Another way to handle convertibility is to issue the stablecoin to buy income-producing assets and hold only a ‘fractional’ reserve of the pegged currency. The gold standard existed in part because the public worried that the value of central bank money would be too volatile without the link to gold. But the central bank’s backing of gold was never one-for-one.
The danger with this fractional reserve method comes when everyone wants to convert their stablecoin back to the pegged currency at once – the equivalent of a bank run which occurs when the number of customers wanting to take back their deposits exceeds what the bank has available.
A bank run doesn’t mean a bank is insolvent rather it doesn’t have enough cash on hand – a liquidity crisis.
Banks have always had to deal with the problem of bank runs and central banks had to deal with them during the period of the gold standard.
To manage this central banks use their official interest rates to discourage withdrawals. With the gold standard, conversions of central bank money meant gold outflows, these flows threatened reserves of gold, so the central bank would respond by raising its discount rate.
Interestingly, some stablecoins come with a supposedly new way of maintaining the price peg, where there is no reserve or convertibility. Instead, algorithms promise to remove the need for convertibility: