Understanding the Risks: Traditional Stablecoins vs. Synthetic Dollars

Stablecoins are one of the most popular crypto asset types, with the top projects ranked only behind Bitcoin and Ethereum in terms of market capitalization. Although addressing the price volatility risk common for crypto, stablecoins still carry other risks. A new category of synthetic dollar projects, which Falcon Finance is part of, aims to offer better incentives compared to classic stablecoins like USDT and USDC. Yet, the design of synthetic dollars also holds risks. In this article, we will provide you a comprehensive overview of inherent risks associated with both stablecoins and synthetic dollars, while explaining how Falcon strives to solve the latter.

Risks of Fiat-Backed Stablecoins

Traditional stablecoins, primarily backed by off-chain fiat reserves, face risks deeply rooted in their centralized nature and reliance on the legacy financial system:

• Custodial risk.
• Counterparty risk.
• Regulatory uncertainty.
• Centralization risk.

One of the primary concerns is custodial risk. Since the reserves (cash, bonds, treasuries) are held by centralized custodians like banks, fiat-backed stablecoins are exposed to counterparty risk. There’s the danger that a custodian could mismanage funds, suffer a failure (as seen with traditional banks), or have assets frozen due to external pressures, leading to a depeg, as occurred with USDC after the collapse of Silicon Valley Bank. While audits offer some assurance, the day-to-day management of these vast, off-chain reserves remains somewhat opaque compared to on-chain operations.

This leads directly to another concern of regulatory uncertainty. As stablecoin issuers operate at the intersection of crypto and traditional finance, they are prime targets for government oversight. Future regulations concerning reserve composition, operational requirements, or even outright bans could significantly impact their functionality and accessibility. One example is Tether’s USDT, which, despite being the largest-cap stablecoin, was delisted from some crypto exchanges after the new law on stablecoins came into force in the European Union in 2025.

Finally, the inherent centralization risk means these stablecoins are operated by single companies. This makes them susceptible to actions like censorship or the freezing of funds, where the issuer can block transactions or blacklist addresses at will or upon legal request. It also establishes a single point of failure: any significant legal, financial, or operational challenge faced by the issuing company could directly threaten the stability and usability of the stablecoin itself.

Risks of Synthetic Dollars

Synthetic dollars, while offering greater transparency and potential yields through on-chain mechanisms compared to stablecoins, introduce a different set of risks, primarily related to technology and market dynamics:

• Smart contract risk.
• Strategy risk.
• Market volatility risk.

The most prominent is smart contract risk. Synthetic dollar protocols usually rely on multiple smart contracts for various operations, deployed on the blockchain. That introduces the possibility of bugs, exploits, or vulnerabilities. And because many smart contracts are often interconnected, a flaw in one protocol’s smart contract could potentially cause cascading effects across protocols.

Another significant concern is strategy risk. Synthetic dollars often generate yield and maintain their peg through various trading and hedging strategies. These strategies, whether they are based on funding rates, arbitrage, or staking, are not guaranteed to succeed. They can underperform or even fail, especially during “black swan” events or periods of extreme market stress. Unexpected shifts in funding rates, disappearing arbitrage opportunities, or reliance on oracles (external price feeds) that could be manipulated can impact both yield generation and the stablecoin’s peg.

Lastly, market volatility risk remains a persistent threat. While synthetic protocols use user cryptocurrencies as reserves, they often employ hedging, yet extreme price swings can test these defenses, leading to liquidations that might cascade. Furthermore, a “bank run” scenario, where numerous users attempt to redeem their synthetic dollars simultaneously, can strain liquidity and put immense pressure on the pegging mechanisms.

How Falcon Finance Mitigates Risks

Falcon Finance, as a synthetic dollar protocol, explicitly acknowledges these risks and has built a framework designed to address them, drawing heavily on transparency, diversification, and robust management.

Firstly, it implements a multi-faceted strategy to mitigate the strategy risk and protect user assets. This is complemented by an active, dual-layered risk management system, which combines automated monitoring with manual oversight to evaluate and adjust positions around the clock. During periods of high volatility, an advanced trading infrastructure allows for strategic risk reduction to preserve assets. The Insurance Fund, backed by a portion of protocol profits, serves as protection against periods of low or negative yields and can function as a last-resort buyer for USDf in open markets, enhancing Falcon’s economic stability.

To address market volatility, especially concerning non-stablecoin assets, the protocol requires overcollateralization. In particular, Falcon Finance applies a certain overcollateralization ratio (OCR), ensuring that minted USDf maintains a crucial buffer by demanding more collateral value than the USDf minted. OCR isn’t static. Rather, it is dynamically calibrated based on factors like asset volatility, liquidity, and market slippage, optimizing for both safety and capital efficiency.

A 7-day cooldown period, applied in Falcon Finance for exchanging USDf back into one of the collateral assets, helps prevent vampire attacks and “bank run” scenarios common in the crypto market.

Falcon Finance also mitigates smart contract risk: the project uses the ERC-4626 standard for its tokenized yield vaults to avoid potential pitfalls of custom-built solutions and benefit from a standard designed with security and composability in mind. This standard incorporates protections against common vault exploits, such as share inflation attacks. Falcon Finance also committed to rigorous, multi-faceted attestations conducted by a leading audit firm HT Digital. These include quarterly Proof-of-Reserve (PoR) audits and ISAE3000 assurance reports to verify operational integrity and asset backing.

Conclusion

The world of stablecoins offers powerful tools for navigating the crypto landscape, but it is not without its hazards. Both traditional, reserve-backed stablecoins and modern synthetic dollars present distinct risk profiles. Centralized models grapple with custodial, regulatory, and single-point-of-failure issues, while decentralized synthetics face challenges related to smart contracts, strategy execution, and market volatility. 

Protocols like Falcon Finance are actively tackling these challenges through innovative design, diversification, and a strong commitment to transparency and security. However, users must remain vigilant, understand the mechanisms behind the tokens they use, and conduct due diligence before engaging with any blockchain protocol.