Stablecoins are one of the newest hot spots on the crypto market. They have the potential to enhance the efficiency of the provision of financial services including payments, and to promote financial inclusion. They might offer a new way to transact and
retain value, starting to redefine modern finance. We all have seen their incredible growth in 2020 and 2021 under the DeFi market influence as I described in my former blog. Stablecoins however bear a number of risks that could harm. They are not that stable
as is suggested. And think of the systemic risks when stable coins are being used all over the world. Disruptions in the value of a stablecoin could not only have damaging impact on the broader crypto market, but also on the real financial world, unless regulators
step in. Main question is: what kind of regulatory oversight would work best without harming innovation?
What are stable coins?
Stablecoins are a type of cryptocurrencies that are pegged to and/or backed by the underlying real-world assets what can be anything from fiat money, commodities or even another cryptocurrency. Like their name suggests, stablecoins are designed to have value
that stays (rather) stable with traditional currencies or the underlying commodities. Many stablecoins are collateralized at a 1:1 ratio with their peg, which can be traded on exchanges across the world.
Stablecoins have been created to overcome the price volatility of crypto currencies such as Bitcoin or Tether, which stems from the fact that there is no robust mechanism to determine their real-world value. Given high levels of distrust in those cryptocurrencies,
investors tend to resort to safer options like stablecoins. These may leverage the benefits of cryptocurrencies and blockchain without losing the guarantees of trust and stability that come with using fiat currencies. Currently, there are more than 200 stablecoins.
At the time of writing of this blog the total value of stablecoins issued on public blockchain networks has surpassed $110 billion, compared to $28 bn at the start of 2021, which reflects the high institutional and retail demand in unstable times.
Types of stable coins
Based on design, we can split stablecoins into a number of major types: fiat-collateralized, crypto-collateralized, commodity-collateralized, and algorithmic or non-collateralized.
Fiat-collateralized stablecoins are the simplest and most common type. They are pegged to fiat currencies like the US dollar or the Euro, and usually backed at a 1:1 ratio, by holding a basket of dollar- or euro-denominated assets. This means that for each
of such stablecoin in existence, there is a fiat currency in a bank account. Traders can exchange their stable coins and redeem their dollars directly from the exchange at any time. The most popular fiat-collateralised stablecoins are Tether (USDT) (market
cap $62 bn) and USD Coin (USDC0 (market cap $ 27,3 bn).
These are stablecoins that are backed by commodity assets, like precious metals, gold, silver, real estate, or oil. This theoretically indicates to investors that these stablecoins have the potential to appreciate in value in parallel with the increase in value
of their underlying assets, thereby providing an increased incentive to hold and use these coins. One example of these stablecoins is PAX Gold (PAXG) (market cap $330 mio), that relies on a gold reserve.
Another type are crypto collateralized stablecoins. These are pegged to other cryptocurrencies as collateral. Because the crypto values themselves are not stable, these stablecoins need to use a set of protocols to ensure that the price of the stablecoin
issued remains at $1. They are often collateralized by a diversified reserve of cryptocurrencies that can sustain shocks and yet remain stable. Another mechanism involves over-collateralization, which means for a crypto-backed stablecoin that is pegged 1:2,
for each stablecoin, cryptocurrency worth twice the value of stablecoins will be held in reserve. Since everything occurs on the blockchain, these crypto-backed stablecoins are much more transparent, have open source codes, and can be operated in a decentralized
manner, unlike their fiat-backed counterparts. However, they are also more complex to understand, and therefore lack popularity. The most popular crypto-backed stablecoin is Dai (market cap $56.8 mio), created by MakerDAO, whose face value is pegged to the
US dollar, but is collateralized by Ethereum.
Algorithmic or non-collateralized Stablecoins
A fourth class are so-called algorithmic stablecoins, also known as non-collateralized stablecoins. This is a very different design as it is not backed by any collateral. It operates in the way fiat currencies work, in that it is governed by a sovereign
such as a country’s Central Bank. Given the evident difficulties these stablecoins have at maintaining value stability their usefulness is limited.
Algorithmic stablecoins use total supply manipulations to maintain a peg. The basic mechanism is creating a new coin, setting a peg, and then monitoring the price on the exchange. This can be done algorithmically, in a decentralized way, with open source
code that is visible and auditable by everyone. This so-called rebasing is a speculative investment asset where the probability of gain and the probability of loss are both greater than zero. A second category of algorithmic stablecoins are coupon-based coins.
The difference from rebasing coins is that holders don’t see their number of tokens change unless they do specific actions. The downside, however, is that coupon-based coins seem to be much more unstable. Some of the more known ones include Ampleforth (AMPL),
Based, Empty Set Dollar (ESD) and Dynamic Set Dollar (DSD).
How do stablecoins work?
Some central stablecoins, such as Tether, require a custodian to regulate the currency and then reserve a certain amount of collateral. Tether holds the US dollar in a bank account. The amount held must be equal to what they issue to maintain the order of the
system. In this way, price fluctuations should be prevented. However, there are other stable decentralized cryptocurrencies, such as the crypto-backed stablecoin Dai that achieve this goal without a central authority figure. They use smart contracts on the
Ethereum blockchain to manage the collateral and maintain order. Stablecoins automatically adjust the number of tokens in circulation to keep the price stable. This means that the value of stable coins should (in theory) not fluctuate frequently, as in normal
Why are stablecoins used?
