Why Stablecoins Need Regulation

Stablecoins are one of the most significant innovations in the Web3 ecosystem because they create a stable store of value in a crypto market prone to price fluctuations. They are typically pegged to a specific asset—most commonly the U.S. dollar—making them less volatile than cryptocurrencies like Bitcoin or Ethereum. This reduced volatility makes them ideal for everyday transactions and as a “safe haven” to which investors retreat during times of market turbulence. However, as we’ve learned from our Principled Approach to Web3 Regulation, this added layer of reliability introduces new risks that demand thoughtful, principle-based regulation.

What are stablecoins?

Not all crypto tokens are built the same and that is especially true for "stable" coins which come in several different designs. They can be:

• Fiat-backed: meaning the stablecoins are minted when a user trades for them.
• Algorithmic: meaning that the pricing mechanism is determined by an algorithm based on the many liquidity pools that make up the stablecoin.
• Crypto-backed: meaning that other crypto tokens represent the liquidity and pricing functionality of that stablecoin.
• Commodity-backed: meaning that a commodity like gold or silver represents the value and pricing functionality of that stablecoin.

How does a stablecoin get "backed" by other liquidity and how does it stay stable?

Each token that is created is just a token until its creator wants it to be purchased by the public, thats when the mechanism to determine and enforce the tokens price needs to be established and constructed. Traditionally, when a non-stable token is to be purchased by the public, the pricing mechanism and equation used is the Constant Product Formula, or the x * y = k equation. In this formula, x represents the quantity of the token you want to sell and y represents the token used to buy it, while k remains constant across all trades within the liquidity pool. Because this formula is enforced by the smart contract, it is immutable and self-executing—meaning no centralized authority can alter it. Each trade automatically updates the token balances, causing the price to shift and update in real-time, and every transaction is recorded on the blockchain for anyone to inspect. This transparent, onchain mechanism holds the token price accountable to actual market activity rather than human intervention or external manipulation.

Stablecoins, however, rely heavily on offchain components like external oracles, real-world collateral, or algorithmic controls to maintain their peg. While these can be effective in theory, they are more complex and not as easily audited on a continuous basis, making it challenging to verify the promised stability or backing. By contrast, the Constant Product Formula operates entirely onchain, making it straightforward for market participants to verify that trades are executed according to immutable smart contract rules. This contrast highlights why non-stable coins benefit from immediate, trustless price discovery, while stablecoins often require more layers of oversight and regulation to ensure they remain truly “stable.”

There are many stablecoins out there but for the sake of this article we are focusing on USDT, DAI, USDC, and UST, and especially during this time period:

• USDC (11/02/2018 – 5/28/2022)
• USDT (11/9/2017 – 5/28/2022)
• DAI (11/19/2019 – 5/28/2022)
• UST (Terra) (11/26/2020 – 5/28/2022)

The stable-ness of the USDT, DAI, USDC, and UST (Terra) tokens were assessed through a multiple regression model with market cap and transaction volume taken at daily increments. The desire here is to understand the ballast, or weight, that an individual stablecoins market cap has on the impact that the transaction volume has on the price swing for that day, if there is any. As cryptocurrency is becoming more adopted, we want to know if they are scalable to maintain their peg with the increasing transaction volume and market cap.

This report analyzes the weight, or significance, that the market cap has on the influence between the price swing, or the high and low prices, for any particular day, so that we can attempt to create a forecasting model to predict future price swings based on an individual tokens market cap. The assumption to start this all was that as a tokens market cap increases, the less of an affect the daily transaction volume has on the swing in a stablecoins price, which would be the ballast of that token.

What are we even referring to when we are discussing the “stability” of a stablecoin? Is the stability based on a time-horizon, the volume per transaction, aggregate volume per DEX, or could it even be based on the collateralization that we are told of? Most of this report will be based on data that is correlated in relation and not necessarily casually related, though more analysis will be done progressing towards producing causally related data reports and risk models. For example, this report does not take into consideration collateral, pricing mechanisms/oracles, depth of pools, individual transaction volumes, price swing cover, or if the transaction are buys/sells, though they will all be analyzed and discussed in future reports.

In order to understand depegging we have to analyze the times the stablecoins have depegged, and we did that by analyzing the "ballast factor" of a stabelcoin, with the results below:

Below are the scale ranges for USDT, USDC, and DAI:

Immediately interpreting the results, we see that USDC has a shallow ballast with its worst factor being 16.12, though the ballast factor does not get as low, or as close to 0 as we would like for it to be. DAI has a ballast range furthest from 0 while its worst ballast factor is more than twice that of USDC. USDT has widest ballast range with the worst factor being 56,338, however, its ballast range does come the closest to 0.

