Demystifying Stablecoins: The use cases, the pegging mechanism, and the implications on financial market

Executive Summary

• Stablecoins are primarily used as the “cash” or “base asset” for on-chain trading. with emerging use cases in cross-border payments, treasury management, and tokenization - offering faster, lower-cost, and more flexible alternatives to traditional financial services.
• Stablecoins offer a unique blend of crypto asset benefits and stability through their pegging mechanisms. Whether backed by fiat, crypto, or controlled by algorithms, these pegs face challenges. Technological and regulatory advancements are expected to address many of these challenges, though potential conflicts of interest as well as profitability challenges from duration risks, remain critical considerations.
• Fiat-collateralized players like Tether (USDT) and USD Coin (USDC) dominate the market, each with distinct characteristics. Comparing these to traditional pegged currencies, such as the Hong Kong dollar, underscores that the key to a successful peg is maintaining sufficient market confidence to prevent a "run dynamic."
• The stablecoin community currently only owns 3% of short tenor T-bills outstanding. Continued exponential growth may have an impact, but whether this growth stems from substituting existing demand is crucial. The U.S. dollar's dominance remains unchallenged, if not reinforced, as major stablecoins are predominantly pegged to it.

In the ever-evolving landscape of digital finance, the recent market frenzy has cast a spotlight on stablecoins. A series of legislative steps in the US and globally has underscored the growing importance of stablecoins in the crypto ecosystem. This burgeoning interest was further amplified by Circle's highly anticipated IPO in June, whose share price rallied by over 700% at the peak.

It is a rapidly growing market. Market capitalization surged from around US$3 billion in 2019 to over US$230 billion in 2Q25. As we delve into the intricacies of stablecoins, this paper aims to demystify their mechanics, key market players and use cases, and examine potential implications on traditional financial assets such as U.S. Treasuries and the U.S. dollar.

Where can stablecoins be used?

Stablecoins serve as a bridge between the fiat system and the crypto world. Currently, they are primarily used as the “cash” or “base asset” for on-chain trading. Crypto investors often hold stablecoins as a store of value or “dry powder” when moving in and out of other crypto assets, eliminating the need to convert back into fiat currencies, which usually imply haircuts. On exchanges, most crypto pairs are quoted against dominant stablecoins, enabling rapid rotation and efficient price discovery. Additionally, stablecoins can be posted as collateral on perpetual, futures, and options platforms, offering lower basis risk compared to more volatile crypto assets.

Several other use cases have emerged, although most are still in the early stages. Nonetheless, the opportunity is significant – stablecoin enabled solutions may become attractive alternatives to some traditional financial services. 

1. Cross-border payments and remittance

 Stablecoins could enable around-the-clock cross border settlement, minute-level latency, and lower fees. Think of them as digital dollars/euros you can send 24/7 to anywhere in the world, like email for money.

2. Treasury and deposit

Businesses can hold stablecoins as working capital, earn yields through tokenized cash management solutions, and settle payables globally as needed. Individuals in high-inflation countries without access to the U.S. dollar can use stablecoins as a store of value—for example, some use cases have been observed in Venezuela.

3. Tokenization 

Stablecoins can provide settlement for tokenized assets, which opens new possibilities for core capital-market functions such as fundraising, equity, and debt financing. As tokenized deposits, tokenized mutual funds, real-world assets (RWAs), and other future on-chain securities increasingly become integral to the global capital market ecosystem, stablecoins are the “cash” used to buy/sell them instantly.

Tokenization allows the securitization of a specific asset and its entire lifecycle to be placed on-chain. In this context, stablecoins essentially serve as the cash leg for issuance, trading, and post-trade settlements. With stablecoins, on-chain securities can be settled with atomic delivery-versus-payment (DvP), enabling the simultaneous exchange of assets and payment.

