Stablecoins are crypto assets designed to maintain a value of $1. Issuers of stablecoin ensure this stability by holding an equivalent amount of US dollar-denominated assets in reserve, such as bank deposits, Treasuries, corporate bonds, and loans. Because dollars can’t move natively on blockchains, stablecoins enable dollar-based transactions within crypto systems, combining fiat stability with the speed and flexibility of digital assets.
Despite their promise of stability, however, stablecoins often trade above or below $1. In this paper, the authors examine how stablecoins’ unique market structure contributes to their price and financial (in)stability. Stablecoins operate in a two-tiered market. Only select institutional arbitrageurs can mint and redeem tokens directly with the issuer at a fixed $1 price, while most investors trade on secondary markets where prices fluctuate with supply and demand. Arbitrage between the two markets allows institutional traders to profit when secondary market prices diverge from $1. This can pull prices back towards $1, but also force issuers to liquidate reserves when arbitrageurs request redemptions.
The authors begin by collecting and analyzing data across six major fiat-backed stablecoins, along with market price data and institutional details on redemption mechanics and access. They identify the following stylized facts concerning stablecoin arbitrage:
- The trading price of stablecoins in the secondary market commonly deviates from $1.
- The redemption and creation of stablecoins in the primary market is performed by a small set of arbitrageurs, whose concentration varies by stablecoin.
- Stablecoins with a more concentrated set of arbitrageurs experience more pronounced price deviations in the secondary market.
- Stablecoins differ in how much they transform short-term liabilities into long-term or illiquid assets. The mismatch between liabilities and assets means that during periods of stress, coin issuers may need to sell illiquid reserves at a loss to meet redemptions.
Building on these patterns, the authors adapt Diamond and Dybvig’s (1983) model of bank runs, which explains how bank runs can occur even when banks hold riskless assets, to the unique structure of stablecoins to investigate how arbitrage impacts the asset’s riskiness. Their model shows the following:
- Stablecoins are exposed to run risk because illiquid reserves must be sold at a discount to meet redemptions during stress. This creates a first-mover advantage, as investors who redeem early are more likely to receive full value.
- The model reveals a central tradeoff whereby improving price stability through more efficient arbitrage increases run risk, while limiting arbitrage lowers financial fragility but allows larger and more persistent price deviations.
- Stablecoin issuers optimally choose the degree of arbitrage access based on their reserve liquidity. Issuers holding illiquid assets find it optimal to restrict arbitrage to limit costly redemptions and protect against fire sales. Investors value both price stability and run risk when choosing which stablecoin to hold.
- Calibrating the model to September 2021 data, the authors estimate the probability of a run at 2.50% for USDT (Tether) and 2.13% for USDC (USD Coin), two of the largest stablecoins.
- The model’s policy counterfactuals show that redemption fees can reduce run risk by discouraging mass redemptions, but they also weaken the price peg by dampening arbitrage incentives.
- Allowing stablecoin issuers to pay dividends from reserve earnings can reduce run incentives while preserving price stability, offering a potentially effective design and regulatory tool.
In the last several years, the market for stablecoins has grown exponentially — the six largest US dollar-backed coins had a market capitalization of $5.6 billion at the start of 2020, by the beginning of 2022 they were worth over $130 billion. The growth in value has attracted the attention of legislators across jurisdictions, stablecoin regulation has been drafted and is under consideration in the US, UK, and EU. This paper has direct policy relevance for these discussions, as it highlights a key tradeoff between price stability and market stability, and evaluates several policy solutions.