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Stablecoins have evolved into a rapidly expanding financial infrastructure, and regulators globally are striving to keep pace, stressing the need for a clear understanding of their design, risks, and yield mechanisms to inform debate and discussion.
Since the US GENIUS Act’s approval in summer 2025, we have also seen significant movement in other regions, including the UK Financial Conduct Authority’s (FCA) new cryptoasset regime and Brazil and Argentina’s virtual asset service provider (VASP) frameworks.
Stablecoins enable money to move more quickly and efficiently across digital networks. By allowing near-instant settlement and programmable transfers, they can be used not only by new fintech challengers but also by incumbent financial institutions looking to modernise payment infrastructure. In this sense, stablecoins are emerging less as a replacement for the system and more as a new layer within it.
However, with hundreds of billions of dollars already circulating globally, they are increasingly viewed by some as a potential competitor to traditional banking. Concerned regulators and banking groups argue that allowing payment stablecoins to offer interest-like returns could accelerate the migration of deposits away from traditional banks. Notably, the Bank of England is considering holding limits to combat the risk of deposit outflow.
Analysis by Standard Chartered Bank suggests US banks alone could lose up to $500 billion in deposits by 2028 as stablecoin adoption grows. From the banking sector’s perspective, the concern is not only competition, but stability: deposits fund lending, support payment systems and anchor the modern financial system.
Crypto companies frame the issue differently. In their view, stablecoins are not bank deposits, but programmable digital assets that enable new financial models. Yield mechanisms, they argue, reflect innovation and consumer choice rather than a workaround for banking rules.
The disagreement has increasingly moved into policymaking. But to understand the debate, it helps to start with the mechanics: how stablecoins are structured, how yields are generated and what risks those designs may create for users, markets and the broader financial system.
Understanding stablecoin design
Stablecoins are not all designed the same way. Although they fundamentally aim to maintain a stable value, often by tracking a currency such as the US dollar, the mechanisms used to achieve this differ significantly, with each model presenting its own levels of transparency, resilience and risk.
Most regulatory frameworks currently focus on fiat-backed stablecoins, rather than crypto-collateralised or algorithmic models. For example, the EU’s Markets in Crypto-Assets Regulation (MiCA) and the US’ GENIUS Act both centre their rules on tokens backed by identifiable reserves such as cash or government securities. In Hong Kong, the stablecoin licensing regime strictly targets fiat-referenced stablecoins, with guidelines that expressly exclude algorithmic or crypto-collateralised stablecoins
There are three broad categories of stablecoins.
- Fiat-backed: such as USDT (Tether) and USDC (Circle)
This type of stablecoin is by far the most common. These tokens are supported by reserves of traditional assets such as cash, bank deposits or short-term government securities held by the issuer.
In theory, each token can be redeemed for the equivalent amount of the underlying currency. This structure makes them relatively simple to understand and has helped them gain traction in payments and trading, although they rely heavily on trust in the issuer and the quality of its reserves.
- Crypto-collateralised: such as DAI and LUSD
Crypto-collateralised stablecoins take a different approach, by using other cryptocurrencies rather than fiat assets as backing.
Because crypto assets can be volatile, these systems are typically over-collateralised, meaning users must deposit more value than the stablecoins they receive. Smart contracts automatically manage collateral levels and liquidate positions if values fall too far. This design increases transparency and decentralisation, but can also make the system more complex and sensitive to market swings.
- Algorithmic: such as TerraUSD and AMPL
Algorithmic stablecoins aim to maintain a price peg using programmed market incentives rather than traditional reserves.
Different models exist: rebasing systems adjust token supply across holders, seigniorage-style designs pair the stablecoin with a secondary token that absorbs volatility, and collateralised algorithmic models rely on smart contracts that automatically liquidate on-chain collateral to defend the peg. These mechanisms are highly sensitive to market conditions because they depend on arbitrage and confidence. If demand falls sharply, incentives to stabilise the price can weaken, especially in dual-token systems where declines in the secondary asset reduce the system’s capacity to restore the peg, as was the case with the Terra-Luna crash in 2022.
As previously mentioned, it is crucial to note that in many jurisdictions, algorithmic stablecoins are not treated as regulated “stablecoins” because they lack a reliable reserve backing.
Understanding stablecoin yield
According to the Federal Deposit Insurance Corporation (FDIC), the national rate (the average of rates paid by all insured depository institutions and credit unions with rates weighted by each institution’s share of domestic deposits) for a 12-month certificate of deposit stands at 1.55 percent annual percentage yield (APY). In comparison, Coinbase offers up to 2.00 percent APY for holding Dai, a US dollar-pegged stablecoin.
Evidently, rewards offered by crypto exchanges have proven themselves as competitive as traditional saving accounts, if not more so, strengthening concerns over a systemically significant deposit flight.
Stablecoin yield does not come from the token itself, but from third-party services. The main mechanisms include:
- Proof of Stake: Many blockchain networks use a decentralised group of validators and asset holders to verify and process crypto transactions instead of a bank or payment processor in the middle. By “locking” some of their holdings into a staking pool, users contribute to the validation process in exchange for monetary rewards.
- Holding: Cryptoexchanges offer lucrative monetary rewards for simply holding stablecoins; this approach functions most similarly to deposits.
- Lending with centralised finance (CeFi): CeFi lending operates similarly to traditional banking, with platforms such as Nexo taking custody of users’ crypto-assets and lending them out, paying depositors in return. Unlike bank loans, CeFi loans often require minimal or no paperwork. For instance, Coinbase allows US customers in many states to borrow up to $100,000 without a credit check; greater borrowing activity allows for better payouts for depositors.
- Lending with decentralised finance (DeFi): DeFi facilitates transparent, peer-to-peer (P2P) lending, completely without a middleman, and the lack of third-party fees mean potentially higher returns compared to conventional financial products. Investors who contribute their cryptocurrency to DeFi lending protocols are compensated for providing capital to borrowers.
It is important to recognise that holding stablecoins does not typically provide the same consumer protections as traditional deposits, which in many jurisdictions benefit from deposit insurance schemes, such as the FDIC in the US or the Financial Services Compensation Scheme (FSCS) in the UK, which protect customers if a bank fails.
Stablecoin holders generally lack equivalent safeguards, meaning they may face losses if an issuer becomes insolvent, reserves prove insufficient, or a trading platform holding the assets collapses.
In many cases, retail users may have limited visibility over the quality or vulnerability of the underlying assets until problems emerge, by which point losses may already have materialised.
In addition, not all consumers are aware that stablecoin holdings are not backed by schemes such as the FDIC and FSCS, meaning there is a need for customer education, whether voluntary or mandated by regulation.
Understanding stablecoin risks
Given that stablecoins are not uniform in design, they also have distinct risk profiles. These risks can broadly be grouped into three key categories.
- Reserve and collateral risk
This arises where stability depends on the quality, liquidity and transparency of underlying assets. Fiat-backed models, although generally perceived to be safer, rely on the credibility and management of reserves, whereas crypto-collateralised structures are exposed to the natural volatility of their underlying assets.
- Operational and governance risk
The operational risks of stablecoins include cyber-attacks, fraud and outages in supporting infrastructure, all of which could disrupt redemptions or cause losses for holders. These risks are amplified by the complexity of the crypto ecosystem and the reliance on third-party service providers such as custody platforms and trading venues.
Governance structures also differ significantly between stablecoin models. Centralised issuers rely on internal controls, asset management practices and disclosure standards, while decentralised systems depend on smart contracts and distributed decision-making.
Supervisors such as the Bank of England warn that systems governed primarily through code may struggle to respond quickly to unforeseen events or operational failures, particularly when there is no single authority responsible for risk management or contingency actions.
Similarly, the EU’s Digital Operational Resilience Act (DORA) highlights regulators’ growing focus on operational resilience and the risks posed by critical third-party providers. These issues are highly relevant to stablecoin ecosystems, which often rely on external technology, custody and infrastructure partners.
- Market confidence and stabilisation risk
Stablecoins ultimately depend on user confidence that the peg will hold and that redemption mechanisms will function. If doubts arise about reserves, liquidity or governance, investors may rush to exit simultaneously, creating dynamics similar to runs seen in other financial products.
These dynamics are particularly acute in algorithmic stablecoins, where stability relies heavily on market incentives rather than external backing. Such systems often depend on arbitrage and the credibility of their stabilisation mechanisms; if confidence erodes, those mechanisms can fail quickly.
Taken together, these challenges illustrate that stablecoin stability is not inherent but engineered, and the robustness of that engineering determines the level of systemic and consumer risk.
Why should you care?
Understanding the mechanics behind stablecoins is essential. Firms that properly grasp these structures can communicate more effectively with policymakers and will be better placed to make good commercial decisions.
A deep understanding of stablecoin mechanics helps firms contribute constructively to shaping regulation. It enables advocacy for policies that balance innovation and stability, protect consumers and ensure legislative outcomes reflect the diversity and complexity of the ecosystem. In a rapidly evolving market, nuance is essential for meaningful engagement with policymakers.
By highlighting such nuance early on, firms can prevent over-regulation and support effective oversight, allowing discussions about yield, redemption safeguards, and systemic risk to be grounded in fact rather than assumption.
