What Are Stablecoins?

 

Crypto-currencies have been around for over a decade, but they still haven't made it into mainstream commerce. One reason for this is volatility: the value of crypto-currencies is often determined by rampant speculation.

Crypto-currency investors have become millionaires overnight, only to lose much of their fortune a few weeks later. 

While this can be exciting to see, it also shows the unreliable nature of popular cryptocurrencies like bitcoin - especially as a means of payment for goods and services.

Stablecoins are designed to have a much more fixed value than normal crypto-currencies.

The idea is that stablecoins can enjoy the benefits of crypto-currencies without the extreme volatility associated with them, which would go a long way towards crypto-currencies being seen as a viable way to buy something. 

After all, most businesses aren't interested in accepting a payment method whose value could crash the next day. 

If traditional crypto-currencies are like investing in a high-risk stock, stablecoins are like withdrawing money from an ATM.

And demand for stablecoins is booming: From October 2020 to October 2021, the total value of stablecoin assets increased by about 495 percent, according to The Block.

This reflects the momentum of the so-called "stablecoin invasion." There are now more than 200 stablecoins in the world, representing a market of nearly $130 billion. 

In addition, two stablecoins backed by the USD, the Paxos Standard (PAX) and the Gemini Dollar (GUSD), have been approved and regulated by the New York State Department of Financial Services.

Financial services incumbents are also paying attention to this opportunity - JPMorgan Chase, for example, has piloted and launched a stablecoin, JPM Coin, for its corporate clients.

 Moreover, a January 2021 survey of central banks found that two-thirds of respondents are actively exploring the potential impact of stablecoins on financial stability.

Yet, despite supposedly responding to the volatility of crypto-currencies, stablecoins are now under scrutiny, with U.S. and Chinese regulators claiming they pose a serious risk to financial systems.

In this article, we take a look at stablecoins, from what they are to why they are emerging as a disruptor in the crypto-currency space, to why the pressure is growing to tighten regulation of these digital currencies. We also analyze the different types of stablecoins, as well as their applications and limitations.

What are stablecoins?

Stablecoins - in the form of a digital currency - aim to mimic traditional currencies.

A stablecoin is typically a crypto-currency that is backed by the value of an underlying asset. The nature of that underlying asset varies from coin to coin, and we'll get into that later in this article.

Many stablecoins are linked to certain fiat currencies, such as the U.S. dollar or the euro, at a 1:1 ratio and can be traded on exchanges. 

Other stablecoins are linked to other types of assets, such as precious metals like gold or even other crypto-currencies.

Why use stablecoins?

Stablecoins are not subject to the extreme price volatility that many other cryptocurrencies are affected by.

In 2010, for example, a programmer bought a pizza for 10,000 bitcoins, worth about $688 million at bitcoin's peak in November 2021. 

On the other hand, any merchant who accepted those bitcoins at that record price would have lost over $200 million by the end of the year.

As a result, many businesses are skeptical of crypto-currency as a viable payment method. Microsoft, for example, began accepting bitcoin as a payment method in 2014, before temporarily halting it in 2018 due to volatility. Online gaming platform Steam was forced to do the same.

Stable currencies, meanwhile, aim to gain the potential benefits of crypto-currencies - such as transparency, security, immutability, and decentralized control - without losing the safeguards and stability that come with using fiat currency.

Initially, early crypto-currency holders used stablecoins as a safe haven in the event of a market decline or crash.

 If the price of bitcoin began to fall rapidly, a holder could convert his or her bitcoin into a stablecoin within minutes on a single platform, avoiding potentially massive losses.

Without this option, the crypto-currency holder would have had to transfer their capital into fiat currency. 

Yet, many crypto-currency exchanges do not allow fiat on their platform or charge significant fees on the transfer into fiat.

But stablecoins hold promise in other emerging applications. For example, they could benefit industries and individuals who need to make international payments quickly and securely, from migrant workers sending money to their families to large companies looking for a cheaper way to pay their foreign suppliers.

Stablecoins could also be used in the financial services ecosystem.

But before we dive deeper into the use cases, we need to understand the different types of stablecoins.

STABLECOINS BACKED BY FIAT CURRENCY

The most common type of stablecoin is backed - or backed by - fiat currency.

Stablecoins backed by fiat currency are backed at a ratio of 1:1, which means that one stablecoin is equal to one unit of currency. 

