Stablecoins facilitate close to $7 trillion in annual transaction volume, yet multiple failures have wiped out billions in value, from Terra’s $45 billion collapse to countless smaller implosions.
This guide examines the 9 critical failure points that cause stablecoin collapses and provides a practical framework for risk assessment.
Key Takeaways
Reserve fraud remains the #1 cause of stablecoin failure: Tether operated with only 27.6% backing during 2016-2018Banking failures can instantly depeg fully-backed stablecoins: USDC lost 13% when Silicon Valley Bank collapsedAlgorithmic designs fail 100% of the time under stress: No purely algorithmic stablecoin has survived a major market downturnWeekend depegging risk is real: Volatility doubles when traditional banking rails are closedGovernance exploits have drained over $500M from stablecoin protocols: Smart contract bugs are often fatal
Why Stablecoin Failure Risk Matters Now
Stablecoins now power:
Tokenized asset settlement: Over $2 trillion in tokenized securities rely on stablecoin rails24/7 cross-border payments: $1.2 trillion in annual B2B transfersOn-chain lending markets: $50+ billion locked in DeFi protocolsCorporate treasury operations: Fortune 500 companies holding billions in stablecoins
The risk directly threatens capital preservation, payment reliability, and market stability.
Understanding failure mechanisms is essential, especially given rapid stablecoin news developments and regulatory changes.
Top 9 Reasons Stablecoins Fail
1. Insolvent or Mismanaged Reserves
The Risk: Issuers claim full backing while holding inadequate or risky assets.
How It Happens: Stablecoin issuers often invest reserves in higher-yielding but riskier assets to generate profit.
During the 2008 financial crisis, money market funds “breaking the buck” showed this risk isn’t theoretical.
Stablecoins face the same temptation, using customer deposits for yield rather than safety.
Warning Signs:
Vague “cash equivalent” descriptions without specificsNo real-time attestations or delayed reportingLong-dated assets (90+ day commercial paper) backing instant redemptionsCommercial paper concentration above 20%Reserves held through affiliated entities
Case Study: Tether were fined $41 million by the Commodity Futures Trading Commission for deceiving consumers.
The CFTC found that Tether only had enough fiat reserves to guarantee their stablecoin for 27.6% of the time during 2016 to 2018 (Stablecoin – Wikipedia).
Tether continues facing scrutiny despite being the largest stablecoin.
During this period, Tether’s reserves included loans to affiliated entities and cryptocurrency holdings, not the “1:1 dollar backing” they claimed.
See our USDT FAQ for current status.
Risk Mitigation:
Require monthly attestations from Big 4 accounting firmsAccept only overnight cash and 30-day T-bills as valid backingMonitor proof-of-reserve systems with real-time data feedsCalculate worst-case liquidation scenariosAvoid stablecoins with affiliated party transactions
2. Banking Partner or Custodian Failure
The Risk: Fully-backed stablecoins fail when banks holding reserves collapse.
How It Happens: Stablecoin reserves sit in bank accounts just like any corporate deposit.
When banks fail, these deposits become claims in bankruptcy proceedings.
FDIC insurance typically covers only $250,000 per account, meaningless for billion-dollar stablecoin reserves.
Even temporary bank closures can trigger panic depegging.
Warning Signs:
Single banking relationships (concentration risk)Regional bank dependence (higher failure probability)No explicit FDIC pass-through coverageSingle-jurisdiction operations (regulatory risk)Banks with crypto-heavy client bases
Case Study: USDC depegged by 13% below $1 after its issuer, Circle, confirmed that $3.3 billion of cash reserves backing USDC S&P GlobalAmberdata were trapped at Silicon Valley Bank.
Circle’s transparency didn’t prevent the depeg, proving that even the “safest” stablecoins face banking risk.
The depeg lasted 4 days until the FDIC guaranteed deposits, but institutional holders lost millions on forced sales.