Tokenization provides an alternative to traditional capital market practices, enabling securities to be truly programmable. The result is faster, lower-cost settlement and more flexible product design. However, legal and compliance implications as well as cybersecurity concerns could persist. In response to potential disruptions, some traditional players, such as banks and brokers, have started to actively integrate blockchain technology into their systems to capture the opportunity.

Back to Basics – how does the stablecoin “peg” work?

Stablecoins are a type of cryptocurrency that are designed to “peg” against a specific asset or a basket of assets, typically fiat currencies like the U.S. dollar. With the pegging mechanism, they combine the benefits of crypto assets with the stability against fiat currencies. There are several ways the peg could work:

1. Backed by fiat. Fiat-collateralized stablecoins are the most typical and represent some of the most used stablecoins at present. These stablecoins are backed 1:1 by a reserve of fiat currency held by the issuer, to ensure that the stablecoin can be redeemed for its pegged value. Examples include Tether (USDT) and the USD Coin (USDC). 

2. Backed by crypto. Crypto-collateralized stablecoins are backed by other crypto assets rather than fiat. They often need to be over-collateralized to account for price volatility of the backing assets. Examples include DAI, a stablecoin that is backed by Ethereum (ETH) and other cryptocurrencies in a decentralized manner.

3. Controlled by algorithms. Algorithmic stablecoins do not have any collateral but use algorithms to control the supply. If the price goes above or below a certain threshold, the algorithm automatically increases or decreases the supply to stabilize the price. Examples include Ampleforth (AMPL) and Terra (LUNA, before its collapse).

Are Stablecoins Stable?

Historically, all major stablecoins experienced large price fluctuations. Some may even de-peg eventually. Confidence impairment drove some of the largest shocks, such as spillover of crypto/banking risk events, major hacks and exploits. Technical issues with market functionality can also cause temporary price dislocations - issues with fiat rails and banking access can lead to slower redemption channels or changes in counterparties; significant imbalances on-chain liquidity composition can mechanically shift prices; market structure frictions such as venue fragmentation can also delay arbitrage processes.

Here we provide a brief history of major stablecoins to help reflect on potential risks associated with them. It is also important to note that technological advancement and evolvement in regulatory frameworks are expected to address many of these challenges.

Tether (USDT)

USDT currently holds a dominant position in the stablecoin market, accounting for approximately two-thirds of the market share. Launched in 2014 as Realcoin, then rebranded to Tether; early issuance on Bitcoin’s Omni layer, later expanded to Ethereum (ERC 20, 2017), Tron (TRC 20, 2019), and many other chains. Its widespread adoption across numerous cryptocurrency exchanges and frequent use in trading pairs contribute to its high liquidity. Tether, the issuer of USDT, operates offshore (BVI/Hong Kong) with less direct prudential supervision.

The precise composition of backing assets has been a subject of controversy. In 2021, the Commodity Futures Trading Commission (CFTC) imposed a $41 million penalty on Tether for alleged misstatements regarding its reserves and their composition during the period from 2016 to 2018. In response, Tether has since committed to providing quarterly reserve attestations. The company has significantly reallocated its reserves toward U.S. Treasury bills and reverse repo, and had eliminated its holdings in commercial paper by late 2022. According to its Q2 2025 attestations (by accounting firm BDO), USDT is 100% backed with a small excess reserve, and cash or equivalents (i.e. U.S. Treasury bills, reverse repos) account for roughly 80% of its backing assets; rest include secured loans, bitcoin, gold, and other investments.¹

Several major price deviations took place historically, as shown in the chart below.

USD Coin (USDC)

Launched in 2018 by Circle and Coinbase, USDC is regarded as one of the most "compliant" fiat-collateralized stablecoins currently available. Circle is a U.S. company operating onshore with money-transmitter licenses across most U.S. states, a BitLicense from the State of New York, a Major Payment Institution license from Singapore and an EU e-money (MiCA) license. 