Stablecoins are used in the crypto market for a number of reasons. Crypto currency owners may turn profits into stablecoins in the short term with the intention of investing in other cryptocurrencies when opportunities arise, rather than turning profits into
fiat money and transferring them to their bank account.
Stablecoins are also invested in cryptocurrency exchanges or decentralised finance (DEFI) applications to return interest and yield. Investing in crypto currency exchanges in particular offers a safe and attractive alternative to traditional savings methods
offered by legacy finance. They empower more people to harness the benefits of the blockchain without the risk of large market fluctuations. In the event of a local fiat currency crashing, people can easily exchange their savings with US dollar backed or Euro-backed
or even gold-backed stablecoins, thereby preventing the further depreciation of their savings.
Where are stablecoins used?
With the growing number of stablecoins the use cases keep growing.
Switch between volatile cryptocurrencies and stablecoins
Stablecoins are most popularly used to quickly switch between a volatile cryptocurrency and a stablecoin, while trading, to protect the value of holdings. They provide traders with a ‘safe harbor’, which allows them to reduce their risk to crypto-assets
without the need to leave the crypto ecosystem.
Allow the use of smart contracts
Stablecoins allow for the use of smart financial contracts that are enforceable over time. These are self-executing contracts that exist on a blockchain network, and do not require any third party or central authority’s involvement. These automatic transactions
are traceable, transparent, and irreversible, making them an ideal tool for salary/loan payments, rent payments, and subscriptions.
Because these stablecoins are seen as relatively less volatile compared to other cryptocurrencies like Bitcoin and Ether, the idea is that stablecoins might be more widely accepted in mainstream commerce. Consumers, businesses and merchants would therefore
be more comfortable with using stablecoins as true units of exchange.
Stablecoins allow payers to get as close to the benefits of cash as possible. Stablecoins are freely transferable just like cash; anyone on the blockchain network can receive and send coins. The coins are structured as bearer instruments, giving the holder
the rights to redeem the coins for US dollars at any time. This is especially relevant in the decentralized finance (DeFi) segment, where stablecoins play an important role to enable the ecosystem. Mainstream applications with stablecoins are also picking
up in cross-border payments, where they are being used to facilitate cross-border trade and remittances.
Risks of stable coins
While stablecoins have the potential to enhance the efficiency of the provision of financial services, they may also generate risks to financial stability, particularly if they are adopted at a significant scale. Some stablecoins are actually riskier than
they may seem. Stablecoins may bear risks in terms of asset contagion, collateral and accountability. We also shouldn’t ignore the risks that stablecoins potentially pose to the financial system in terms of systemic risks thereby undermining sovereign currencies.
Not all stablecoins are stable
Notwithstanding their name and the suggestion that their value is quite stable, not all stablecoins are really 100 percent price-stable. Their values are dependent on their underlying assets. Stable coins can only be truly stable if they are 100% backed
by cash. The reason for that is that the issuers of fiat-collateralized stablecoins need to manage the supply of their coins through issuing and redeeming to ensure the value of their coins maintains roughly 1-to-1 with the fiat currency. This stands true
for commodity-backed and crypto-backed stablecoins as well. The promise can only work if the stablecoin issuer properly manages the reserves. Since cryptocurrency prices can fluctuate violently, crypto-backed stablecoins are more susceptible to price instability
than other collateralized stablecoins.
Asset contagion risk
The rapid growth of stablecoin issuance could, in time, have implications for the functioning of short-term credit markets. Certain stablecoins are today’s economic equivalent of money-market funds, and in some cases their practices could lead to lower
values, creating significant damage in the broader crypto market. There are potential asset contagion risks linked to the liquidation of stablecoin reserve holdings. These risks are primarily associated with collateralised stablecoins, varying based on the
size, liquidity and riskiness of their asset holdings, as well as the transparency and governance of the operator.
Fewer risks are posed by coins that are fully backed by safe, highly liquid assets.
One of the most known and most widely traded stablecoin is Tether. Each Tether token is pegged 1-to-1 to the dollar. But the true value of those tokens depends on the market value of its reserves. Tether has disclosed that as of 31 March it held only 26.2%
of its reserves in cash, fiduciary deposits, reverse repo notes and government securities, with a further 49.6% in commercial paper (CP).
Also further collateral consequences, particularly because the recent rise in crypto prices, has been fuelled in significant part by debt. It is questionable whether stablecoins could liquidate sufficient investments quickly to satisfy the demand if needed.
The consequences of such an inability to meet a sudden wave of withdrawals could be significant in the larger crypto ecosystem.
Lack of accountability
The drawback of fiat-collateralized stablecoins is that they are not transparent or auditable by everyone. They are operated just like non-bank financial intermediaries that provide services similar to traditional commercial banks, but outside normal banking
regulation. They therefor may escape accountability. In the case of fiat-backed stablecoins traders need to blindly trust the exchange or operator to trade in these currencies or try to find and examine out its financial disclosers by…
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