Written by: ARK Invest, Raye Hadi

Translated by: Block unicorn

Introduction

This article is the first in a four-part series aimed at explaining the complex mechanisms in the stablecoin space. The operational mechanisms of stablecoins are quite intricate, and there is currently no comprehensive educational resource that integrates the mechanisms, risks, and trade-offs of various stablecoins. This series aims to fill that gap. This guide provides investors with a framework for evaluating stablecoins based on issuer documentation, on-chain dashboards, and explanations from project teams.

The series consists of four parts, with the first part introducing stablecoins, including their design and history. The remaining three parts will focus on the three main categories of stablecoins:

• Fiat-backed stablecoins (Part Two)
• Multi-asset collateralized stablecoins (Part Three)
• Synthetic dollar models (Part Four)

These articles will outline the management of stablecoin reserves, the opportunities presented by yield and incentive mechanisms, the ease of token acquisition and native integration, as well as the resilience of tokens based on governance and compliance. Each article will also explore external dependencies and anchoring mechanisms, which determine whether stablecoins can maintain their value during market pressures.

Part Two of this series will first introduce stablecoins that are primarily backed by fiat currency, which is currently the most mainstream and direct design. Parts Three and Four will evaluate more complex types of stablecoins, including multi-asset collateralized stablecoins and synthetic dollar models. These in-depth analyses will provide investors with a comprehensive framework to help them understand the relevant assumptions, trade-offs, and risk exposures of each type of stablecoin.

Enjoy the first part of this series.

Stablecoins: The ChatGPT Moment of the Crypto Industry

The emergence of stablecoins marks a turning point in the development of the cryptocurrency industry. Today, governments, businesses, and individual users around the world recognize the advantages of using blockchain technology to simplify the global financial system. The evolution of cryptocurrencies has demonstrated that blockchain can serve as a viable alternative to traditional financial systems, enabling digital-native, global, real-time value transfer—all accomplished through a unified ledger.

This recognition, combined with the global demand for the U.S. dollar, has created a unique opportunity to accelerate the integration of cryptocurrencies with traditional finance. Stablecoins are at the intersection of this integration, relevant to both traditional institutions and governments. Key factors driving the adoption of stablecoins include:

• Traditional institutions striving to maintain their relevance as global payment landscapes modernize.
• Governments seeking new creditors to finance their fiscal deficits.

Although the motivations of governments and existing financial institutions vary, they all understand that they must embrace stablecoins, or risk losing influence as the financial landscape shifts. Recently, ARK's Head of Digital Asset Research, Lorenzo Valente, published a detailed paper on this topic—"Stablecoins May Become One of the Most Resilient Financial Allies of the U.S. Government."

Today, stablecoins are no longer just niche tools for cryptocurrency traders; their adoption by retail investors is accelerating. They have become a primary means for cross-border remittances, decentralized finance (DeFi), and emerging markets (which lack stable fiat currencies) to access U.S. dollars. Despite the increasing utility and adoption of stablecoins, the complex structure and mechanisms underpinning the stablecoin system remain opaque to many investors.

Understanding Stablecoins

Stablecoins are tokenized rights issued on a blockchain, where holders can claim an asset worth one dollar, which can be traded both on-chain and off-chain. Stablecoins are supported by collateral reserves, which are managed through traditional custodial institutions or automated on-chain mechanisms, and stabilized through anchoring arbitrage mechanisms. Stablecoins are designed to absorb volatility and maintain parity with a target asset (usually the U.S. dollar or another fiat currency).

Stablecoins are heavily dollar-denominated, which is a natural result of their alignment with market demand for synthetic dollar exposure in dollar-scarce markets. Stablecoins combine the stability of the dollar, the cost-effectiveness of blockchain, and 24/7 accessibility, making them an attractive medium of exchange and a reliable store of value. This dynamic is particularly pronounced in markets long plagued by currency instability and restricted access to U.S. bank accounts. In this context, stablecoins effectively serve as a digital gateway to dollar exposure, as evidenced by the regions with the fastest growth in on-chain activity by 2025: the Asia-Pacific, Latin America, and Sub-Saharan Africa.

