An Introduction to Stablecoins

On January 23, 2025, the White House issued the “Strengthening American Leadership In Digital Financial Technology” Executive Order (EO).¹ The EO sets in motion, as part of a broader digital asset strategy, a policy mandate “to promote the development and growth of lawful and legitimate dollar-backed stablecoins worldwide.” The EO also establishes the president’s Working Group on Digital Asset Markets (Working Group), tasks it with submitting a report that proposes a new federal regulatory framework on the issuance and operation of digital assets in the U.S., and specifically calls out stablecoins. As one of the earliest EOs from the White House, it signals that digital assets, and stablecoins in particular, are significant priorities for President Trump and his administration.

In early February, lawmakers promised stablecoin legislation within the first 100 days of the Trump administration. Since then, both the House Financial Services Committee and the Senate Banking Committee have separately introduced and approved legislation to regulate the issuance of and investment in stablecoins in the U.S., building on legislative efforts that have been ongoing for years. Both the House bill, known as the Stablecoin Transparency and Accountability for a Better Ledger Economy (STABLE) Act, and the Senate bill, known as the Guiding and Establishing National Innovation for U.S. Stablecoins (GENIUS) Act, seek to establish a framework for licensing, issuance, operation, and supervision of U.S. dollar-denominated stablecoins.

While these two bills move toward adoption, banking organizations and financial institutions with varying levels of experience in stablecoins are considering new business opportunities in the future digital asset landscape. With a directive from the Trump administration and bipartisan support in both chambers of Congress, stablecoins could be the first digital asset class with comprehensive legislative and regulatory clarity guiding its issuance and use.

This Advisory is a part of a series by Arnold & Porter covering the evolution of the digital asset landscape in the U.S.² This Advisory provides an introduction to stablecoins, their use cases, current approaches and structures, and associated risks. A second stablecoin Advisory will discuss legislative and regulatory approaches to stablecoins and opportunities for banking organizations and financial institutions considering entry into the stablecoin asset class — whether as issuer, custodian, or otherwise.

What Is a Stablecoin?

Stablecoins are digital assets that are designed to maintain a stable value through backing by another asset or some other stabilizing feature. Put another way, stablecoins are assets that live on the blockchain and are designed with certain features that are meant to keep their value steady through good conditions and bad. They seek to serve as a tokenized form of currency that is programmable and capable of benefiting from all the other attributes of distributed ledger technology (DLT). And, because of DLT, stablecoins may be settled instantaneously.
Stablecoins can be categorized by the asset or stabilizing mechanism backing them:

• Fiat-backed stablecoins maintain a stable value through a one-to-one tie to or “peg” with a traditional fiat currency or cash-equivalents, such as government-issued securities, bank deposits, repurchase agreements, commercial paper, and certain commodities, or a combination of such assets.
• Crypto-backed stablecoins are collateralized using cryptocurrencies and operate similarly to fiat-backed stablecoins.
• Algorithmic stablecoins are non-collateralized and maintain value through a mathematical equation tied to certain reference points that adjust the supply of the stablecoin based on market demand.³
• Bank-issued stablecoins (tokenized deposits) are deposit-like obligations of a bank with ownership of the deposits established using DLT.

A decade ago, high price volatility prevented cryptocurrencies from serving as an effective and stable payment instrument. Stablecoins emerged as an alternative and were designed to address this volatility issue.⁴ However, as crypto-asset demand has grown, so has demand for stablecoins.⁵ Stablecoins have attracted traditional financial institutions and markets participants who, to date, have been hesitant to enter the crypto-asset arena because of price volatility associated with other crypto-assets.

What Are the Uses of a Stablecoin?

