A stablecoin is a crypto-asset--i.e., a digital asset underpinned by blockchain technology--that aims to maintain a stable value relative to a fiat currency. We outline here our analytical approach for evaluating a stablecoin's ability to maintain this peg and assigning an assessment on a scale of 1 (very strong) to 5 (weak) (see chart). See the glossary for definitions of terms.
Our stability assessments are predominantly based on public information. We may form our opinion based on limited information or may decide not to assign a stablecoin stability assessment if we deem the available information insufficient.
Under this analytical approach, we do not assess stablecoins whose stability relies solely or primarily on the creditworthiness of the issuing entity (sometimes referred to as tokenized deposits). We also do not assess algorithmic stablecoins that are either uncollateralized or collateralized primarily by endogenous collateral (that is, collateral created by a stablecoin protocol to support its peg algorithmically).
THE ANALYTICAL APPROACH
We apply a framework to assess a stablecoin's ability to maintain its peg to a fiat currency, on a scale of 1 (very strong) to 5 (weak).
First, we assess asset quality risks, including credit, market value, and custody risks. Second, we analyze to what degree any overcollateralization requirements and liquidation mechanisms may mitigate these risks. We combine these factors to determine the asset assessment of 1 (very strong) to 5 (weak).
For example, some stablecoins promise to maintain the peg via pools of fixed-income assets of varying liquidity. Other stablecoins promise to do so via crypto-assets. Some are based on a mix of both. Some stablecoins seek to reduce the risks related to their underlying assets by requiring overcollateralization and establishing mechanisms for early liquidation or support against adverse movement in the value of the assets.
After assessing asset quality, we then consider five additional areas:
- Governance: Considers, among other aspects, who can make key decisions, features that align interests with those of stablecoin holders, transparency about risk appetite, policies and reserves, and the comprehensiveness and frequency of reserve attestations or audits.
- Legal and regulatory framework: Considers the framework, plus the extent to which it gives visibility into and confidence in the stablecoin's prospective ability to maintain the peg.
- Redeemability and liquidity: Analyzes the technical features and agreements underpinning the primary market redeemability, secondary market liquidity, and underlying payment rails of the stablecoin.
- Technology and third-party dependencies: Looks at possible risks linked to the blockchains on which stablecoins are exchanged, the smart contracts at the core, and possible third-party dependencies, such as the reliance on oracles used as data feeds by the smart contract.
- Track record: Includes any recent deviations from the peg, their cause, and reliability of remedial actions, if any.
We assess the strengths and weaknesses for each of these five areas. Our holistic view may result in an adjustment. As a result, the stablecoin stability assessment can be in line with or lower than the asset assessment.
DEFINING THE STABILITY OF A STABLECOIN
The stablecoin stability assessment reflects our view of a stablecoin's ability to maintain a peg to a fiat currency (or basket of currencies). A stablecoin's market price could deviate from its peg for many reasons. We consider quantitative and qualitative factors to determine how such a deviation influences our assessment. More quantitative factors include:
- The magnitude of the deviation (decline or increase) in the stablecoin price versus the fiat currency; and
- The persistence of the deviation over time (longer or shorter).
Some more qualitative factors include:
- The reason for the deviation--for example, whether the deviation was mainly the result of a deterioration in the quality of the assets backing the stablecoin or a technological disruption; and
- The reaction of the sponsor/protocol to the deviation--for example, the sponsor of the stablecoin commits to inject additional funds/assets in case any of the assets backing the stablecoin become impaired.
For example, we may worsen our assessment if we observe a price deviation that is not quickly corrected--because of the impairment of one of the reserve assets--and no credible action plan from the stablecoin sponsor to resolve the issue promptly. In this instance, we may assign the weakest assessment of 5 if we do not expect the stablecoin to reestablish the peg within a few days. We could subsequently improve our assessment if we believe that the underlying causes for the price deviation have either been addressed or no longer exist. However, we may also maintain a weaker assessment if we view the weakened track record as a risk to future price stability.