Moreover, stablecoins have fundamentally transformed cryptocurrency, especially the development of decentralized finance (DeFi), by introducing a liquid, low-volatility unit of account. Without stablecoins, on-chain markets would be forced to trade using more volatile assets like Bitcoin (BTC), Ethereum (ETH), or Solana (SOL), which would not only expose users to price risks but also diminish the practical utility of decentralized finance (DeFi).

Stablecoins enhance the price discovery and on-chain transaction settlement efficiency of DeFi protocols by providing stability in on-chain assets pegged to the dollar, thereby improving capital efficiency. This stability and reliability are crucial for the core infrastructure on which these new financial markets depend. Therefore, maintaining the specific anchoring mechanisms and reserve structures that uphold these characteristics is vital for their resilience, especially during market pressures.

Asset or Debt Instrument? Substantive Differences in Stablecoin Design

The underlying mechanisms and reserve structures of stablecoins directly influence their economic and legal behavior. Different architectures have their own advantages and disadvantages in terms of regulatory compliance, censorship resistance, the degree of crypto-native design, and control and stability. They also determine how stablecoins operate and the risks, behaviors, and limitations that holders must bear. These nuances raise critical questions about how to understand stablecoins—for instance, whether specific types of stablecoins should be viewed as assets or debt instruments.

In this context, stablecoins can be considered "assets" when holders have direct legal ownership of the stablecoin or its supporting reserves, allowing them to retain enforceable rights even in the event of the issuer's bankruptcy. Conversely, when the issuer retains legal ownership of the reserves and holders only possess contractual claims, effectively making them unsecured creditors, stablecoins resemble "debt instruments." This distinction depends on the legal design of the issuer and the structure of reserve custody.

The classification of tokens primarily hinges on who controls the reserves backing the tokens and whether that party has a legal obligation to fulfill redemption duties. While most issuers may intend to honor redemption obligations even under pressure, if there is no explicit legal obligation or reserves controlled by users, the token's function resembles that of a debt instrument. This distinction determines whether holders still possess enforceable rights to the underlying collateral in the worst-case scenario.

The table below outlines the differences in this classification among different types of stablecoins.

Such structures are typically carefully designed based on the regions, target markets, or specific uses that the stablecoin addresses. Even so, differences in legal structures can lead to subtle distinctions that may significantly impact token holders. Notably, this is just one of many interesting cases where intentional or unintentional structural differences can have profound implications for stablecoins and investors.

Past Stablecoin Failures Closely Linked to Design Flaws

Some past issues involved stablecoins decoupling from selected fiat currencies during crises. These events serve as a profound reminder that design differences can have tangible consequences, especially during market pressures. In fact, every type of stablecoin has experienced failures, reflecting their respective structural flaws and design choices. The following will discuss some of the most notable failure cases among the three types of stablecoins. This discussion will lay the groundwork for the in-depth analyses of "fiat-backed," "multi-asset collateralized," and "synthetic dollar model" in Parts Two, Three, and Four of this series.

The Failures of SVB, Silvergate, and Signature Banks

In March 2023, the collapse of three U.S. banks focused on cryptocurrency—Silvergate, Silicon Valley Bank (SVB), and Signature Bank—highlighted the reliance of fiat-backed stablecoins on the traditional banking system. Silvergate's downfall began when it lost support from the Federal Home Loan Bank (FHLB). Previously, due to the Federal Reserve's unprecedented rate hikes, Silvergate held a large amount of long-term government bonds and mortgage-backed securities, which had become untenable. To cope with the growing withdrawal demands, Silvergate had to sell assets at significant losses, accelerating its bankruptcy process and shaking market confidence in SVB and Signature Bank, ultimately leading to the collapse of both banks.

When Circle disclosed its $3.3 billion exposure to SVB, its stablecoin USDC's peg to the dollar plummeted to $0.89, triggering panic in both DeFi and centralized markets until the Federal Deposit Insurance Corporation (FDIC) intervened to guarantee all deposits. Within days, USDC regained its peg. However, this shockwave affected all stablecoins, including DAI, which also decoupled due to its significant collateralization with USDC. Subsequently, Circle adjusted its banking partners, but the crisis still raised concerns about the fragile connections between stablecoins and banks.

