Following the astronomical rise of cryptocurrencies, stablecoins have emerged as the next frontier of innovation in digital assets, with the potential to revolutionize monetary transactions across the globe.
In an oversimplified way, stablecoins are the digital equivalent of cash and work both as a store of value and transactional currency. They are based on blockchain infrastructure, the same core technology as cryptocurrencies — granting stablecoins both the security and transparency of cryptos and the stable price action of fiat currencies.
Stablecoins can also reduce the costs of transactions by cutting out the middlemen from today’s payment system, eliminating credit card and cross-border fees.
But central banks and regulators vehemently criticize these digital cash alternatives for posing a risk to the stability of the financial system. U.S. Securities and Exchange Commission chairman Gary Gensler recently likened them to poker chips and also called them potential securities. To explore the complicated regulatory environment around stablecoins, let’s take a look at what these digital assets are and how they compare against fiat currencies.
This Forkast.News explainer looks at:
- What are stablecoins?
- Types of stablecoins
- Pros and cons of stablecoins
- What are some regulators afraid of?
- What is the future of stablecoins?
What are stablecoins?
Stablecoins are cryptocurrencies based on blockchain technology, but just like fiat currencies, they’re tethered to external assets, like dollars, pounds, yuan or gold. This makes their price action consistent with the currency they are pegged against, unlike cryptocurrencies, which can fluctuate by 10% or more on any given day. This gives stablecoins benefits over both fiat and cryptocurrencies.
Stablecoins are versatile digital assets that can be used as a transactional currency, much like cash, and as a store of value. Stablecoins can also be used for lending, providing liquidity and yield-farming in the DeFi space. Thanks to their price stability, they are useful in scenarios where regular cryptos can’t be utilized.
For instance, taking up a mortgage in a cryptocurrency like Bitcoin or Ethereum could end up costing you twice the amount of your house (or half of it) depending on the price action of the respective asset. Whereas a stablecoin-denominated loan is as predictable as the fiat currency it is tethered to.
Stablecoins can be decentralized or centralized, depending on their type. We’ll further explore the types of stablecoins below.
Types of stablecoins
There are four types of stablecoins, mainly based on the assets that are tethered against them, which is the foundation of their price stability.
- Fiat currency-backed stablecoins
Fiat-collateralized stablecoins are currently the most popular type of stablecoins on the market, with stablecoins that claim to be U.S. dollar-backed at the forefront. As the name suggests, these coins use a currency like the U.S. dollar as collateral. Although some stablecoins have claimed in the past to issue tokens in a 1:1 ratio, with a token having the value equivalent of the fiat it is backed against, the truth has turned out to be more complicated and controversial.
Tether’s USDT, for example, is the most popular stablecoin by market capitalization. But Tether is also currently banned in New York after the state Attorney General found that Tether’s parent company iFinex falsified statements on the backing of their stablecoin and in fact did not maintain a 1:1 dollar-to-USDT reserve. An outcry ensued, with some media pointing out, based on Tether’s own disclosures, that cash in fact made up as little as 2.9% of USDT’s reserves. Tether’s more recent court-mandated quarterly disclosure showed that the majority of its reserves were “cash and cash-equivalents” such as commercial paper, certificates of deposit, U.S. Treasury bills and cash, with the remainder of Tether’s reserves a combination that included corporate bonds and crypto.
Circle’s USDC, another popular stablecoin, until recently was only 61% backed by cash and cash-equivalents. But Circle recently announced that USDC would be 100% backed by the U.S. dollar and T-bills.
- Commodity-backed stablecoins
Stablecoins pegged against commodities are backed by hard assets to assure price stability. The assets can include real estate, silver, gold, or a combination of precious metals. Gold is currently the most popular hard asset used as collateral for stablecoins, as well as one of the most trusted assets.
- Cryptocurrency-backed stablecoins
Stablecoins backed by cryptocurrencies are “over-collateralized,” meaning the collateral is worth more than the coin, to cover any potential losses. Simply put, there is a larger number of crypto collateral in the reserve than the issued number of stablecoins, due to the high volatility of cryptocurrencies.
For instance, if a stablecoin is backed by Bitcoin, $1,000 worth of Bitcoin must be held as reserves for issuing $500 worth of the stablecoin, to accommodate price swings up to 50% in the reserve currency.
- Algorithmic (non-collateralized) stablecoins
Non-collateralized stablecoins, also referred to as algorithmic stablecoins, rely on smart contract algorithms for price stability. These algorithms are similar to the criteria employed by central banks in sustaining the correct value of fiat currencies.
Algorithmic stablecoins are built on decentralized blockchains — usually Ethereum — and their consensus mechanism is responsible for increasing or decreasing the token supply, as needed.
The pros and cons of stablecoins
Currently, there are 67 stablecoins in the crypto ecosystem, with a total market capitalization of over US$129.4 billion, according to CoinMarketCap.com, at press time. The explosive growth of this asset class is partly due to the benefits it brings to both investors and the macroeconomy.
We’ll explore the main advantages and disadvantages of stablecoins below.
Pros of stablecoins
- Faster cross-border payments
Since the escrow is streamlined by smart contract algorithms, and the blockchain operates around the clock — as opposed to central financial institutions — payment settlements can be processed 24/7. This makes all financial transactions faster, especially cross-border ones that can take up to five business days using a regular banking network.
- Lower fees
The average credit card processing fee ranges from about 1.3% to 3.5%, plus the payment processor’s cut, forcing small businesses to charge more for credit card payments or exclude them altogether.