STABLECOIN STABILITY ASSESSMENT
Asset Assessment
Asset quality
To assess the quality of the assets, we look at various factors, including:
- The credit risk of the assets;
- The market value risk of the assets;
- The custody risk, mainly the nature of the custody agreement and the creditworthiness of the custodians; and
- Any other factors that could affect the liquidity of the assets, like foreign exchange risk.
We have minimum requirements in terms of credit risk and market risk when assessing asset quality (see table 1 for examples).
Table 1
| Examples of minimum requirements for asset quality assessments | |
|---|---|
| Asset quality | Minimum requirements (examples) |
| 1 (very strong) |
--Sovereign treasuries rated at least 'AA/A-1+' category (or equivalent) with maturity less than 90 days --Cash deposits with 'AA/A-1+' category (or equivalent) institutions --Cash equivalents (e.g., highly liquid money market funds, overnight repos backed by treasuries, or longer-dated treasury-backed repos with 'AA/A-1+' category, or equivalent, institutions) |
| 2 (strong) |
--Sovereign treasuries rated at least 'A/A-1' category (or equivalent) (with maturity less than 180 days) --Cash deposits with 'A/A-1' or 'A/A-2' category (or equivalent) institutions --Cash equivalents (e.g., treasury-backed repos with 'A/A-1' category, or equivalent, institutions) |
| 3 (adequate) | Most of assets with credit and market quality risks commensurate with a 2 (strong) assessment and a minority of higher-risk assets (such as lower-rated or unrated fixed-income instruments) |
| 4 (constrained) | Mostly higher-risk assets (such as lower-rated fixed-income instruments) |
| 5 (weak) | Other assets |
Below are examples of how we would assess assets, on the scale from very strong to weak:
1 (very strong): We would typically assess assets as 1 (very strong) if they have very strong credit quality--for example, sovereign debt rated in the 'AA' category or cash deposits with 'A-1+' rated institutions.
2 (strong): Similarly, we would assign an assessment of 2 (strong) if the reserve assets are fixed-income instruments with strong capacity to meet financial commitments but are somewhat more susceptible to adverse economic conditions or changing circumstances than instruments in higher-rated categories. (These can include, for example, sovereign debt rated in the 'A' category or cash deposits with at least 'A-2' rated institutions.)
3 (adequate): We would assign a 3 (adequate) if the majority of the underlying assets are at least commensurate with an assessment of 2 (strong) and a minority of assets are higher risk (for example, lower-rated or unrated fixed-income instruments).
4 (constrained): We would assign a 4 (constrained) if the underlying assets are primarily fixed-income assets with adequate capacity to meet financial commitments. These assets would be more susceptible to adverse economic conditions or changing circumstances than assets in less risky categories.
5 (weak): We would assign an asset assessment of 5 (weak) if the underlying assets are mainly volatile assets (typically equity or cryptocurrencies) or if the current value of the underlying assets is lower than the nominal amount of the stablecoin in circulation.
Factors that could lower initial assessment: We could lower our asset quality assessment if we perceive weaknesses in the creditworthiness of the custodian with which the assets are deposited. Weak creditworthiness could lead to logistical challenges and affect overall market confidence. We may also adjust our asset quality assessment if, in our view, it does not capture additional risks, such as foreign currency translation risk. This risk could materialize if the underlying assets are denominated in a fiat currency different from the currency of the peg.
Overcollateralization and liquidation mechanisms
We may improve the asset quality assessment by up to two levels if a stablecoin is overcollateralized and includes a collateral liquidation mechanism that mitigates asset quality risks. We assess the factors in table 2. We improve the asset quality assessment by one level if one of the factors is strong, and by two levels if both of the factors are strong.