Stablecoin proponents posit a variety of possible use cases for stablecoins, such as providing liquidity and stability in decentralized finance, operating as a bridge to traditional financial systems, and creating opportunities for financial inclusion.⁶ There are multiple potential use cases for well-designed, asset-backed stablecoins, including those most commonly referenced:

• Medium of Exchange. First and foremost, stablecoins can act as a medium of exchange inside the crypto ecosystem and can facilitate transmission of value in and out of the crypto ecosystem. They can operate as a medium of exchange within blockchain-based electronic trading environments; as a mechanism for exchanging value among different blockchain-based electronic environments; and as a mechanism for converting value from electronic trading environments back into fiat.⁷
• Store of Value. Stablecoins can be held in a digital wallet as a store of value or an investment product, similar to a bank account or a money market fund. As a store of value, properly structured stablecoins can be used as a stable investment for those looking to avoid credit risk, market risk, currency volatility, inflation, and economic instability. The arguments for this use case presume robust mechanisms for pegging to high-value assets denominated in U.S. dollar (USD) or other government currency. Of course, if stablecoin issues are barred from paying interest or yield to holders, as is contemplated under the forthcoming legislation, stablecoins are less useful for investment, but still useful as a means of holding a stable value in an electronic environment.
• Merchant Transactions. Merchant transactions in stablecoins can allow for the purchasing of products and services through digital payments settled via a stablecoin,⁸ which may enable consumers, merchants, and developers to transact with reduced processing time and minimal fees. This is one of the most highly anticipated use cases for stablecoin growth.
• Cross-Border Payments and Remittances. Cross-border transactions have historically been expensive, slower, and complicated due to reliance on a complex system of intermediaries and settlements; stablecoins potentially provide a faster and cheaper solution. Proponents of stablecoins also argue that stablecoins can provide faster, more reliable, and less expensive remittance services that can facilitate greater financial inclusion for those who are unbanked or underbanked, particularly in the developing world.
• Foreign Exchange. Settlement risk and opacity have long been concerns in the high volume foreign currency exchange market. Stablecoins could facilitate faster and simplified transactions, thereby mitigating risk resulting from fluctuations in exchange rates because they have a shorter settlement time.

As stablecoins grow, we may see their use cases not only grow in number but further develop, becoming more concrete, widely accessible, and enhanced in their operations.

Current Size of the Stablecoin Market

Tether was the first stablecoin issued in 2014. Since then, the market capitalization for stablecoins has grown significantly and today is over $220 billion, up from $4 billion in 2020.⁹ Analysts expect the market to grow significantly once there is greater legislative and regulatory clarity in the U.S. There are approximately 200 stablecoins distributed globally, with many of the largest pegged to the USD. Tether (USDT) is by far the largest stablecoin by market capitalization at $146 billion.¹⁰ Tether trades on multiple blockchains, allowing it to be a major liquidity provider in the crypto space.

Stablecoin Structures

Every stablecoin is represented by a token on a blockchain and programmed smart contracts register any changes on that blockchain. Although all stablecoins exist on a blockchain, different types of stablecoins operate in distinct ways and use different structures.

Fiat-Backed Stablecoins. Fiat-backed stablecoins are designed to be redeemable for fiat currency on a one-to-one basis. They are collateralized in order to keep the stablecoin pegged to the applicable fiat. At issuance, the purchase price is used to fund collateral held with a custodian. The custodian takes custody of the collateral funds, records the transaction on the applicable blockchain, and smart contacts mint new tokens. Such tokens are then issued to the purchaser. Meanwhile, the collateral will remain in reserve until it is redeemed so that the proportion of stablecoin tokens to the fiat currency remains one-to-one.

The collateral in reserve is often invested in cash equivalents (e.g., Treasury bills, commercial paper, and money market mutual funds), but most stablecoins do not pay interest out to holders. Instead, the issuers of the stablecoin typically retain amounts gained from such investments. To redeem a stablecoin, the reverse process commences. Through smart contracts, the surrendered stablecoins are “burned” and the custodian releases collateral funds to the stablecoin holder, although, depending on the contractual arrangement, there may sometimes be ambiguity about whether a holder of a stablecoin can require a custodian to redeem.

Crypto-Backed Stablecoins. The structure and operational mechanics (minting and burning) of crypto-asset-backed stablecoins are the same as those of fiat-backed stablecoins with the primary difference being the asset class used for collateralization. However, due to volatility in the value of cryptocurrencies, this type of stablecoin maintains its value through overcollateralization and use of algorithms to manage the ratios of cryptocurrency to stablecoins issued. Unlike fiat-backed and other asset-backed stablecoins, customers of crypto-backed stablecoins “lock” cryptocurrency in smart contracts and then the smart contract calculates the appropriate amount of stablecoin to issue to the user in order to maintain a stable value.