Thus, for every stablecoin that exists, there is (theoretically) one real fiat currency held in a bank account to back it.

When a person wishes to exchange money for their coins, the entity managing the stablecoin takes the amount of fiat currency in its reserve and sends it to the person's bank account. 

The equivalent stablecoins are then "burned" or permanently removed from circulation.

Fiat-backed stablecoins are about the simplest structure a stablecoin can have, and the simplicity has great advantages. It's easy to understand for anyone new to crypto-currencies - which, in turn, can allow for wider adoption.

As long as the economy of the country to which a stablecoin is pegged remains relatively stable, the value of a pegged coin shouldn't fluctuate much either.

However, while stablecoin issuers backed by fiat currency usually claim that their crypto-currency is backed by fiat currency at a 1:1 ratio, this is not always true. 

The stablecoin issuer may place its cash reserves in other assets, such as corporate bonds, secured loans, or investments.

This has been the case with Tether (USDT) and USD Coin (USDC), the most popular stable currencies backed by the dollar. 

Both have generated controversy in recent years as their claims of a 1:1 stablecoin/fiat ratio have come under scrutiny.

An investigation by the Commodity Futures Trading Commission (CFTC) found that from 2016 to 2019, Tether falsely claimed to have held an equivalent amount of fiat currency for every USDT. In October 2021, the CFTC fined Tether $41 million.

Tether's certification report shows that only 10% of its reserves were cash and bank deposits at the time, a far cry from a 1:1 ratio.

A similar controversy surrounds USDC, which is run by a consortium that includes digital currency company Circle and cryptocurrency exchange Coinbase. 

The USDC's issuers have claimed that it is "always exchangeable 1:1 for U.S. dollars" and fully backed by U.S. dollars held in a bank account. However, Circle revealed in July 2021 that only 61% of USDC reserves were in cash and cash equivalents, with the remainder in certificates of deposit, U.S. Treasury bills, commercial paper, corporate bonds, and municipal bonds. 

The following month, the Circle announced that USDC reserves would now include only cash and U.S. Treasury bonds.

Despite these issues, demand for both stablecoins remains high - USDT is the third-largest cryptocurrency by market capitalization as of January 2022, behind bitcoin and Ethereum.

In fact, both currencies have captured more than two-thirds of the stablecoin market, with USDC steadily reducing USDT's market share.

Some stablecoin issuers have undergone strict regulatory oversight in order to guarantee their customers their cash reserves.

This is the case with the Pax Dollar (USDP) and the Gemini Dollar (GUSD), two stablecoins backed by the dollar that are regulated by the New York State Department of Financial Services.

 The issuers of both coins publish monthly audits of their reserves which are verified by independent accounting firms.

There are many other stablecoins backed by fiat currencies around the world. In Singapore, payment processor Xfers has launched the XSGD stablecoin, which is backed 1:1 by the Singapore dollar. 

In Europe, the EURS token from tokenization platform Stasis is backed by the euro.

STABLE CURRENCIES BACKED BY COMMODITIES

Commodity-backed stable currencies are backed by other types of interchangeable assets. The most common commodity is gold. However, there are also stablecoins backed by oil, real estate, and various precious metals.

Holders of stablecoins backed by commodities are essentially exposed to the value of a real-world asset. 

These assets have the potential to appreciate - or depreciate - over time, which can affect the incentives to trade these coins. 

Stable commodity-backed coins are sometimes marketed as a way to open up certain asset classes, such as real estate, to small investors.

COLLATERALIZED STABLECOINS

These are stablecoins backed by other cryptocurrencies.

In theory, this allows stablecoins backed by crypto-currencies to be more decentralized than their fiat-backed counterparts, since everything is done using blockchain technology.

To reduce the risks associated with price volatility, these stablecoins are often over-collateralized to absorb price fluctuations in the collateral.

For example, to get $500 worth of stablecoins, you need to deposit $1,000 worth of Ether (ETH). In this scenario, the stablecoins are now 200% collateralized, and even if the price drops 25%, the $500 of stablecoins is backed by $750 of ETH. They are often backed by multiple crypto-currencies to spread the risk.

They can also allow for more liquidity than commodity-backed stablecoins, as they can be quickly converted into their underlying asset.

Crypto-currency-backed stablecoins are a relatively complex form of stablecoin and have not gained as much traction as other approaches.

The most popular example of a stablecoin backed by crypto-currencies is Dai.

