Fiat-Backed Stablecoin

What Is a Fiat-Backed Stablecoin?

A fiat-backed stablecoin is a digital token whose value is pegged to a fiat currency (typically the US dollar) and backed by reserves of that currency or close equivalents. For every token in circulation, the issuer claims to hold one dollar (or euro, or other fiat unit) worth of assets in reserve. When a holder wants to redeem their tokens, the issuer destroys the tokens and returns the corresponding fiat.

This model is the simplest stablecoin design conceptually: the token is essentially a digital receipt for dollars sitting in a bank account or invested in short-term government securities. The peg holds because authorized participants can always arbitrage any deviation by minting new tokens when the price rises above $1 or redeeming tokens when it falls below $1.

Fiat-backed stablecoins dominate the market. USDT (Tether) and USDC (Circle) collectively represent over $200 billion in circulating supply. Their widespread adoption stems from their straightforward design: users understand that dollars back the tokens, even if the specifics of reserve composition vary significantly between issuers.

How It Works

The mechanics of a fiat-backed stablecoin revolve around three processes: minting, redemption, and reserve management. Each process involves different participants and trust assumptions.

Minting

When new tokens need to enter circulation, the process follows a consistent pattern across issuers:

1. An authorized participant (institutional client, exchange, or OTC desk) sends fiat currency to the issuer's bank account via wire transfer
2. The issuer verifies receipt of funds and confirms the sender's KYC/AML status
3. The issuer's smart contract (or authorized wallet) mints the equivalent amount of stablecoin tokens on the target blockchain
4. The newly minted tokens are sent to the participant's wallet address

Most issuers restrict direct minting to institutional participants. Retail users acquire fiat-backed stablecoins on secondary markets: exchanges, DEXs, or peer-to-peer transfers.

Redemption

Redemption reverses the minting process. An authorized participant sends stablecoin tokens to the issuer, the tokens are burned (permanently destroyed), and the issuer wires fiat currency back to the participant's bank account. This burn-on-redemption mechanism keeps the circulating supply matched to reserves.

Redemption timelines vary. USDC typically processes redemptions within one business day for verified Circle accounts. USDT redemptions historically required higher minimums and longer processing times, though Tether has expanded access over the years.

Reserve Management

The reserve is where fiat-backed stablecoins diverge most. Not all reserves are created equal:

Circle holds USDC reserves primarily in the Circle Reserve Fund (managed by BlackRock), consisting of short-dated US Treasuries and overnight repurchase agreements. This composition prioritizes safety and liquidity.

Tether's reserves have historically been more diverse, including commercial paper (now eliminated), secured loans, and other investments alongside Treasuries. Tether publishes quarterly attestation reports, though these have faced scrutiny for lacking the depth of a full audit.

The Arbitrage Mechanism

The peg to $1.00 is maintained through arbitrage rather than algorithmic mechanisms. This is what distinguishes fiat-backed stablecoins from algorithmic designs that can suffer catastrophic depegging:

Market price > $1.00:
  Arbitrageurs mint new tokens at $1.00 from the issuer
  Sell tokens on the open market at the higher price
  Pocket the difference as profit
  Increased supply pushes price back toward $1.00

Market price < $1.00:
  Arbitrageurs buy tokens on the open market below $1.00
  Redeem tokens with the issuer for $1.00 in fiat
  Pocket the difference as profit
  Reduced supply pushes price back toward $1.00

This mechanism is robust as long as minting and redemption remain accessible. Disruptions to either process (bank failures, regulatory freezes, issuer insolvency) can break the arbitrage loop and cause depegging. USDC briefly traded below $0.90 in March 2023 when Silicon Valley Bank, which held a portion of Circle's reserves, collapsed.

Trust Assumptions

Every fiat-backed stablecoin requires users to trust multiple centralized entities. Understanding these trust assumptions is critical for evaluating risk:

The Issuer

The issuer (Circle, Tether, Paxos, etc.) is responsible for maintaining reserves equal to or greater than the circulating supply. Users trust that the issuer is not fractionally reserved, has not misappropriated funds, and will honor redemption requests. Unlike on-chain protocols where reserves are transparent by default, fiat reserves sit in traditional bank accounts and require off-chain verification.

The Auditor or Attestation Provider

Independent accounting firms provide attestations or audits of the reserves. An attestation confirms reserve balances at a specific point in time. A full audit goes deeper, examining controls, processes, and historical accuracy. Most stablecoin issuers publish attestations, not full audits, and these snapshots may not reflect reserve composition between reporting dates.

Circle publishes monthly attestation reports from Deloitte. Tether publishes quarterly reports from BDO Italia. The difference between an attestation and a full audit matters: attestations verify a snapshot, while audits evaluate ongoing compliance. Neither guarantees that reserves are managed prudently between reporting periods.