Table 2
| Evaluating overcollateralization and liquidation mechanisms | ||
|---|---|---|
| Description | Examples of strong characteristics | |
| Liquidation threshold and mechanics | The speed at which collateral can be liquidated and the level at which liquidation is triggered both affect the risk of insufficient liquidation proceeds. | We expect that the collateral can be liquidated within 24 hours, either through an automated mechanism or, if human intervention is required, clearly established roles and responsibilities in the event a liquidation threshold is breached. We then assess whether the level of the liquidation threshold would be sufficient to cover a material and sudden drop in the collateral value. We do so generally by comparing to observations of historical market value declines for the collateral in stressed conditions. |
| Ability to liquidate | It may not be possible to liquidate if a large exposure must be liquidated at once, or a large amount relative to market liquidity for the asset. A liquidation mechanism that has operated effectively through periods of market stress may be more likely to succeed. |
--The exposure to asset liquidations is granular, and market movements do not trigger simultaneous liquidation of several positions; --The total amount of each asset is not excessively large relative to its typical trading volume; and --The stablecoin has demonstrated its ability to liquidate at scale through a significant market value stress. |
If multiple asset types or overcollateralization and liquidation mechanisms back a stablecoin, we first perform this analysis separately for each pair of asset type and mechanism. For example, we may assess that one asset type has a robust liquidation threshold and another does not.
We then consider how losses on the collateral would affect stablecoin holders. For example, if overcollateralization is not fungible across asset types, such that stablecoin holders are exposed to losses on the weakest asset-type/mechanism pair, our assessment is based on that pair.
If a stablecoin's collateral includes a reserve fund intended to cover losses on the collateral, we may remove from the assessment the weakest asset-type/mechanism pair(s) for which we assess that the reserve would be available and sufficient to cover any losses.
The Five Additional Factors
Our stablecoin stability assessment may be worse than the asset assessment, based on our analysis of the following five additional factors: governance and independent verification of reserves, legal and regulatory framework, liquidity and redeemability, technology and third-party dependencies, and track record.
We assess these factors holistically. If we identify weaknesses that are not appropriately addressed or mitigated, we may worsen the stability assessment, generally by one level, or more if we view a weakness as very material. In certain cases, weaknesses in some areas might be appropriately addressed or can be offset by strengths in others, leading to no adjustment. The overall view cannot result in a stablecoin stability assessment that's higher than the asset assessment because we do not believe that strengths in these five factors can offset weakness in the assets.
Governance
We analyze risks related to how a sponsor manages a stablecoin, how internal procedures and policies can create or mitigate risks, and the frequency and comprehensiveness of the third-party verifications (see table 3). We also analyze the sponsor's risk appetite and its approach toward asset management.
Table 3
| Examples of governance strengths and weaknesses | ||
|---|---|---|
| Subfactor | Strength | Weakness |
| Governance framework |
The existence of mechanisms to minimize the risks related to reserve management and conflicts of interest. The existence of clearly defined rules to act in the best interests of the stablecoin holders. |
Decision-making that could result in significant delays or erratic outcomes. Governance concentrated with a limited number of governance token holders--for decentralized stablecoins--since this could result in decisions that may not be in the best interests of the stablecoin holders. |
| Third-party verification |
The existence of monthly (or as often as required by the regulators) third-party verification of the stablecoin reserves coupled with adequate public disclosures. Third-party verification that is typically done by a renowned audit firm. |
The absence of third-party verification of the reserve assets or insufficient disclosures. (For example, disclosing the type of assets without being specific about the creditworthiness of the counterparties, the geographical diversification, or concentration of assets, etc.) |
| Risk appetite | The existence of a well-defined risk appetite statement with conservative guidelines for instrument eligibility and reserve management. | Absence of guidelines or frequently changing guidelines for instrument eligibility and reserve management. |
Legal and regulatory framework
The existence of an effective direct or indirect legal and regulatory framework for stablecoins and their sponsors can protect holders by setting legal and regulatory requirements. An example is a framework that requires the segregation of the reserve assets from the sponsor's, sets minimum requirements on the quality of the assets, or requires periodic supervision of the stablecoin sponsors and management.
First, we assess whether the assets are sufficiently legally separated from the sponsor's assets and are protected in case of bankruptcy. We then assess the scope and the intent of the regulatory framework and to what extent it's focused on preserving the stability of the coin. In addition, we look at the regulator's capacity to intervene to implement preventive or corrective actions if needed, such as if the stablecoin sponsor is not fully compliant with the requirements (see table 4).
