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Stablecoins and Reserves Explained: How They Work and Where the Risks Lie

Stablecoins promise a steady price by backing digital tokens with reserves. How the backing works, how it can fail, and how regulators are responding.

By Wells Love Editorial Desk · October 25, 2026 · 8 min read

Most crypto assets swing widely in price, which makes them awkward for payments. Stablecoins try to solve that by tying a token to a reference asset, usually a national currency such as the US dollar, so that one token aims to stay worth one dollar. They are used to move money between exchanges, to settle trades, and increasingly for cross-border payments.

The promise of stability is not magic. It rests on reserves, contracts and redemption rights, and when any of these is weak the peg can break. This guide explains the main designs, how reserves work, what has gone wrong in the past and how regulators are responding.

The main designs

• Fiat-backed. The issuer holds cash and short-term assets and promises to redeem tokens one for one. This is the most common design.
• Crypto-backed. Tokens are issued against volatile crypto collateral held in smart contracts, usually in larger amounts than the tokens issued (overcollateralisation) to absorb price drops.
• Algorithmic. Stability depends on code and market incentives, often with a companion token, rather than on solid reserves. This design has the worst track record.

How a fiat-backed stablecoin works

A customer sends dollars to the issuer and receives the same number of tokens. The issuer places the money in reserves. When a customer wants dollars back, the issuer takes the tokens out of circulation and pays out. Because arbitrageurs can buy tokens below one dollar and redeem them at par, the market price tends to stay near the peg, as long as people trust that redemption will work.

Many holders never redeem directly. Instead they trade tokens on exchanges, where the price depends on supply, demand and confidence. That is why the peg can wobble even when reserves are sound if redemption is limited to large, approved customers.

What reserves can contain

Quality matters more than quantity. A reserve made of cash and short-dated government securities can be sold quickly at close to face value. A reserve that includes commercial paper, corporate bonds, loans or other crypto assets carries more risk, because those holdings can lose value or become hard to sell in a panic. Key questions for any issuer are:

• Are reserves held in segregated accounts, protected if the issuer fails?
• Are they held at regulated banks, and how concentrated is that exposure?
• How often are they reported, and are the reports attested or audited by independent firms?
• Can any holder redeem, and how fast, and are there fees or minimums?

When the peg broke

In May 2022, TerraUSD, an algorithmic stablecoin, lost its peg and collapsed together with its companion token, wiping out large amounts of investor money and shaking the whole crypto market. In March 2023, the stablecoin USDC briefly traded well below one dollar after its issuer disclosed that part of its cash reserves was held at Silicon Valley Bank, which was failing. It recovered once authorities protected that bank's depositors, which shows how reserve location can matter as much as reserve size.

Why regulators care

Authorities see several risks. A run on a large stablecoin could force rapid sales of government securities, affecting wider markets. Weak disclosure leaves consumers unable to judge safety. Payment-system and anti-money-laundering rules also apply when tokens move across borders. International bodies such as the Financial Stability Board and the Bank for International Settlements have published recommendations and analysis on these points.

The European Union has adopted a dedicated crypto-asset framework known as MiCA, which includes rules for stablecoin issuers, and the United States has moved toward federal stablecoin legislation. Details, deadlines and scope change, so check the current text from the relevant regulator before relying on any summary.

Stablecoins versus bank deposits and CBDCs

A bank deposit is typically covered by deposit insurance up to a limit and is a claim on a supervised institution. A stablecoin is usually a claim on a private issuer and its reserves, often without insurance. Central bank digital currencies, which we examine in a separate guide, would be direct liabilities of the central bank. Each design balances convenience, safety and control differently.

What to check before using one

• Read the issuer's latest reserve report and who verified it.
• Confirm the redemption terms, including who may redeem and how long it takes.
• Look at the legal entity and jurisdiction, and what happens if the issuer fails.
• Remember that using a stablecoin on an exchange adds platform risk on top of issuer risk.

Stablecoins can be useful tools, but they are not savings accounts. This article is general education, not investment advice.

Sources and further reading

• Bank for International Settlements: research and publications on stablecoins
• Financial Stability Board: crypto-asset and stablecoin recommendations
• Federal Reserve: financial stability and payments publications
• EUR-Lex: official text of the EU MiCA regulation

This article is for information and education only and is not investment, tax or legal advice. Figures, rules and dates change; verify details with official sources before acting. See our Financial Disclaimer and Editorial Policy. Spotted an error? Tell us.