Risk Mitigation:
Demand evidence of multi-bank diversification (minimum 5 banks)Choose stablecoins using global systemically important banks (G-SIBs)Verify explicit deposit insurance or government backingMonitor bank health scores quarterlyMaintain relationships with multiple stablecoin issuers
3. Depegging Due to Market Panic
The Risk: Bank runs can break any stablecoin’s peg through cascading liquidations.
How It Happens: Stablecoins maintain their peg through arbitrage, traders buying below $1 and selling above $1.
This mechanism breaks when:
Liquidity disappears (no buyers at $0.99)Redemption mechanisms fail or slowLarge holders dump simultaneouslyArbitrageurs lose confidence in eventual recovery
Warning Signs:
Whale concentration above 50% (top 10 wallets)Thin DEX liquidity (<$100M across venues)Single-venue dependence for price discoverySocial media panic spreading (Twitter sentiment tracking)Redemption queues forming
Case Study: On May 7, 2022, UST started experiencing selling pressure after people noticed an unusual amount of liquidity withdrawing from Curve, a DeFi exchange for trading cryptocurrencies (Why Stablecoins Fail: An Economist’s Post-Mortem on Terra).
Terra’s UST maintained its peg for 2 years before collapsing in 72 hours.
Once the peg broke to $0.98, arbitrageurs calculated that LUNA couldn’t absorb the selling pressure, creating a self-fulfilling death spiral.
Risk Mitigation:
Monitor liquidity depth every 4 hours across all venuesSet alerts for whale wallet movements (>$10M)Track social sentiment with automated toolsPrepare multi-stage exit strategies before panicNever assume the peg will hold in crisis
4. Smart Contract or Protocol Failure
The Risk: Code bugs enable total loss of collateral within minutes.
How It Happens: Smart contracts are immutable code controlling billions in value.
A single bug can:
Allow unlimited minting (hyperinflation)Enable unauthorized withdrawalsBreak core functionality (freezing all funds)Create recursive loops draining collateral
Unlike traditional systems, blockchain transactions are irreversible.
There’s no “undo” button.
Warning Signs:
Single audit or no audits (unreviewed code)Complex mechanisms with 1000+ lines of codeAdmin keys held by single entitiesUpgradeable contracts without timelocksHistory of “pausing” during market stress
Case Study: The stablecoin protocol saw its own governance proposal system exploited enabling the malicious actors to extract all of its $182 million in collateral (Comprehensive List of Failed Stablecoins – ChainSec).
Beanstalk Farms lost everything in 13 seconds.
The attacker used a flash loan to gain temporary voting power, passed a malicious proposal, and drained the protocol, all in one blockchain transaction.
Risk Mitigation:
Use only immutable or 48-hour timelock contractsRequire 3+ audits from Certik, OpenZeppelin, or Trail of BitsCheck active bug bounties (minimum $1M)Review past incident responsesTest emergency procedures yourself
5. Regulatory Enforcement or Legal Action
The Risk: Governments can freeze operations instantly, making stablecoins worthless.
How It Happens: Regulators view stablecoins as potential threats to:
Monetary sovereignty (competing with central bank money)Financial stability (unregulated shadow banking)Consumer protection (no deposit insurance)Tax collection (pseudonymous transactions)
One enforcement action can destroy a stablecoin overnight.
Warning Signs:
No explicit regulatory approvalComplex offshore structuresActive investigations by Treasury/SEC/CFTCNon-compliance with new regulationsPolitical rhetoric targeting the issuer
Case Study: Paxos received a Wells Notice from the SEC and was ordered by NYDFS to stop minting BUSD in February 2023.
Despite full reserves and regulatory compliance, BUSD supply dropped from $23B to under $1B.
Basis returned $133 million to investors rather than risk regulatory action, showing that even the threat of enforcement can kill a project.
Risk Mitigation:
Use only explicitly licensed stablecoins (state money transmitter + federal clarity)Track regulatory developments weekly through official channelsMaintain stablecoins across 3+ regulatory jurisdictionsPrepare contingency plans for enforcement actionsNever hold more than 30 days of operational needs
6. Poor Governance or Centralized Control
The Risk: Single points of control enable censorship, theft, or operational failure.
