserve composition?
• For decentralised designs, are key metrics—such as collateral ratios and liquidation volumes—available on-chain dashboards?
• Does the project provide clear documentation explaining how it would handle severe stress scenarios?

5.4 What Are the Hidden Dependencies?

• Does the stablecoin depend on continuous growth in deposits or on unusually high yields to remain attractive?
• Is the design heavily reliant on a single other token, protocol or bridge?
• Could network congestion, oracle failure or governance disputes impair basic operations?

No design can eliminate all risk, but asking these questions turns “stablecoin” from a generic label into a set of concrete trade-offs that can be evaluated and compared.

6. From Blind Trust to Informed Use

The three examples in this article—fiat-backed reserves caught in a banking event, an algorithmic design that could not withstand a rapid change in sentiment, and a multi-collateral system stressed by network congestion—do not mean that stablecoins are inherently flawed. Instead, they illustrate that each architecture concentrates risk in different places.

Stablecoins can be powerful tools: they simplify cross-border transfers, enable non-custodial lending and provide a bridge between traditional finance and on-chain applications. But they are not interchangeable, and they are not a guarantee of safety on their own. The same digital dollar symbol on a screen can represent a claim on cash in a regulated trust account, an over-collateralised loan or a complex algorithmic system.

For individuals and institutions alike, the most important shift is from blind trust to informed use. Before parking significant value in any stablecoin, it is worth reading the documentation, understanding where the reserves sit and considering how the design might behave under stress. Diversifying across different models, keeping position sizes aligned with one’s risk tolerance, and staying informed about regulatory and technological developments can all contribute to more resilient use of these tools.

In the end, the question is not whether stablecoins are good or bad. It is whether users understand what they hold. A stablecoin that behaves like an IOU from a single company carries very different implications from a token backed by segregated reserves or by a diversified pool of collateral. Recognising that difference is the first step toward using these instruments responsibly in a fast-evolving digital economy.

Disclaimer: This guide is provided for informational and educational purposes only. It does not constitute financial, investment, legal or tax advice, and it should not be treated as a recommendation to buy, sell or hold any digital asset. Digital assets, including stablecoins, carry risks that may not be suitable for every reader. Always conduct your own research and consider consulting qualified professionals before making decisions related to cryptocurrencies or other financial instruments.