Smart contracts that facilitate the issuance of cryptocurrency-backed stablecoins are more complex than those used in fiat-backed stablecoins due to the variable nature of cryptocurrencies. The price of cryptocurrency collateral is continually monitored and reported back into the smart contracts and then used in the calculations for token issuance.

Algorithmic Stablecoins. There are two models used for algorithmic stablecoins, both of which seek to adjust the supply of stablecoins to maintain their value. Seigniorage uses two tokens, a stablecoin and a seigniorage token, often referred to as a bond or share token. If the stablecoin is trading above its pegged value, the stablecoins protocol will mint new tokens and distribute them to participants. If the stablecoin is trading below its pegged value, the protocol will allow the seigniorage token to be purchased for the price that the stablecoin is currently trading at and be redeemed for a stablecoin once the value returns to the pegged value. The other model is rebasing. This model uses a single token system and an elastic supply of tokens that will dynamically change the number of tokens in circulation to maintain a stable value. In addition, some stablecoins, sometimes referred to as “fractional stablecoins,” are hybrids: partially algorithmic and partially collateralized.

Bank-Issued Stablecoins (Tokenized Deposits). In this structure, a traditional bank issues transferrable debt obligations, denominated in a fiat currency, that are redeemable by the bank for fiat currency, with ownership tracked on the blockchain. These are essentially tokenized bank deposits, and may be eligible for deposit insurance if the ownership tracking mechanism is documented in a way that meets the requirements of the Federal Deposit Insurance Corporation (FDIC). While currently a small market, deposit tokens may grow along with stablecoins.

Regulation Under Money-Transmitter Laws and Other State Laws

Issuers and intermediaries of stablecoins (other than tokenized deposits) are regulated in many states under money transmitter laws, much like issuers of money orders and travelers checks. This regulatory status brings with it strict collateralization requirements for the amount of outstanding stablecoins, with the types and amounts determined by those regulatory frameworks. This regulatory status also makes applicable anti-money laundering and “know your customer” requirements, as well as other regulatory obligations.

Other states, including New York, California, and Arkansas, regulate stablecoins under digital asset regulatory frameworks.

Risks

While stablecoins are typically viewed as the safest form of digital asset, they have risks like all other traditional and nascent financial products.

Risk That They Will Not Hold Their Value. Most stablecoins keep their peg by being backed with high-quality assets that can be liquidated in short order to meet the demands of their holders. As described above, the proceeds of a stablecoin’s initial issuance are generally invested in liquid assets with short maturities, such as U.S. Treasury securities, repurchase agreements, and bank deposits. The stability of a stablecoin depends on whether the stablecoin can be invested appropriately, safely, and in the right maturities.

In addition, if the stablecoin market grows, the difficulty of accessing appropriate investments may increase. Banks that hold uninsured balances for stablecoin issuers will also need to manage the liquidity risks of such holdings.

Transparency and Regulatory Risk. One criticism of stablecoins to date is a potential for lack of transparency in collateral asset reserve composition. Without regulatory requirements establishing standards for collateral asset reserves (and the reporting of reserves to stablecoin holders and the public), it is difficult to determine the overall health of stablecoins and what systemic risk they may pose. Further, as governments adopt regulatory regimes for stablecoin issuance and operations, competing regulatory frameworks can create complicated compliance requirements and heighten costs. Stablecoins developed ahead of clearly laid out regulatory requirements may need to be modified or redesigned to meet new requirements, such as reserve minimums.

Cybersecurity Risk. Stablecoins are technology created through programming that is subject to cybersecurity risk like all forms of technology. Cybersecurity risks for stablecoins include theft (of both stablecoins or tied collateral), malicious hacking or operating of smart contracts, data oracle attacks, or general vulnerabilities that arise in software development or third-party add-ins and support.