Backing assets of USDC only contain cash, U.S. treasury bills, and reverse repo. They are held with regulated U.S./EU banks and in an SEC-registered government money market fund managed by BlackRock.² Reserves are segregated, and holding details are made publicly available. Monthly attestations on backing assets are issued by Deloitte, with audited financials for the issuer.³ KYCs are conducted for issuance/redemption, with extensive law-enforcement cooperation i.e. The Office of Foreign Assets Control (OFAC) sanctions.⁴  

Despite a market cap of almost 40% of USDT, USDC is much less traded and thus demonstrates lower liquidity (see Chart 3). Large price deviations have been rare except for a significant price drop between March 10 and 12, 2023, due to its exposure to the Silicon Vally Bank (SVB). During this period, USDT traded at a material premium as capital fled into USDT.

TerraUSD (UST)

TerraUSD (UST) was an algorithmic stablecoin that aimed to maintain a 1:1 peg with the US Dollar through a mechanism involving the Luna cryptocurrency. Before its collapse, UST had reached a market cap of roughly $18 billion. In May 2022, UST experienced a massive depeg, dropping to as low as $0.30 due to a combination of market volatility and a loss of confidence in its underlying mechanisms. The collapse of UST led to significant losses for investors and contributed to the broader cryptocurrency market downturn. The event ultimately resulted in the failure of the Terra ecosystem and the collapse of its sister token, Luna.

Apart from UST, some other popular algorithmic stablecoins also ended up de-pegged, including IRON issued by Iron Finance (a dual-token model involving the TITAN token), Neutrino USD (USDN) associated with the Waves blockchain, etc.

DAI

DAI is the most emblematic crypto-backed stablecoin at present. Issued by MakerDAO, it is 1:1 pegged to the USD. It operates in a decentralized manner and is overcollateralized. Initially, DAI was backed solely by ETH, but it has since expanded to include various crypto assets like ETH variants and wBTC. It later expanded to other stablecoins through the Peg Stability Module (PSM) in late 2020 and Real World Assets (RWAs) in 2021, materially tightening the peg thereafter. DAI is an example of the classic crypto-backed model, whereas some peers i.e. USDe adopt a different model that depends on off-chain hedging.

A key feature of DAI is overcollateralization, meaning that more collateral is held than the value of the DAI issued. Users can lock their collateral in "Vaults" to mint DAI. They are required to pay a variable stability fee and must maintain their collateral above a specified liquidation ratio. If a Vault's collateral falls below this ratio, the collateral is auctioned off to repay the DAI, ensuring the system's stability.

Large price fluctuations of DAI have been mainly driven by spillovers from its backing assets.  For instance, the crash of ETH in March 2020 and the collapse of Terra/UST in May 2022 led to DAI trading at a premium, meaning it was valued above $1. A notable exception occurred in March 2023 during the SVB/USDC incident, when DAI's price dropped to the high ~$0.80s because of its substantial USDC exposure in the PSM. However, it largely recovered within 24 hours. Several small deviation episodes took place due to liquidity skews and usually resolved within hours.

The “peg”: Fiat-collateralized stablecoins vs traditional currency

Undoubtedly, the 'peg' is the most fundamental feature of stablecoins. In the realm of fiat-collateralized stablecoins, the most apt analogy within the traditional financial world is currencies that maintain a fixed exchange rate, such as the Hong Kong dollar (HKD).  Here, we use the HKD to illustrate how a peg works, and what makes a successful peg that endures.

The HKD's peg to the USD is widely regarded as one of the most successful in history. The peg has withstood numerous extreme market conditions. During the 1997 Asian financial crisis, when several other Asian currencies were forced to de-peg and eventually gave up on their fixed exchange rates, the HKD remained steadfast. It also navigated the tumultuous waters of the 2008 Global Financial Crisis, the 2015 China equity collapse, the social unrest of 2019, and the COVID-19-induced market collapse in 2020, all while facing significant short positions taken by hedge funds.