Banking Partners

Fiat reserves must be held somewhere, and that means banks. The banking partner's solvency directly affects the stablecoin's backing. If the bank fails and reserves are not fully insured or recoverable, token holders bear the loss. This risk materialized during the SVB crisis, when $3.3 billion of USDC reserves were temporarily inaccessible.

Regulatory Landscape

Fiat-backed stablecoins are the most regulated category of stablecoin, and regulatory frameworks are evolving rapidly across jurisdictions.

EU: Markets in Crypto-Assets (MiCA)

Under MiCA, fiat-backed stablecoins that reference a single currency are classified as e-money tokens (EMTs). Issuers must obtain e-money institution authorization, hold reserves in secure, segregated accounts, and grant holders a direct redemption right at par value at any time. MiCA also distinguishes EMTs from asset-referenced tokens (ARTs), which reference baskets of assets or currencies.

United States

US stablecoin regulation remains fragmented. Stablecoin issuers operate under a patchwork of state money transmitter licenses and federal guidance. Proposed legislation like the GENIUS Act and the STABLE Act would establish federal frameworks for stablecoin issuance, requiring full reserve backing, regular audits, and clear redemption rights. Until comprehensive legislation passes, issuers navigate an uncertain regulatory environment where requirements differ by state.

Implications for Holders

Regulatory classification determines what protections holders receive. Where stablecoins are classified as specified stablecoins or e-money tokens, holders may have legal redemption rights, segregated reserve protections, and recourse in the event of issuer failure. In jurisdictions without clear frameworks, holders are essentially unsecured creditors of the issuer.

Use Cases

Fiat-backed stablecoins serve as foundational infrastructure across cryptocurrency markets and increasingly in traditional finance:

• Trading and settlement: stablecoins function as the primary quote currency on most cryptocurrency exchanges, replacing the need for fiat banking rails during trading hours
• Cross-border payments: sending USDC or USDT across borders settles in minutes rather than the days required by correspondent banking networks, at a fraction of the cost
• DeFi collateral: fiat-backed stablecoins serve as base collateral in lending protocols, liquidity pools, and yield strategies across DeFi ecosystems
• Dollar access in restricted markets: in countries with capital controls or volatile local currencies, fiat-backed stablecoins provide access to dollar-denominated value without requiring a US bank account
• Yield-bearing variants: some stablecoins like USDB pass through yield generated from reserve assets (Treasury bills) to holders, transforming stablecoins from pure payment instruments into yield-bearing assets

Comparison with Other Stablecoin Models

Fiat-backed stablecoins represent one approach in a spectrum of stablecoin designs, each with distinct tradeoffs:

Crypto-collateralized stablecoins (like DAI/USDS from MakerDAO) use overcollateralization ratios that exceed 100%, relying on on-chain liquidation mechanisms to maintain solvency. Algorithmic stablecoins attempt to maintain peg through supply expansion and contraction, but as TerraUSD demonstrated, this model is vulnerable to reflexive death spirals when confidence breaks.

Risks and Considerations

Counterparty Risk

The fundamental risk of fiat-backed stablecoins is counterparty risk. Users depend on the issuer to maintain adequate reserves, honor redemptions, and operate honestly. Unlike Bitcoin or on-chain protocols, there is no way to independently verify fiat reserves without trusting the issuer's reported attestations. If the issuer becomes insolvent, holders may face losses similar to depositors in an uninsured bank failure.

Censorship and Freezing

Fiat-backed stablecoin issuers can freeze tokens at specific addresses. Both Circle and Tether have frozen addresses in response to law enforcement requests and sanctions compliance. This capability is a feature for regulatory compliance but a risk for users who may face freezes due to errors, overly broad enforcement, or jurisdictional disputes. As of early 2025, Tether had frozen over $1.8 billion across hundreds of addresses.

Banking System Dependency

Fiat-backed stablecoins inherit the risks of the traditional banking system. Bank runs, policy changes, regulatory actions against banking partners, or loss of banking relationships can all impact a stablecoin's ability to maintain its peg and process redemptions. The concentration of reserves in a small number of banking partners amplifies this risk.

Reserve Composition Opacity

While attestations provide periodic snapshots, the day-to-day management of reserves remains opaque. Reserves can shift between asset types between reporting dates. An issuer might hold 100% Treasuries on attestation day but invest in riskier assets during intervening periods. Without continuous on-chain proof of reserves, holders must trust that attestation snapshots reflect normal operations rather than window-dressing.

Oracle and Price Feed Risks

In DeFi contexts, fiat-backed stablecoins depend on accurate oracle price feeds to function correctly as collateral. If oracles report stale or manipulated prices, protocols may incorrectly value stablecoin collateral, leading to cascading liquidations or undercollateralized positions.

This glossary entry is for informational purposes only and does not constitute financial or investment advice. Always do your own research before using any protocol or technology.