Illicit Activity Risk. A commonly cited stablecoin risk is illicit use by bad actors. Efficient operation of stablecoins limits the use of traditional financial intermediaries which (some argue) creates opportunity for bad actors to bypass anti-money laundering checkpoints to avoid detection. Legislative and regulatory guidance may clarify obligations to prevent, monitor, and detect activities such as fraud, money laundering, sanctions and tax evasion, and terrorist financing in stablecoins.

Liquidity Risk. This is the risk that the issuer will not have a sufficient amount of fiat currency available to redeem the stablecoins when presented by the holders. This risk is addressed by issuers holding a portfolio of highly liquid collateral (bank deposits, reverse repos, U.S. government securities, and the like) that can be quickly converted to cash to meet redemptions, and potentially other mechanisms, such as lines of credit with banks.

Interest Rate Risk. This is the risk that collateral owned by the stablecoin issuer declines in value as interest rates rise, with the resulting value insufficient on a mark-to-market basis to support the outstanding amount of stablecoin. This risk is most acute if there are large increases in interest rates; if the collateral as a whole has a longer overall weighted average maturity, life or portfolio duration because a substantial part of the collateral consists of assets other than very short term debt instruments; or if significant numbers of investors start redeeming their stablecoins for fiat currency. Issuers of stablecoins profit from the income of the invested collateral net of expenses. This may create a financial incentive for issuers to increase that return by investing collateral for a longer term and at a higher credit risk than might be optimal for protection of the principal amount of the outstanding stablecoins.

Credit Risk. This is the risk that the issuers of the collateral default, or are downgraded, resulting in portfolio losses on the collateral, making the remaining value of the collateral insufficient to meet redemptions of stablecoins as they occur.

Legal Uncertainty Risk. These risks are related to ambiguity in the legal status or treatment of stablecoins under applicable laws, which may affect their value or enforceability. Examples include the status of the issuer of the stablecoins under the Investment Company Act.

Bankruptcy/Insolvency Risk. There are a variety of risks associated with a possible bankruptcy proceeding involving a stablecoin issuer, not all of which have been fully resolved. For example: (1) the possibility of a determination by the bankruptcy court that the collateral supporting the stablecoin is property of the bankruptcy estate, which could materially reduce recoveries of stablecoin holders; (2) the timing and method of valuing the claims of stablecoin holders; (3) the timing and method of valuing the collateral; (4) the existence of other secured and unsecured debt of the bankrupt entity, which may reduce assets available for the stablecoin holders; and (5) the inability of stablecoin holders to access or redeem their stablecoins until completion of the bankruptcy case. Moreover, different jurisdictions may have varying legal interpretations of these and other issues creating uncertainty with respect to the outcome of a bankruptcy or insolvency proceeding.

A substantial majority of retail investors purchase their stablecoins on the secondary market through intermediaries, which presents additional material risks to stablecoin holders. In addition to the risks related to an issuer insolvency discussed above, the risks associated with the intermediary dynamic include the following: (1) the stablecoin holder may only redeem its stablecoins through the intermediary, which may not be willing to return the stablecoins if there is a pending insolvency proceeding of the issuer; (2) the stablecoin holder lacks contractual recourse against the issuer; (3) the collateral backing the stablecoin may be held for the benefit of the intermediary, but not the retail investor; and (4) an insolvency proceeding of the intermediary, which does not hold collateral backing the stablecoin, meaning the retail investor may be treated like other general creditors of the intermediary.

Finally, bank-issued stablecoins would be subject to FDIC insolvency rules.

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While stablecoins have been in development for over a decade, under the Trump administration, stablecoin issuances and participation are expected to grow. Statutory and regulatory clarity in the coming months could help create confidence in an industry that has historically been viewed as risky and speculative. Growth in investor and market confidence will create opportunities for new entrants in the stablecoin marketplace and business development among financial institutions. Both banks and non-bank entities will have opportunities to participate in the stablecoin industry, either as issuers, custodians, or in other capacities.

We expect in the coming year Congress will pass legislation on the issuance of stablecoins, providing regulatory clarity and paving a clear pathway for new entrants in the market. Our next Advisory will discuss the currently proposed legislation related to stablecoins.

© Arnold & Porter Kaye Scholer LLP 2025 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.