Stablecoins cut out all the costs associated with credit card payments by eliminating the middlemen from the transaction, making low-fee, peer-to-peer transactions possible.
Stablecoins are more adaptable to change than fiat currency since they are made up of code. The programmability of these coins enables many new use cases, like the creation of branded stablecoins similar to the Facebook-backed Diem, lending, or customized loyalty and reward programs.
Stablecoins are inherently stable thanks to blockchain, the underlying technology. This ensures secure peer-to-peer transactions through the same cryptographic features and consensus algorithms. For instance, Tether is secured by proof of stake consensus, just like Cardano, DASH, and Tezos.
- Promotes crypto adoption
Stablecoins bridge the gap between fiat and cryptocurrency, especially for people who are new to blockchain technology. They provide an alternative that is easier to understand, making the concept of digital assets more fathomable.
Cons of stablecoins
- Relative stability
Despite their name, stablecoins are only considered relatively stable in terms of price movement. For instance, Tether, currently the largest stablecoin by market cap, previously dropped as low as US$0.57 on March 2, 2015, and surged as high as US$1.32, on July 24, 2018.
- Requires a third-party operator
While crypto-collateralized and algorithmic stablecoins can be decentralized, the vast majority of stablecoins are centralized and require a third-party operator. And while single entity accountability has its advantages in decision-making and implementing updates, it also poses the risk of manipulation.
- Complicated regulatory environment
Stablecoins face regulatory scrutiny from both governments and central financial institutions, due to being disruptive to the fiat system. In addition, stablecoin issuers have to navigate the complexities of both the crypto and fiat regulatory environment.
- Lack of transparency
Except for decentralized, crypto-backed stablecoins, where there is a shared public ledger, the other types of stablecoins lack the inherent transparency of open-source blockchain infrastructure.
As an example, Tether (USDT) previously claimed that USDT was 1:1 U.S. dollar-based. Only after Tether settled a lawsuit with the New York State Attorney General did the company offer greater disclosures on the exact makeup of its reserves in the form of a court-mandated report on a quarterly basis.
- Lack of anonymity
Stablecoin exchanges have stringent KYC (know your customer) regulations, meaning that the identity of stablecoin buyers is verified, going against one of the fundamental principles of cryptocurrency — anonymity.
What are some regulators afraid of?
Despite the beneficial use cases stablecoins bring to the financial system, some regulators fear the explosive growth in stablecoins’ popularity and disruption potential to monetary systems.
Stablecoins first became a regulatory concern in 2019, when Facebook announced its plans for Diem, formerly known as Libra, the social media platform’s own stablecoin. Diem had a rough reception from the U.S. Congress, as Democratic Rep. Maxine Waters requested that “Facebook agree to a moratorium on any movement forward on developing a cryptocurrency until Congress and regulators have the opportunity to examine these issues and take action.”
Diem is now in development as a U.S. dollar-pegged stablecoin, having faced strong regulatory headwinds every step of the way. The People’s Bank of China has also articulated its concerns over the potential risks of stablecoins to global financial systems, as deputy governor Fan Yifei said in a briefing that global stablecoins could bring risks and challenges to international monetary mechanisms and clearing systems.
So why are regulators so hostile to this new class of cryptocurrency?
For one, central institutions are concerned about stablecoins diminishing or replacing their national currencies, which could ultimately endanger the stability of fiat money.
Second, stablecoins aren’t just a threat to the current payment system, but endanger governments’ monopoly over issuing new currency. Most governments around the world are now researching or actively developing their own central bank digital currencies, and stablecoins — which can play a similar role in the economy — could be a threat to that.
Last but not least, the stablecoin industry itself was spooked by the “bank run” that recently caused Iron Finance’s collapse shaking the confidence of investors and exposing a major vulnerability in the price stability of algorithmic stablecoins. On June 17, 2021, Iron Finance’s TITAN dropped from US$64.19 to US$0.000000015109, in a single day. The price of IRON (one of TITAN’s pegs) has dropped from its US$1 peg to US$0.61, just as the price of TITAN started to fall, causing whales to start selling and TITAN’s peg destabilizing. Due to Iron Finance’s poor tokenomics, the project that once had over US$2 billion in total value locked, is now inactive and working on rebuilding the IRON V2.
What is the future of stablecoins?
Despite concerns, regulators may be coming to terms with stablecoins and their potential to reinvent the current financial system. Corporations are also increasingly embracing stablecoins or stablecoin-like financial products and services.
In an effort to regulate the stablecoin industry, U.S. lawmakers proposed the STABLE act in December 2020 — a bill requiring all stablecoins to be 1:1 dollar-backed. “Digital currencies, whose value is permanently pegged to or stabilized against a conventional currency like the dollar, pose new regulatory challenges while also represent a growing source of the market, liquidity, and credit risk,” the bill’s three Congressional sponsors, Rep. Rashida Tlaib, Rep. Jesús “Chuy” García, and Rep. Stephen Lynch said in a joint statement at the time.
In September 2020, the European Union published a proposal for regulations on stablecoins, requiring them to be registered — as the advent of global stablecoins is seen as a potential catalyst for the growth of the crypto market. At press time, the proposal hasn’t been passed.
In Asia, regulations over stablecoins run the gamut. While China prohibits the buying and selling of any cryptocurrency, including stablecoins, the Bank of Thailand recently outlined a framework for regulating stablecoins.
In the meanwhile, corporations are also now dabbling with stablecoins to create frictionless, low-fee digital payments. Besides Facebook’s experiments with Diem, retail giant Walmart is also planning to patent a stablecoin. The “Walmart Coin” is designed as an alternative for low-income households that find banking services expensive.