Generally, we see the absence of, or weaknesses in, legal segregation of assets as negative--unless, in our view, the sponsor's creditworthiness minimizes the risk to the assets.
Table 4
| Examples of strengths and weaknesses that can inform our legal and regulatory analysis | ||
|---|---|---|
| Subfactor | Strength | Weakness |
| Segregation of the assets | Reserve assets are held separate and maintained in accounts protected against the bankruptcy of the sponsor, even if regulation does not require it or if no regulatory environment exists at the time of the evaluation. | We have doubts about the asset separation, and the sponsor credit quality is weak. |
| Regulatory framework |
A well-defined regulatory framework exists with clear requirements in terms of governance and quality of the reserve assets. The regulatory framework subjects the sponsor to periodic supervision by the regulator. There is a track record of regulatory intervention to protect the stablecoin holders. |
A regulatory framework does not exist, or it has significant gaps in coverage. Regulatory oversight is done on an ad hoc basis. |
Redeemability and liquidity
A holder's ability to exchange a stablecoin 1 to 1 with the relevant fiat currency provides an arbitrage opportunity in the event of any deviation in the market price of the stablecoin, and it therefore can support price stability. We derive the overall liquidity and redeemability assessment based on our holistic review of three subfactors (see table 5). A strength in one subfactor may offset a weakness in another.
Table 5
| Examples of strengths and weaknesses that can inform our redeemability and liquidity analysis | ||
|---|---|---|
| Subfactor | Strength | Weakness |
| Primary market redeemability |
For a centralized stablecoin, broad ability to redeem 1 to 1 against an issuer. For a decentralized stablecoin, a mechanism to exchange 1 to 1 with other stablecoins. We assess such a mechanism's functioning, asset composition, and volume. |
No or very narrow redeemability against an issuer, limited, for example, to a very small group of authorized participants, or to redemptions above a high threshold amount. For a decentralized stablecoin, absence of (or significant constraints in) a 1 to 1 exchange mechanism. |
| Secondary market liquidity | Strong track record of robust liquidity on both centralized and decentralized exchanges. | Shallow secondary market or limited track record. |
| Payment rails | Broad availability of parties that can support convertibility 24/7. | Narrow availability of parties that can support convertibility 24/7, or exchanges for fiat permitted only during market hours. |
Technology and third-party dependencies
The blockchain technology and smart contracts underpinning a stablecoin can have a material impact on its ability to maintain its peg and on its holders' ability to redeem it against fiat currency in a timely fashion. We consider three subfactors in our overall assessment (see table 6).
Resilience of the blockchain technology: We consider how well tested the underpinning blockchain is. For example, this can include how many years it has been in operation, what volume of transactions have occurred, and the track record of reliability and any incidents or outages. Some stablecoins operate on multiple blockchains. This can support the stability of the stablecoin by opening additional sources of liquidity but can also expose its users to potential risks when transitioning from one chain to another (referred to as "bridging risks").
Resilience of the smart contract: We address the audit quality, the code complexity and transparency, and the upgrade mechanism. See the glossary for definitions of terms related to smart contracts.
An audit is a critical step to identify and mitigate possible vulnerabilities that could lead to potential loss of funds. The existence of multiple audits from external and well-known auditors typically factors positively in our assessment of the smart contract's robustness.
In terms of code complexity, the use of a well-tested programming language and contemporary compiler version to write the smart contract is crucial. The use of old compiler versions with known vulnerabilities could lead to exploits. In terms of transparency, the best practice is to make the smart contract's repository open source and enable verification of the source code. This allows anyone to inspect and verify the functions of the smart contract.
We also address the ability to upgrade the smart contract, which involves changing the business logic while preserving the contract's state. The ability to upgrade allows for a vulnerability to be addressed when the smart contract is in operation. But it's important to understand who is able to implement an upgrade and what security measures are in place to prevent a malevolent actor from amending the smart contract. Using proxy contracts adds another layer of complexity and increases the possibility of critical flaws.