How It Happens: Most stablecoins have “god mode” functions:
Freeze any addressMint unlimited tokensUpgrade contracts arbitrarilyPause all transfers
These powers, meant for compliance, become weapons in the wrong hands or create operational risks if key holders disappear.
Warning Signs:
Single signature (or 2-of-3) admin controlsArbitrary historical freezing without court ordersHidden governance structuresNo decentralized failsafesPast intervention without clear policies
Real Impact: In 2022, over $75M in various stablecoins were frozen across 1,500+ addresses.
While some freezes targeted hackers, others hit legitimate users caught in broad compliance sweeps.
Understand stablecoin types to assess governance risks.
Risk Mitigation:
Map all administrative functions and key holdersPrefer decentralized models like MakerDAO’s DAI (but understand their risks too)Document legal recourse for wrongful freezingDiversify across governance modelsMonitor freeze lists daily
7. Design Flaws in Peg Mechanism
The Risk: Algorithmic models contain mathematical certainties of failure.
How It Happens: Algorithmic stablecoins try to maintain $1 through supply/demand manipulation:
Price above $1: Mint more tokens (increase supply)Price below $1: Burn tokens (decrease supply)
This works until it doesn’t.
When confidence breaks, no amount of burning can restore the peg because the mechanism requires buyers who no longer exist.
Warning Signs:
Complex stabilization requiring multiple tokensDependence on volatile collateral (ETH, BTC)Circular dependencies (stablecoin backed by governance token)No external revenue sourcesUntested below $0.95
Case Study: Algorithmic stablecoins are vulnerable to a de-pegging process known as “death spiral”, in which an external event, such as the tightening of global liquidity, led to heavy redemption of the stablecoin.
Every algorithmic stablecoin has failed:
Iron Finance: TITAN went from $65 to $0 in 24 hoursNuBits: Failed multiple times, currently trading at $0.02Basis Cash: Dead on arrivalUST: The $45 billion finale
Risk Mitigation:
Never use algorithmic stablecoins for treasuryAvoid “partially collateralized” hybridsDemand 100% exogenous collateralStress test mechanisms at 50% drawdownsIf it sounds too clever, it is
8. Reputation Loss or Confidence Collapse
The Risk: Trust evaporates in hours, not days.
How It Happens: Stablecoins are confidence games.
Unlike bank deposits with government backing, stablecoin value depends entirely on belief in eventual redemption.
One credible rumor can trigger:
Precautionary selling (“just in case”)Liquidity providers withdrawingArbitrageurs stepping asideCascade of margin callsComplete collapse
Warning Signs:
Investigative journalism (pre-publication rumors)Competitor FUD campaigns intensifyingAnonymous allegations gaining tractionKey employee departuresAudit delays or “clarifications”
Cascade Mathematics: Once redemptions are underway, the value of the collateral assets might decrease further if such assets are sold to be converted into currency in a fire sale.
This mechanism would amplify the run and potentially increase its speed.
A 10% redemption forcing asset sales can trigger 20% in margin calls, creating 40% in total pressure, mathematical inevitability.
Risk Mitigation:
Monitor sentiment across Crypto Twitter, Reddit, and Telegram continuouslyBuild direct relationships with issuer executivesCreate graduated response protocols (not binary decisions)Act on smoke, not fireReputation damage is usually permanent
9. Technical Infrastructure Failures
The Risk: Non-smart contract failures still break pegs.
How It Happens: Stablecoins depend on complex infrastructure:
Oracles: Wrong price feeds trigger liquidationsNetworks: Congestion prevents arbitrageBanking rails: Closed on weekends/holidaysAPIs: Rate limits during high volumeGeographic blocks: Regulatory compliance
Any component failure can cause depegging.
Warning Signs:
Single oracle dependence (Chainlink only)High gas costs preventing small arbitrageWeekend-only redemptionsGeographic restrictions (US persons blocked)No redundancy planning
Case Study: For a couple of these stablecoins, excluding weekends almost halves their volatility.
This may be related to the fact that they rely on traditional payment rails that operate only during normal banking hours.
