Volatility has been synonymous with crypto since 2016, with whiplashes of price run-ups and crashes that test the faith of even the staunchest HODLers.
In an attempt to tame the roller coaster results, crypto entrepreneurs developed a unique category of digital currencies called stablecoins. Stablecoin issuers attempt to maintain a stable value by pegging the coin to a reserve asset, such as fiat currency or commodities.
Like all things crypto, the rise of stablecoins has not been, well, stable. In 2022, the Terra-Luna coins collapse wiped out about $40 billion from the cryptocurrency space, earning it the dubious distinction as one of the biggest losses ever in crypto, apart from a general bitcoin sell-off. In March 2023, US prosecutors charged Terra founder Do Kwon for “orchestrating a multi-billion dollar crypto asset securities fraud.”
In spite of the losses, this high-profile failure did not spell the end of stablecoins. Let’s look at an update on stablecoins in the post Terra-Luna era.
Definition and Brief Explanation of Stablecoins
As mentioned above, stablecoins are digital currencies whose issuers peg the value to a stable asset, such as a fiat currency (USD, euro) or a commodity (e.g., gold), or even other cryptocurrencies, to minimize price volatility.
Stablecoins function as both a payment method and a store of value for various DeFi transactions. If and when governments favorably resolve regulatory questions, stablecoins used for purchasing goods and services should broaden. In some countries, stablecoins are already frequently used as a payment method.
The top 5 stablecoins in the US vary depending on market conditions. As the chart below from CoinMarketCap shows, Tether (USDT) and USD Coin (USDC) dominate the market cap rankings as of this writing.
Stabilizing Mechanisms
To make informed decisions about buying or using stablecoins, it’s important to understand that the stabilizing mechanism plays a major role in risk. The further the peg from a stable non-virtual asset like USD or gold, the more the mechanism relies on positive user sentiment to function correctly. The amount of reserves also matters. If users panic, it can cause a fatal run on the coin, as with the Terra-Luna collapse.
Below is a closer look at how issuers try to keep stablecoins stable. Stablecoins fall into three main types based on their stabilizing mechanism:
- Off-chain or fiat-backed stablecoins: These stablecoins are backed by a fiat currency reserve, usually held in a bank account or custodian. For every stablecoin issued, an equivalent amount of fiat currency or dollar-denominated assets is supposed to be held in reserve. Having said that, this is crypto, so there has been some controversy about reserves. Examples of fiat-backed stablecoins include Tether (USDT) and USD Coin (USDC).
- On-chain or cryptocurrency-backed stablecoins: Users lock up a certain amount of a cryptocurrency, such as Ethereum, Bitcoin, or another digital asset, to create crypto-backed stablecoins. The locked-up cryptocurrency acts as collateral to maintain the stability of the stablecoins, and in theory, on-chain stablecoins do not need either an issuer or a custodian to satisfy any claims. MakerDAO’s DAI is a prominent example of a cryptocurrency-backed stablecoin.
- Algorithmic stablecoins: These stablecoins rely on algorithms and smart contracts to maintain stability. The algorithm adjusts the supply of stablecoins based on predefined rules to regulate the price and maintain stability. Terra was, and Ampleforth is, an example of algorithmic stablecoins. Based on past performance, algorithmic stablecoins are the riskiest because part of their stability relies on user beliefs and emotions about the stablecoin’s stability at a given point in time.
Off-chain, or fiat-based stablecoins dominate overall volume, as shown in the blue area of the chart below from the US Federal Reserve Blog. The sharp drop in uncollateralized coins (black area) reflects Terra-Luna’s collapse.
Regulatory and Legal Considerations
The regulatory landscape for stablecoins is evolving, with different jurisdictions taking varying approaches to their classification and oversight. In the United States, stablecoin issuers must comply with existing financial regulations, such as anti-money laundering (AML) and know-your-customer (KYC) requirements.
Currently, US stablecoins are not required to register with the Securities and Exchange Commission (SEC). That may change in the future. In February 2023 the SEC put PAXOS on notice that regulators are considering legal action against the company for operating an unregistered security via their activities as issuer of the Binance coin.
Use Cases for Stablecoins
Stablecoins have many potential use cases across various industries and markets. In developing countries, people use cryptocurrency and stablecoins less as a tradeable asset and more as a hedge against local currency volatility and capital restrictions.
Here are some common use cases for stablecoins:
- Cross-Border Payments: Stablecoins offer a faster, cheaper, and more efficient alternative to traditional cross-border payment systems. With stablecoins, individuals and businesses can bypass intermediaries and settle transactions directly, reducing costs and settlement times.
- Remittances: Stablecoins can significantly improve remittance services, especially for individuals sending money to their families in other countries. Leveraging stablecoins can minimize the high fees and lengthy processing times associated with traditional remittance methods, providing a faster and more cost-effective solution.
- Decentralized Finance (DeFi): Stablecoins are a vital component in the growing DeFi ecosystem. They provide a stable unit of account, medium of exchange, and store of value within decentralized lending, borrowing, and liquidity protocols. Stablecoins enable users to engage in various DeFi activities while minimizing exposure to the volatility of other cryptocurrencies.
- Trading and Arbitrage: Stablecoins can be a reliable base currency for cryptocurrency trading pairs. Traders can quickly move in and out of positions using stablecoins, mitigating the risks of volatile cryptocurrencies. Additionally, stablecoins facilitate arbitrage opportunities between different exchanges, allowing traders to exploit price differences and earn profits.
- Store of Value and Hedging: In countries with high inflation or unstable economies, stablecoins provide a secure store of value. Individuals can protect their wealth by converting their volatile local currency into stablecoins, preserving the value of their assets. Stablecoins also offer a hedge against the volatility of cryptocurrencies, allowing investors to temporarily park their funds in a stable asset during market downturns.
- Microtransactions and Micropayments: Stablecoins are well-suited for facilitating microtransactions and micropayments in various sectors, such as digital content, gaming, and online services. Their low transaction fees and instant settlement capabilities make them ideal for seamless and cost-effective small-value transactions.
- Financial Inclusion: Stablecoins can contribute to financial inclusion by providing individuals in underserved regions with access to digital financial services. They can serve as a gateway for the unbanked and underbanked populations to participate in the global economy, enabling them to make payments, store value, and access financial services.
- Supply Chain and Trade Finance: Stablecoins can streamline supply chain processes by facilitating faster and more transparent transactions between suppliers, manufacturers, and retailers. By digitizing trade finance and utilizing stablecoins for payment settlements, companies can improve efficiency, reduce paperwork, and mitigate risks associated with traditional financing methods.
The “Dollarization” of International Economies
The International Monetary Fund (IMF) has pointed out that economic turmoil incentivizes stablecoin adoption among citizens and businesses located in stressed countries and regions.
While the adoption of stablecoins is still relatively small today, widespread international use of stablecoins pegged to the USD (such as USDT or USDC) could result in the “dollarization” of economies, with both positive and negative consequences.
Another point to consider is if stablecoins pegged to the USD gain global popularity, it would mean that a significant share of cryptocurrency in circulation would be fundamentally influenced, if not controlled, by one central bank, namely the US Fed.
Moving Ahead
As the regulatory landscape matures, stablecoins are already playing a growing role in financial systems across the globe. If you own or trade stablecoins or other crypto assets, ZenLedger can help you simplify your recordkeepng and tax time documentation. Get started for free today!