Secure access control--such as the use of a multi-signature wallet contract, requiring a DAO to approve an upgrade--and use of time locks can help mitigate risks involved with an upgrade to some extent.
Third-party dependencies: For example, these can include dependencies on technological aspects or on oracles.
Table 6
| Examples of strengths and weaknesses that can inform our assessment of technology and third-party dependencies | ||||||
|---|---|---|---|---|---|---|
| Factor | Strength | Weakness | ||||
| Blockchain technology | Well-tested blockchain, with strong track record of reliable use at scale. | Operations on multiple blockchains, some with limited track record, or concerns about possible bridging risks between blockchains. | ||||
| Smart contract |
Audit: --Recent and multiple audits by well-known firms; --No critical or high-risk observations in the audit report(s); or --Encourages public participation by using open source code and offering a bug-bounty program. |
Audit: --No audits; or --High-risk observations in the audit report acknowledged but not mitigated. |
||||
|
Code complexity and transparency: --Open-source repository; --Source code verified; --Written in well-tested programming language and libraries, and uses established market standards such as ERC; --Contemporary compiler version. |
Code complexity and transparency: --Closed-source repository (less/no transparency); --Unverified contracts; --Old compiler. |
|||||
|
Upgrade mechanism: Secure access controls. --Multi-signature wallet contract; --Requires DAO to approve an upgrade. Time locks combined with multi-signature governance for an upgrade. |
Upgrade mechanism: --Single administrator with full access control; --Uses proxy contracts. |
|||||
| Third-party dependencies | Negligible reliance on technical third parties, or strong vetting, reliability, and expertise of these third parties. | Reliance, for instance, on oracles whose data feeds could be prone to errors, interruptions, or exploits. | ||||
| Bug-bounty program--A deal typically from software companies offering compensation to individuals who find bugs in the software. ERC--Ethereum Request for Comment. | ||||||
Track record
We generally consider a stablecoin's track record of price stability over 12 months and how long it has operated at scale (see table 7). We also assess past depeg events, as described in the "Defining The Stability Of A Stablecoin" section.
Table 7
| Examples of strengths and weaknesses that inform our track record analysis | ||
|---|---|---|
| Factor | Strength | Weakness |
| Price stability over prior 12 months | No instances where the peg has been breached (see the "Defining The Stability Of A Stablecoin" section). | At least one instance of breach of the peg. However, if the breach is related to a transitory event, we may not consider it a weakness. |
| Length of track record operating at scale | At least 12 months and demonstrated peg stability at scale (typically more than $1 billion outstanding). | Shorter than 12 months or no record of maintaining stability through significant stress. |
GLOSSARY
Algorithmic stablecoin
A token that is designed to maintain its peg to some traditional finance assets, whether it be fiat currency or a commodity like gold. Unlike other stablecoins, algorithmic stablecoins seek to maintain this peg by backing the stablecoin with endogenous capital, often in the form of a token representing the stablecoin provider organization itself. This endogenous capital is minted and burned into and out of existence as a means of maintaining the peg of the stablecoin to its parent asset.
Audit
A third-party examination and evaluation of a stablecoin's disclosure to ensure that the information presented is an accurate and fair representation of the reserves' composition.
Blockchain
A digital ledger comprising unchangeable, digitally recorded data in packages called blocks. Each block is "chained" to the next block using a cryptographic signature. Blockchain is a subcategory of DLT (distributed ledger technology).
Compiler
Translates smart-contract code into machine-readable format that can be understood and executed on a computation engine like Ethereum Virtual Machine (EVM).
Contemporary compiler
Addresses known bugs and issues and brings new functionalities. However, it's not battle-tested and not proven most secure. Sometimes, benefits of upgrading to the latest compiler version may not be significant for the smart contract. The audit report is usually the best way to check whether auditors have raised any issues or recommendations related to compiler version. If no issues are raised in the audit report, then the compiler version can be considered contemporary.