The Algorithmic Collapse of Terra/Luna

In early 2022, Terra was a leading Layer 1 ecosystem centered around the algorithmic stablecoin UST and its native token Luna. The lending protocol Anchor built on Terra offered depositors a guaranteed yield of 19.5%, serving as a primary source of funding for the TerraLuna ecosystem. UST maintained its peg through an arbitrage mechanism: 1 UST could be exchanged for 1 dollar's worth of Luna, with the issuance of UST destroying Luna, and redemptions minting new Luna. Although Terra's management later increased reserves with BTC (Bitcoin) and other cryptocurrencies, these reserves never exceeded about 20% of UST's supply, leading to a significant lack of funding support for the system. At its peak, TerraLuna attracted billions of dollars in funding, despite its limited external use cases and high yields primarily supported by Terra subsidies rather than genuine borrowing demand.

When the market turned and Luna's price fell below the value of UST's circulation, the redemption mechanism failed. In May 2022, the decoupling of UST from Bitcoin triggered massive capital outflows. Terra restricted redemptions, forcing more funds into the secondary market. As redemptions resumed, Luna massively inflated its supply to absorb fleeing capital, with the token count skyrocketing from hundreds of millions to trillions, causing its price to plummet. The Bitcoin reserves failed to halt the price spiral. Within just a few days, the total market capitalization of UST and Luna evaporated by over $50 billion.

DAI's "Black Thursday"

On March 12, 2020, the MakerDAO community (now renamed Sky Protocol) experienced the disaster known as "Black Thursday." The plummeting price of Ethereum and network congestion led to a systemic failure in the DAI liquidation mechanism. Ethereum's price dropped by over 40%, causing the collateralization ratios of hundreds of vaults to fall below the threshold. Typically, liquidations are completed through on-chain auctions, where "keepers" bid to purchase collateral in DAI. However, on "Black Thursday," high gas fees and delays in oracle updates resulted in many bidding failures, allowing speculators and opportunists to acquire collateral at nearly zero dollars. Over 36% of liquidations were completed at a 100% discount, resulting in a shortfall of 5.67 million DAI and causing significant losses for many vault owners.

To make matters worse, as borrowers rushed to buy DAI to repay debts, DAI became overpriced and decoupled. Normally, arbitrageurs would mint new DAI to meet demand, but this time, network congestion, price volatility, and oracle delays became obstacles. The combination of liquidations and minimal issuance created a supply shock, while demand surged, driving up the peg price. MakerDAO subsequently conducted a debt auction and issued Maker (MKR), a utility token that MakerDAO has since deprecated, to replenish protocol funds. This crisis exposed the vulnerabilities in DAI's liquidation mechanism design and the stability of stablecoins under pressure, prompting Maker to undertake significant reforms to its liquidation engine and collateral model.

The Importance of Stablecoin Design

The collapses of Silvergate, SVB, and Signature Bank, the algorithmic collapse of TerraLuna, and DAI's "Black Thursday" serve as powerful reminders of the importance of stablecoin architecture. These crises highlight how architectural design choices impact system resilience and risk. The collapse of TerraLuna revealed the structural vulnerabilities of fully algorithm-driven stablecoins, indicating that systems lacking sufficient collateral or genuine economic utility are inherently unstable and prone to collapse under pressure.

In contrast, while the decoupling of USDC and DAI was concerning, it was only temporary and prompted both ecosystems to implement far-reaching reforms. Following the Silicon Valley Bank crisis, Circle increased the transparency of its reserves and strengthened its relationships with banks; meanwhile, MakerDAO (Sky Protocol) not only restructured its collateral portfolio to include more real-world assets (RWA) but also upgraded its liquidation mechanism to prevent cascading defaults.

What these events have in common is that they exposed the flaws of their respective stablecoin types and the specific circumstances that were most destructive to those types. Understanding how these architectures have evolved in response to failures is crucial for assessing the design choices and differences of today's stablecoins. Not all stablecoins face the same risks, and their optimization goals vary. Both outcomes stem from their respective underlying architectures. Recognizing this is essential for understanding where stablecoins are vulnerable and how to best utilize them.

Conclusion

This article introduced stablecoins and argued for the importance of stablecoin design. In Parts Two through Four of this guide, I will explore three mainstream types of stablecoins: fiat-backed, multi-asset collateralized, and synthetic dollar models. Each type of stablecoin has differences in resilience and trade-offs, which are as important as their utility or user experience. The unique design, collateral, and governance characteristics of each type of stablecoin (and stablecoins themselves) are key factors determining their respective risks and the expected behavior of holders.

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