Stablecoins are a form of cryptocurrency. Cryptocurrencies are a digital representation of value that functions similarly to most currencies by providing a medium of exchange, unit of account, store of value, and rely on cryptography to secure transactions. Most cryptocurrencies do not require intermediaries or government backing. Stablecoins are a unique subset of cryptocurrency. Unlike Bitcoin, and other similar cryptocurrencies, stablecoins attempt to maintain a fixed, or “pegged” exchange rate, in which their value is fixed against the value of another currency or asset with the aim of maintaining stability in value.
Note: For more information about cryptocurrency generally, see KLRD’s Cryptocurrency overview and detailed memo on cryptocurrency.
There are four main ways in which the value of a stablecoin may be pegged to another asset:
- Fiat currency-backed: A stablecoin can be pegged to fiat currency, like the U.S. Dollar (USD), when that fiat currency is held in reserve against the coin’s value at a depository institution. As the stablecoin price fluctuates, reserves are bought or sold to maintain stablecoin pegging to the reserve asset. In an effort to maintain their stability in value, large issuers sometimes over-collateralize their stablecoins by holding more fiat currency in reserve than the value of the stablecoins issued.
- Commodity-backed: A stablecoin can be pegged to the value of a specific commodity, where the stablecoin issuer holds the commodity and buys or sells the commodity as needed to adjust the stablecoin price.
- Cryptocurrency-backed: Some stablecoins peg their value to other cryptocurrencies. As the stablecoin price fluctuates, the issuer buys or sells the reserve cryptocurrency as needed to restore the stablecoin’s peg. These stablecoins may be overcollateralized to account for the pegged cryptocurrency’s volatility.
- Algorithmic-backed: These stablecoins do not hold reserve assets. Instead, an algorithm on the stablecoin’s blockchain dynamically adjusts its supply to create or destroy stablecoins depending on the change in the stablecoin’s value. In practice, this mechanism typically fails to maintain a stable pegged value because adjustments made by the algorithm cannot keep pace with real-time changes in market conditions.
Unlike other cryptocurrencies whose current usage is mainly as an investment vehicle, stablecoins tend to be focused on facilitating transactions between parties. Currently, there are two major use cases for stablecoins:
- International transfers: Stablecoin users do not need multiple bank accounts in two countries to transfer money from one country to another; they just need one cryptocurrency wallet that transfers their stablecoin to another user’s wallet.
- Peer-to-peer digital transfers: Stablecoins allow users to complete digital transfers without the need for third parties to facilitate the transaction.
While stablecoin usage continues to rise, this cryptocurrency subset still presents risk to users and the finance sector.
Stablecoin Risks
Stablecoins present several risks to users, some of which include:
- False claims that a stablecoin is fully backed by reserves. In 2021, the Commodity Futures Trading Commission (CFTC) fined Tether $41 million for making untrue or misleading statements and omissions of material fact related to the amount of reserves held backing their stablecoin. The CFTC found during a 26-month period that Tether only held 100 percent of reserves 27.6 percent of those days.
- False claims that reserves are fully backed by a specific asset. In the 2021 Tether finding, the CFTC found that Tether was also using non-fiat financial products as part of their reserves.
- Unauthorized use of consumer funds. When consumers purchase a stablecoin, the USD given to the issuer in exchange for the stablecoin should go into the reserves. As seen in the FTX collapse in 2022, issuers could take the USD and use it for personal use instead.
- Volatility in the reserve asset’s price. In March 2023, the stablecoin DAI temporarily de-pegged due to a substantial portion of its reserves being tied to another cryptocurrency. While DAI tried to maintain a 1:1 peg with the USD, about 40 percent of its reserves were in another stablecoin. As cryptocurrency pricing fell, the reserve stablecoin’s price fell and DAI temporarily de-pegged.
- A digital “bank run” on algorithm-backed stablecoins. For stablecoins that rely on an algorithm to create or destroy stablecoins to maintain a pegged value, the algorithm must process its orders faster than the market. In some instances, algorithmic stablecoins have been subject to large selloffs in which the algorithm could not keep up with price volatility, ultimately resulting in failure of the stablecoin to maintain its pegged value. This run is what led to Terra’s collapse in 2022.
- A run on the bank holding a stablecoin’s reserves. According to Reuters, the run on Silicon Valley Bank (SVB) led several stablecoins, including the second largest stablecoin in the world, USD Coin (USDC), to temporarily de-peg out of fear the stablecoins’ reserves held at SVB would not be accessible due to the run on the bank. Eventually, USDC and other affected stablecoins were able to re- peg after the Federal Deposit Insurance Corporation (FDIC) backed up insured deposits and issuers used corporate funds to fill any remaining gaps in their reserves.