Decentralized autonomous organization (DAO)
A collectively owned, blockchain-governed organization working toward a shared mission. In DAOs, decisions are governed by proposals and voting to ensure everyone in the organization has a voice and everything happens transparently on-chain.
Distributed ledger technology (DLT)
A type of database that is spread out across several nodes in different locations and countries so that it can remain decentralized as well as transparent to those involved with keeping records on it. Every single node holds a complete copy of the ledger that is updated regularly through consensus algorithms when new transactions take place. Blockchain is an example of DLT.
Multi-signature wallet
A crypto-asset wallet that requires multiple keys to access and transact. Typically, a specified number of individuals are required to approve or "sign" a transaction before they are able to access the wallet. This is different from most wallets, which require only one signature to approve a transaction. These are often implemented as a governance tool.
Open-source
Collaboratively produced, shared freely through a public repository (e.g., Github), published transparently, and developed to be a community good rather than the property or business of a single company or person. Open-source culture is one of the integral components of blockchain technology.
Oracles
Entities that connect blockchains to external systems, enabling smart contracts to execute based on inputs and outputs from the real world. This can be the "source of truth" for the price of assets or a random number a third-party generates to ensure impartiality.
Payment rails
A payment platform or a payment network that moves money from a payer to a payee.
Protocol
A grouped set of interactions defined by smart contracts and governance that allows any user to interact with the blockchain if they fulfill the basic interaction requirements. This is similar to how a Transmission Control Protocol (TCP) or a Internet Protocol (IP) allows any user to use the internet as long as they follow certain interaction requirements.
Proxy contract
Acts as an intermediatory between protocol users and main implementation contract. The upgrade and maintenance take place behind the scenes. When the user interacts with the protocol, they interact with this proxy contract that has the address of the latest version of the smart contract stored as a variable and "points" to this contract with the necessary variables. When it is time to upgrade, a new contract is written, and the variable holding the last address is changed to the new address. Having a proxy contract means a high level of trust in the project owners (specifically contract administrators that are permissioned to implement changes).
Smart contract
An application written in a coding language that allows for it to be compiled and deployed to a blockchain. This application contains business logic and read/write functions that users can interact with.
Smart contract audit
The process of scrutinizing the underlying code of a smart contract with the goal to pinpoint and rectify any latent security vulnerabilities, errors, or inefficiencies.
Source code verification
Compares a smart contract's source code and the compiled bytecode used during the contract creation to detect any differences. Verifying smart contracts helps in identifying whether the advertised contract code is different from what runs on the blockchain.
Time locks
A smart contract with delay or time-based constraint on the execution of certain actions or transactions. In the context of governance and protocol upgrade (in highly decentralized ecosystems), time locks give users some time to exit the system if they disagree with a proposed change. Without time locks, users need to trust developers not to implement arbitrary changes in a smart contract without prior notice.
RELATED RESEARCH
- Utility at a cost: Assessing the risks of blockchain oracles, Nov. 17, 2023
- What Can You Trust in a Trustless System, Oct. 11, 2023
- Stablecoins: A Deep Dive into Valuation and Depegging, Sept. 7, 2023
- Crypto CeFi And DeFi Must Strike A Balance To Thrive, June 22, 2023
- How DeFi's Operational Risks Could Influence Credit Quality, June 7, 2023
- Stablecoin Depegging Highlights DeFi's Exposure To TradFi Risks, March 15, 2023
- Global Credit Outlook 2023: Future Of Money: Will stablecoins and CBDCS become mainstream?, Dec. 1, 2022
- Stablecoins: Common Promises, Diverging Outcomes, June 15, 2022
This report does not constitute a rating action.
| Primary Credit Analysts: | Lapo Guadagnuolo, London + 44 20 7176 3507; lapo.guadagnuolo@spglobal.com |
| Alexandre Birry, Paris + 44 20 7176 7108; alexandre.birry@spglobal.com | |
| Mohamed Damak, Dubai + 97143727153; mohamed.damak@spglobal.com | |
| Andrew O'Neill, CFA, London + 44 20 7176 3578; andrew.oneill@spglobal.com |
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