The secret to a successful peg is not particularly glamorous: sufficient confidence to prevent the onset of a "run dynamic." It largely depends on two principles:

• First, a commitment to maintaining a backing ratio of 100% or more. This is crucial to assure the market that full redemptions can always be met.
• Second, the asset allocation within the backing portfolio should be primarily designed to handle large redemption events, rather than to generate financial returns. This ensures the ability to meet redemptions in both normal and stressful times.

However, consistent adherence to these two principles is not easy, which is why many pegs have failed in the history of currencies. Here, we compare USDT, the largest stablecoin by market cap, to the HKD, to understand where risks may emerge.  

With the caveat that it's a fast-evolving landscape, and some alternative stablecoins (e.g., USDC) are becoming more compliant, there are several aspects to approach with caution.

1. Conflict of interest from backing assets’ financial return.

There’s a structural temptation to seek for higher financial returns in the backing portfolio. A conflict of interest could emerge in this case as shareholders of the issuer capture the upside from higher financial returns, while token-holders effectively bear the downside if the peg is undermined.

Any return-seeking shift towards non-cash-equivalent assets, including longer duration treasuries, lower-quality credits, lending, or directional bets means higher risks. Even high-quality assets can be illiquid on very short notice. If redemptions exceed readily monetizable cash and equivalent, forced sales could incur haircuts. Directional positions such as equities, commodities and other crypto assets can also introduce mark-to-market risks. If those losses reduce the effective buffer, confidence can crack. If redemption plumbing or reserve liquidity fails, secondary markets can price below par. When par redemptions aren’t broadly accessible or timely, a discount can persist and spiral widen, triggering a “run dynamic”.

2. Profitability challenged by duration risks.

Cash equivalent instruments, such as U.S. Treasury bills held in backing assets, generate interest income for the stablecoin issuer, known as the reserve yield. This yield can be retained without distribution to token-holders, thus becoming a primary revenue source for the issuer. Currently, the high interest rate environment allows the U.S. dollar cash yield to exceed 4%, offering a substantial reserve yield for issuers. However, this also implies that issuers encounter significant duration risks, meaning they are sensitive to changes in interest rates.

We expect the Federal Reserve to start cutting interest rates soon, which raises questions about the profitability resilience of stablecoin issuers.

Implications on the financial market

1. The U.S. treasury market

According to Tether, its exposure to U.S. treasury securities exceeded $127 billion at the end of Q2 2025¹⁴, making it one of the largest holders of U.S. government debt globally. The entire stablecoin community is estimated to hold just below $200 billion in treasury securities, primarily in short-term bills, which accounts for roughly 3% of the $6.2 trillion treasury bills outstanding¹⁵. So far, this size has not been significant enough to meaningfully shift the supply and demand balance in the treasury market.

That said, if the stablecoin market continues to grow exponentially, it could become an increasingly significant driver. However, a key consideration is whether stablecoin issuers are creating new demand for Treasury bills or simply shifting existing demand from sources like bank deposits or money market funds. If it’s the latter, the incremental impact would be minimal. In the event of a peg break, issuers may need to liquidate their backing assets to meet redemptions. Since T-bills are highly liquid and their prices are closely linked to the Federal Reserve’s policy rate, the overall market impact should remain limited.

2. The U.S. dollar

The dollar’s dominance can be hardly impacted by the emergence of stablecoins. And given major stablecoins are predominantly pegged to the US dollar, its dominance is reinforced if anything.

Going back to the basics of functionality of currencies, a dominant world currency needs to take the lead in transactions, central bank reserves, debt issuance, international trade settlement, and so on. So far dollar has seen no real rivals accounting for about 90% of FX transactions, 66% of international debt, 58% of central bank foreign reserves and 48% of SWIFT transactions. We wrote a detailed piece on it earlier this year.

Currently, stablecoin use cases are primarily focused within the crypto ecosystem, serving as the base asset in crypto trading or "the cash on chain." Its application in payments and remittances remains quite limited. While rapid expansion in this area could partially substitute the dollar's usage, particularly in cross-border transactions, it is far from challenging the dollar's dominance. However, it may have a more significant impact on the banking and financing segments of the financial system.