- Inability to convert reserves into liquid assets to maintain the peg. In 2024, reports surfaced that the U.S. Treasury was considering sanctions against Tether for its stablecoin’s widespread use by sanctioned entities. This possible sanction against Tether could prohibit Americans from transacting with Tether and significantly impair or wholly prevent its ability to convert its reserve of U.S. Treasury bills into liquid assets to maintain the stablecoin’s value.
- Use of stablecoins for illicit activities. With stablecoin values relatively consistent compared to other cryptocurrencies like Bitcoin, criminals and scammers tend to rely on stablecoins to transfer money for illicit activities. Chainanalysis’ 2024 report on cryptocurrency crime trends shows that illicit transaction volume involving stablecoin payments continues to rise. In 2023, stablecoin payments made up around 60 percent of all illicit cryptocurrency payments. About 80 percent of all illicit transactions conducted by sanctioned entities and jurisdictions used stablecoins.
Stablecoin Legislation
Proposed Congressional Action
Currently, the United States does not have a stablecoin-specific federal law providing a comprehensive legal framework. In recent years, various legislation has been introduced in Congress providing a regulatory framework for stablecoins. Some areas that were addressed in those bills include:
- Defining stablecoins and issuers;
- Establishing reserve requirements (amounts, custodians, etc.);
- Ensuring compliance with traditional finance provisions like Know Your Customer and Anti-Money Laundering; and
- Authorizing federal and/or state entities to enforce regulation.
State Enactments
Several states have recently enacted stablecoin-specific legislation, examples of which are provided below.
California
Enacted in October 2023, the Digital Financial Assets Law (DFAL) created a regulatory framework, including licensure and enforcement authority, for certain cryptocurrency activities (including stablecoin issuance). The law requires the state’s Department of Financial Protection & Innovation (DFPI) to license and supervise many cryptocurrency asset-related companies, including stablecoin issuers, that serve California residents and provides consumer protections for users. The DFPI is currently developing its regulations.
Nebraska
Enacted in 2021, and updated in 2024, Nebraska’s Financial Innovation Act defines a stablecoin as a controllable electronic record designed to have a stable value that is backed by a reserve asset.
The Act authorizes digital asset depositories to issue stablecoins and hold deposits that serve as reserves at an FDIC-insured financial institution chartered in the state or has a branch in the state. The Act also authorizes such depositories to use stablecoins for payment activities.
Such depositories would be subject to certain licensing requirements. Nebraska’s Department of Banking and Finance issued guidance indicating the following will be among those requirements:
- Issuer-provided daily reports of key general ledger and distributed ledger numbers and a quarterly call report;
- Periodic examination of an issuer’s general ledger balance sheet, external audits, and compliance;
- Review of policies and procedures to prevent money laundering;
- Compliance with “Know Your Customer” regulatory requirements;
- Appropriate federal transaction reporting and other standard banking practices;
- Examiner-issued confidential report to be shared with the issuer and potentially other regulators;
- Requiring certain disclosures from issuers to consumers and investors to inform them of risks, conflicts of interest, and fees; and
- Requiring issuers to provide at least 10 hours of live customer phone support on weekdays to serve state residents.
Texas
Enacted in 2023, the Money Services Modernization Act updates the state’s money services statutes. The Act defined “money” or “monetary value” to include stablecoins.
The Act defines as money any stablecoin that is:
- Pegged to a sovereign currency;
- Fully backed by assets held in reserve; and
- Grants the holder the right to redeem the stablecoin for sovereign currency from the issuer.
The Act also authorizes the Texas Department of Banking to enforce the Act.
Unlike California and Nebraska which have specific regulations related to stablecoin issuers, Texas’ Act applies to all money service providers but allows those providers to participate in stablecoin activities. The only stablecoin-specific provision in the Act permits providers to invest in stablecoins so long as those investments are in the same kind of stablecoin as those issued to consumers by the provider.
Other State Approaches to Stablecoin Regulation
New York
New York has been regulating cryptocurrencies since 2015. In 2022, the state’s Department of Financial Services (Department) issued guidance indicating it would apply certain requirements to stablecoins backed by the U.S. dollar and issued under the Department’s authorization. These stablecoin-specific regulations did not replace any other regulations related to the issuer or Department.
Key regulations from the guidance include the following:
- A stablecoin must be fully backed by a reserve of assets (1:1 backing) as of the end of each business day;
- Stablecoin reserves must be held with a U.S. state or federally chartered depository institution insured by the FDIC or with pre-approved custodians;
- Stablecoin reserves can only be:
- U.S. treasury bills with maturity dates of three months or fewer;
- Reverse purchase agreements fully collateralized by U.S. treasury bills, notes, or bonds; or
- Other Department-approved assets;
- Reserves must be subject to an examination at least once per month by an independent Certified Public Accountant licensed in the United States who attests to certain reporting requirements; and
- Stablecoin issuers must adopt clear redemption policies approved in advance by the Department allowing the user to redeem the stablecoin from the issuer at a 1:1 exchange rate for the U.S. dollar net of any fees.