Why Do We Need Stablecoin Regulation?

When reading about the Wallets and Regulation post, we see how individual users are responsible for their own digital assets—there’s no centralized bank bailing you out. With stablecoins, the underlying collateral (whether fiat, crypto, or algorithmic mechanisms) must be transparent and trustworthy. Otherwise, if the backing assets are misrepresented—or if there is no real backing at all—consumers could lose faith and pull their funds en masse, effectively causing a run on the stablecoin. Such systemic risk can affect the broader crypto market and even bleed into traditional financial markets.

Similarly, the Intro to Crypto Policy DAO article highlights the importance of designing legislation that anticipates technological innovations rather than just reacting to them. Stablecoins enable frictionless, near-instant cross-border transactions. They also serve as a gateway to DeFi opportunities that often yield returns well above traditional bank rates. But without clarity around their legal status, capital requirements, consumer disclosures, or redemption policies, stablecoins could easily slip through the cracks of existing financial frameworks. This lack of clarity endangers both consumers and innovators alike.

Key Reasons for Regulation

1. Consumer Protection
   Stablecoin projects must adhere to transparent backing practices, offer redemption assurances, and disclose how and where their reserves are held. This mirrors how the banking system provides deposit insurance, but now in a new crypto context.

2. Market Stability
   If a major stablecoin project fails or is suspected of insolvency, it can send shockwaves across the market—much like how a failing bank can prompt a broader financial crisis. Thoughtful rules around collateralization and reporting help shore up confidence.

3. Risk Mitigation at the Asset Layer
   As noted in our Principled Approach to Web3 Regulation, the Asset Layer is where tokens like stablecoins live. The same principle-based framework that addresses security, innovation, and privacy should be extended to stablecoins, requiring projects to regularly verify their reserves, undergo independent audits, and disclose critical risk factors.

4. Enabling Innovation
   Proper regulation can foster, rather than stifle, innovation. If stablecoin issuers can operate within a clear legal framework, they are more likely to partner with traditional financial institutions, expand payment systems, and drive user adoption. Overly harsh or ill-fitting rules, on the other hand, risk pushing development underground or offshore.

Principle-Based Regulation in Action

As we discussed in the Principled Approach to Web3 Regulation, regulation must be tailored to each layer of the blockchain. For stablecoins:

• Risk Mitigation
  Clear guidelines for collateralization, auditing, and solvency reduce the chance of a “run” or sudden collapse.

• Security by Design
  Open-source contracts, frequent third-party audits, and robust redemption policies help ensure that stablecoin smart contracts and reserve mechanisms work as intended.

• Supporting Blockchain Innovation
  Encouraging pilot programs for new stablecoin models (e.g., algorithmic, hybrid) allows the market to experiment while maintaining essential guardrails, much like the draft legislation for wallets that balances consumer safety with innovation.

• Privacy & Consumer Protection
  While stablecoins can be more transparent than traditional bank accounts, they also raise questions about potential overreach if user data is tracked. Regulators must find the middle ground between preventing illicit activities and preserving user privacy.

Conclusion

Stablecoins are a cornerstone of the crypto ecosystem, acting as a buffer against volatile price swings while enabling seamless trading and payments. Yet their very stability depends on trust—which in turn necessitates effective, principle-based regulation. Drawing on lessons from our Wallets and Regulation and Principled Approach to Web3 Regulation articles, policymakers and industry leaders must collaborate to craft rules that protect consumers, ensure liquidity and solvency, and foster the next generation of decentralized finance solutions.

By applying the same layer-by-layer thinking we have used throughout our other posts and focusing on risk mitigation, security by design, supporting blockchain innovation, and privacy & consumer protection, we can develop a stable regulatory framework for stablecoins—ensuring they remain a secure, trusted, and innovative part of the broader Web3 ecosystem.

Sources

1. https://www.chainalysis.com/blog/stablecoins-most-popular-asset/
2. " Anatomy of a Stablecoin’s failure: The Terra-Luna case" Antonio Briola, David Vidal-Tomás, Yuanrong Wang, Tomaso Aste. https://www.sciencedirect.com/science/article/abs/pii/S1544612322005359 Finance Research Letters Volume 51, January 2023, 103358