Created by MakerDAO, Dai is a stablecoin with a face value set to USD but was originally designed to be backed by ETH that is locked into smart contracts.

Like the USDC, Dai has become crucial for many Defi applications. Due to its decentralized nature, anyone can generate, buy or sell Dai. 

Developers, in particular, can easily create decentralized applications, or dApps, on the Ethereum blockchain using Dai as a stable medium of exchange.

However, Dai is infamous for Black Thursday, a black swan event in March 2020 where a momentary spike in its price (triggered by the confluence of an ETH price crash and a gridlocked Ethereum network) led to $8 million worth of liquidations for zero Dai.

MakerDAO seems to have learned the dangers of relying solely on volatile crypto-assets. It is now diversifying its collateral base to include stable currencies like the USDC and "real-world assets. 

Confidence in stablecoin has since rebounded - Dai's market capitalization increased 800% between September 2020 and September 2021, and it remains one of the five most popular stablecoins globally.

Jarvis Network's jFIATs, which track the price of their respective currencies against the U.S. dollar and are backed by the USDC, are another stablecoin backed by cryptocurrencies. For example, $100 (about £75) of jGBP would be equivalent to 100 USDC.

There are several jFIATs, each functioning as a digital version of a fiat currency, including the euro, Canadian dollar, Swiss franc, and others. 

These coins can be used on Polygon, a protocol that allows developers to create and connect Ethereum-enabled blockchain networks.

UNSECURED STABLECOINS

Unsecured stablecoins are not backed by anything, which may seem counterintuitive given what stablecoins are. 

Remember that the U.S. dollar used to be backed by gold, but that ended decades ago and the dollar remains perfectly stable because people believe in its value. The same idea can be applied to unbacked stablecoins.

These types of coins use an algorithm-driven approach to control the supply of stablecoins. This model is known as seigniorage shares.

When demand increases, new stablecoins are created to bring the price down to the normal level. If the price of the coin is too low, coins are purchased on the market to reduce the supply in circulation. 

In theory, the prices of these stablecoins would remain stable, as they are determined by supply and demand in the market.

This is the most decentralized form of stablecoin, as it is not backed by any other asset.

However, unsecured stablecoins require continued growth to succeed. In the event of a major crash, there is no guarantee that the coin can be liquidated.

One example is Ampleforth, which launched its AMPL token in late 2018. Ampleforth's algorithms adjust the supply of AMPL daily based on demand to avoid the volatility of fixed-supply cryptocurrencies. 

If demand increases, the Ampleforth protocol will increase the supply of AMPL to restore the balance between price and supply.

A new alternative model is to use an algorithm and associated reserve token to link the stablecoin to the US dollar, instead of using silver reserves. 

These stablecoins are considered decentralized because they do not rely on a single entity to hold the collateral.

Are unsecured destined to fail?

Despite the safeguards built into the design of these coins, some critics argue that algorithmic stablecoins backed by secondary tokens rather than other assets are "built to fail."

 When the price of a stablecoin drops, investors may panic and sell. In the process, they hit more tokens, which reduces their value and makes a bank attack more likely. 

This in turn causes the value of the stablecoin to fall, leading to a cycle known as the "death spiral. When stablecoin and its Titan token fell victim to this spiral, the value of the token dropped to almost zero.

Making stablecoin useful in everyday life would help protect it from such a scenario, as demand would be less likely to collapse quickly. 

That's the premise of Terra, an algorithmic stablecoin with Luna tokens as the collateral asset. Both are developed by Terraform Labs.

An algorithmic market module encourages users to burn or monetize Terra to keep it at its target price. For every Earth minted, a corresponding Moon is burned and vice versa, helping to keep the value of the stablecoin near-constant. 

The higher the demand for the Earth, the higher the value of the Moon.

Use cases are driving adoption, and Terraform Labs has integrated many useful features into the Terra ecosystem. 

Chai, its payment system, reportedly processes more than $1 billion annually and has about 2.5 million users in 2020. 

 For businesses, Chai has an API that allows e-commerce sites to accept various payment options. In both cases, the currency is converted to land, which is transferred to the recipient on the blockchain and converted back to fiat currency.

This allows Chai to offer lower processing fees than some traditional payment processing systems. 

It also means that consumers may not even know they've used a stablecoin - much less need to understand how it works - when paying for a cup of coffee or an online purchase.