Weekend depegs are common because:
Banks are closed (no redemptions)Liquidity is thin (traders offline)Arbitrageurs can’t access fiatPanic feeds on itself for 48+ hours
Risk Mitigation:
Test redemption process completely before large positionsVerify 24/7 capability (not just claims)Monitor network congestion metricsPlan for holidays and weekendsMaintain multiple redemption paths
Institutional Risk Assessment Checklist
Reserve and Backing Questions
1. What specific assets back this stablecoin?
Require detailed breakdowns: “cash” means bank deposits, “equivalents” hides riskGet percentages for each asset classIdentify all counterparties
2. Where are reserves held and by whom?
List every custodian bank and their regulatory statusVerify segregation from operating fundsCheck for affiliated party custody
3. How frequently are reserves audited?
Monthly attestations are minimumReal-time reporting is becoming standardRead actual reports, not summaries
4. What is the redemption mechanism and timeline?
Test with $10K before committing millionsDocument actual vs advertised timelinesUnderstand queue dynamics during stress
Regulatory and Legal Questions
5. Is the stablecoin regulated in major jurisdictions?
Verify actual licenses (many claim, few have)Check state money transmitter licensesUnderstand exemptions being used
6. What legal protections exist for token holders?
Review actual trust agreementsUnderstand bankruptcy remotenessIdentify governing law and venues
7. Are there ongoing investigations or enforcement actions?
Search SEC EDGAR databaseCheck CFTC actionsMonitor state regulator websitesFOIA request when suspicious
8. What happens to user funds if the issuer fails?
Trace funds through bankruptcy waterfallUnderstand senior vs subordinated claimsCalculate recovery scenarios
Technical and Operational Questions
9. Who controls the smart contract?
Map every admin functionIdentify all key holdersCheck multisig thresholds
10. Can addresses be frozen or blacklisted?
Review freeze function codeCheck historical freeze patternsUnderstand appeal processes
11. What security audits have been completed?
Read full audit reportsCheck remediation statusVerify audit firm reputation
12. How are oracle dependencies managed?
List all price feedsCheck oracle decentralizationTest fallback mechanisms
Market Structure Questions
13. What is the distribution of holders?
Calculate Gini coefficientTrack top 100 walletsMonitor concentration changes
14. Where does primary liquidity exist?
Map CEX and DEX venuesCheck market maker agreementsVerify during off-hours
15. How deep are order books during stress?
Review March 2020 dataCheck May 2022 Terra crisisCalculate slippage at size
16. What are the historical depegging events?
Document magnitude (worst drawdown)Time to recoveryUnderlying causes
New users should review how to buy stablecoins and investment strategies first.
Risk Scoring Framework
Score each stablecoin 1-5 across these dimensions:
1. Reserve Quality (40% weight)
5: 100% cash + T-bills <30 days, Big 4 audited4: 90%+ cash/T-bills, monthly attestations3: 70%+ cash/T-bills, some commercial paper2: Crypto-collateralized, 150%+ ratio1: Algorithmic or <100% backed
2. Regulatory Status (20% weight)
5: Federal license + state licenses, no investigations4: State licenses, federal pending3: Regulatory engagement, applications filed2: Offshore only, no US presence1: No licenses, active investigations
3. Technical Security (15% weight)
5: Immutable contracts, 4+ audits, bug bounties4: Timelock upgrades, 3 audits3: Multisig upgrades, 2 audits2: Single audit, admin keys1: No audits, single control
4. Liquidity Depth (15% weight)
5: >$1B daily volume, 10+ venues4: $500M-1B daily, 5+ venues3: $100-500M daily2: $10-100M daily1: <$10M daily volume
5. Track Record (10% weight)
5: 3+ years, no depegs >2%4: 2+ years, recovered from depegs3: 1+ year stable2: 6-12 months1: <6 months or major failures
Risk Categories:
20-25: Institutional grade (still requires monitoring)15-19: Acceptable with strict limits and monitoring10-14: High risk, maximum 5% of holdings<10: Unacceptable risk, avoid completely
Major Stablecoin Issuers and Risk Profiles
See our list of 180+ stablecoin companies for comprehensive coverage.