CENTRAL BANK DIGITAL CURRENCY

 Central Banks Digital Currency,  CBDCs are not generally considered stable currencies, but depending on their use, they may serve a similar function; it has even been speculated that stable currencies and CBDCs may coexist in the long run.

Since CBDCs are issued, controlled, and regulated by a central bank or national monetary authority, they can be exchanged 1:1 for the equivalent of fiat currency and are likely to be legal tender. 

According to the International Monetary Fund (IMF), CBDCs can help reduce the cost of cash transactions and promote financial inclusion, as people do not need to have a traditional bank account to use these digital currencies.

At least nine countries have already introduced their own CBDCs, 14 have launched pilot programs, and others are conducting studies on the concept.

One of the officially launched CBDCs is the Nigerian eNaira. It is based on blockchain technology and can be used by anyone with an eNaira wallet. 

The Nigerian central bank has suggested that the introduction of the eNaira could boost remittances, cross-border trade, and financial inclusion. 

It could also increase tax collection, as informal payments would be more transparent, with transactions much easier to track than cash.

Meanwhile, China has begun large-scale testing of its digital yuan, also known as e-CNY. As of October 2021, some 140 million people had conducted transactions worth 62 billion yuan ($9.7 billion) in e-nyat. 

With the issuance of the CBDC, the country hopes to increase the use of yuan worldwide and reduce the costs of cross-border payments.

Real-world applications

Stable parts have many potential applications in the real world. Here are some examples.

EVERYDAY CURRENCY

Well-designed Stablecoins can be used for commerce like any other currency.

In South Korea, consumers can pay for their morning coffee with tea. Crypto-currencies can also be used as a channel to introduce stablecoins for everyday consumption. 

For example, Visa and Mastercard have issued debit cards that allow transactions in U.S. dollars.

Stablecoins can also be used for overseas money transfers, as there is no need to convert different fiat currencies. 

Residents of India can receive Stablecoins backed by U.S. dollars without having to convert them to rupees and without losing interest charges.

OPTIMIZE RECURRING AND P2P PAYMENTS

Stablecoins also enable smart financial contracts that can be applied over time.

Smart contracts are self-executing contracts that exist on the blockchain network without the need for a third party or central authority to enforce them. 

These automated transactions can be traceable, transparent, and irreversible, making them suitable for paying salaries and loans, rents and subscriptions.

For example, an employer could set up a smart contract that automatically transfers stablecoins to its employees at the end of each month. 

This is especially beneficial for companies with employees around the world, as it avoids the high cost and multi-day process of transferring and exchanging fiat currency, for example, from a bank account in New York to an account in China.

In another scenario, a smart contract could be set up between a landlord and a tenant to automatically transfer rent payments on the first of each month.

The same idea could be applied to automatic loan payments or monthly fees, such as those for gyms.

FAST AND CONVENIENT MONEY TRANSFERS FOR MIGRANT WORKERS

In today's world, many migrant workers rely on companies like Western Union to send money to their families and loved ones. 

This can be a time-consuming and expensive process, and families end up losing much of their funds due to high fees.

Crypto-currencies offer the possibility of fast transactions and low fees, but the problem remains that a crypto-currency like bitcoin can experience large fluctuations in value overnight.

Stable currencies, however, may be a better alternative. Workers and their families around the world could use digital wallets to receive stablecoins from anywhere in the world almost instantly, with low fees and no price fluctuations.

With billions of dollars transferred around the world every year, this is a massive use case for Stablecoins.

This is the primary use case for Meta's (Facebook) Novi crypto-currency, which launched with a pilot program to transfer money between users in the United States and Guatemala. 

Currently, Novi uses PAX, but the company says it will launch its own stablecoin, Diem, once regulators approve it.

Banks themselves can also push for the introduction of stable currencies for this purpose. South Korea's Shinhan Bank and South Africa's Standard Bank are currently testing a proof of concept for the use of stablecoins for cross-border money transfers.

Projects like this will help determine the extent to which stablecoins are accepted by the public and how profitable this use case can be in the real world.

PROTECTION AGAINST CURRENCY COLLAPSE AND MARKET VOLATILITY

In the event of a loss of value of a fiat currency, citizens could quickly exchange their collapsing currency for relatively safe stablecoins backed by dollars, euros, or even gold, thus protecting themselves against further losses in value.

Stable currencies could also offer protection in the event of global market volatility. The uncertainty of the Covid 19 economic crisis, for example, has increased demand for stable digital assets, especially as more volatile cryptocurrencies like bitcoin have seen their value drop in the short term in response to initial blockades.

IMPROVING CRYPTOCURRENCY EXCHANGES

Currently, few crypto-currency exchanges support fiat currencies due to strict regulations.

 However, the use of stablecoins allows exchanges to bypass this problem and offer crypto-currency trading pairs by simply using a stablecoin backed by USD instead of actual dollars.

This promotes the general acceptance of crypto-currency trading, as it makes the process of acquiring crypto-currencies easier for newcomers and they can still think in terms of dollars or euros, rather than the constantly fluctuating value of bitcoin.

HUMANITARIAN AID

In crisis situations, Stablecoins can be a fast and cost-effective way to send humanitarian aid to another country. 

Because they can be tracked through the blockchain, stablecoins can also improve the transparency and accountability of donations. (Learn more in our explanation of what blockchain is).

In June 2020, the nonprofit Grameen Foundation sent emergency cash aid to entrepreneurs in the Philippines. 

During the community-wide lockouts, it was difficult for recipients to claim cash due to restrictions on people's movement that made it difficult to withdraw money from banks and money transfer centers.

 Instead, the foundation used Celo stablecoins to send financial support totaling nearly $160,000 to at least 730 entrepreneurs.

However, stablecoins are not a panacea for the problems of cross-border humanitarian aid. The World Economic Forum (WEF) points out that intended users of these "humanitarian stablecoins" may lack digital literacy, access to digital tools, or even an Internet connection. 

And although some humanitarian organizations have floated the concept of a global stable currency to be used for aid, the WEF warns that this could centralize aid delivery, widening the gap between large organizations with extensive resources and their smaller, local counterparts.

FACILITATING DECENTRALIZED CURRENCY TRADING.

In September 2020, Waves. The exchange introduced decentralized foreign exchange (DeFo) trading. There are at least 10 stablecoins on the platform, including the U.S. dollar, British pound, Turkish lira, and Brazilian real.

Unlike traditional forex trading, which opens at specific market hours and can take a while to settle transactions, Waves. Exchange's platform is open 24/7 and promises instant trading.

Stable currencies have their limits.

The Tether scandal is an example of how a stable currency can go wrong. Currency-backed stable currencies are centralized, which means they are managed by a single entity. 

Thus, one must trust that this entity actually backs its stable currencies with real fiat money.

To address this trust issue, stable currencies could adopt approaches such as regular third-party audits to increase transparency. 

Stable currencies backed by fiat money are also subject to all the regulations that come with fiat money, which affects the efficiency of the exchange process and the potential efficiency of the digital asset. 

For example, Facebook's Libra currency promised a stable currency backed by a basket of global fiat currencies, broadening the coin's appeal and utility.

 However, it received so much flak from regulators that project leaders abandoned their goal of multiple currencies, distanced themselves from Facebook, and changed the brand name. To this day, the network is still struggling to get regulators to approve its own stable currency.

Due to their more regulated nature, stable currencies may also have less liquidity than ordinary cryptocurrencies.

This is especially true for commodity-backed stablecoins. For example, if you wanted to get your real gold bars one day, it could take months and require an expensive trip to a physical vault.

Plus, there is always the risk that the value of the underlying asset could collapse.

Think of "Black Wednesday" in the U.K. in 1992 or the ruble crisis in Russia in 1998. If such an event occurs for the fiat to which a stablecoin is pegged, it would be devastating for that stablecoin as well.

Stablecoins pegged to cryptocurrencies also have their own problems.

Their peg to other cryptocurrencies makes them much more vulnerable to price instability than stablecoins backed by fiat or commodity currencies.

They are tied to the health of a particular cryptocurrency (or combination of cryptocurrencies), meaning that if that cryptocurrency falls sharply, the stablecoin will eventually suffer the same fate. If prices fall, they will automatically be liquidated in the underlying cryptocurrency.

This is another disadvantage of stable currencies backed by cryptocurrencies: They are difficult to understand, which significantly increases the risk of unexpected events for the people who hold them.

Finally, while stable currencies offer the potential to streamline financial services, they are likely to face resistance from local governments. 

For example, in a country with high inflation, the government may seek to block stable currencies pegged to foreign currencies in order to protect demand for the local currency.