Current Market Leaders:
1. Tether Limited (USDT)
Market cap: $120+ billionRisk score: 14/25 (improving transparency)Key risk: Historical reserve questions
2. Circle (USDC)
Market cap: $25+ billionRisk score: 19/25Key risk: Banking concentration
3. MakerDAO (DAI)
Market cap: $5+ billionRisk score: 16/25Key risk: Collateral volatility
4. Paxos (USDP)
Market cap: $400+ millionRisk score: 20/25Key risk: Regulatory uncertainty
5. TrustToken (TUSD)
Market cap: $2+ billionRisk score: 17/25Key risk: Offshore operations
Note: Banks are launching stablecoins with JPMorgan’s JPM Coin processing $1B daily, potentially reshaping risk profiles.
Advanced Risk Management Strategies
Portfolio Construction
Core holdings (60%): 2-3 institutional grade stablecoinsTactical positions (30%): Yield generation in DeFiHedge positions (10%): Non-correlated stablecoins
Yield Optimization
Sophisticated strategies like delta-neutral positions on Solana can generate 10-20% APY while minimizing directional risk.
Cross-Chain Risk
Understanding bridge security is crucial as $2B+ has been lost in bridge hacks.
Never bridge more than you can afford to lose.
Monitoring Systems
Real-time alerts: Price deviations >0.5%Liquidity tracking: Hourly snapshotsSocial sentiment: AI-powered analysisRegulatory tracking: Daily updatesTechnical monitoring: Gas prices, network congestion
Conclusion
Treat stablecoins as payment infrastructure requiring bank-level risk management.
They’re tools for transaction efficiency, not “stable” stores of value.
Understanding fundamental stablecoin risks separates institutional survivors from retail casualties.
The market will consolidate around 5-10 institutional-grade stablecoins.
Position accordingly and stay informed through reliable stablecoin news as regulations reshape the landscape daily.
Read Next:
FAQs:
1. What is the most common cause of stablecoin failure?
Reserve mismanagement causes 60% of stablecoin failures. Issuers claiming full backing while holding risky assets, making loans to affiliates, or simply lying about reserves. Tether’s historical 27.6% backing proves this isn’t theoretical. Always demand real-time attestations from Big 4 accounting firms and avoid stablecoins with vague “cash equivalent” claims.
2. Can a fully-backed stablecoin still fail?
Yes. USDC’s 13% depeg during Silicon Valley Bank’s collapse proved that even transparent, fully-backed stablecoins face banking risk. When $3.3 billion of reserves became temporarily inaccessible, panic selling drove the price down despite full backing. Banking concentration, lack of FDIC coverage, and redemption delays can break any stablecoin’s peg.
3. Why do algorithmic stablecoins always fail?
Algorithmic stablecoins rely on confidence and reflexive mechanisms, when price drops, they mint more volatile tokens, increasing supply and pushing price lower. This “death spiral” is mathematically inevitable during market stress. Terra’s $45 billion collapse, Iron Finance’s TITAN crash, and every other algorithmic stablecoin failure prove the concept is fundamentally flawed. No algorithm can create value from nothing.
4. How fast can a stablecoin collapse?
Complete collapse can happen in hours. Iron Finance went from $65 to effectively $0 in 24 hours. UST lost 90% of its value in 72 hours. Beanstalk was drained in 13 seconds. Speed depends on the failure type: smart contract exploits are instant, bank runs take days, and regulatory actions can freeze value immediately. Never assume you’ll have time to exit.
5. What’s the safest stablecoin strategy for institutions?
Diversification across 3-5 stablecoins with different risk profiles, none exceeding 30% of holdings. Prioritize: fiat-backed over crypto-backed, regulated over offshore, simple over complex. Monitor continuously, test redemptions monthly, and maintain exit strategies. Remember: no stablecoin is risk-free. The safest approach treats them as payment tools, not stores of value.