A stablecoin is a cryptocurrency that is pegged to another currency, commodity or asset. The most widely used stablecoins are pegged to the US dollar. This means, one stablecoin should be worth $1.
Stablecoins combine the digital and borderless nature of cryptocurrencies with the low volatility of traditional fiat currencies. However, stablecoins come with risks and face increased scrutiny from regulators.
As the name suggests, a stablecoin is a cryptocurrency with a stable value. Bitcoin and other cryptocurrencies are traditionally very volatile. This means, their exchange rates with other currencies like the US dollar fluctuate significantly.
Bitcoin traded as low as $4,000 in March 2020. In November 2021, its price shot up to around $69,000. TradingView “Bitcoin / U.S. Dollar” Accessed May 23, 2022. On any given day, bitcoin’s exchange rate with the US dollar might increase or decrease by 10%.
This volatility provides bitcoin with attractive upside potential. Proponents of bitcoin argue that despite its volatility, it is a great long-term store of value and hedge against inflation.
Those that believe bitcoin will one day act as a currency point out that its volatility might subside once its adoption increases. To serve as money in everyday transactions bitcoin must act as store of value, medium of exchange and unit of account.
Stablecoins aim to bridge this gap by pegging the value of a stablecoin to the value of the fiat currency that people already use as a medium of exchange.
The question then is, why not just use the fiat currency outright as medium of exchange? The reason someone would choose to use a stablecoin over a traditional fiat currency is that stablecoins are fully digital.
Unlike the US dollar, Euro, yen or Swiss Franc, which rely on traditional payment networks like SWIFT, stablecoins use public-key cryptography and distributed ledgers to enable digital transactions.
This means, stablecoins allow the transfer of fiat currencies over alternative payment networks. Instead of holding 1 US dollar in a bank account, someone can buy a stablecoin like Tether (USDT) and hold and transfer value outside of the traditional banking system.
These cryptocurrencies don’t experience the same volatility as other cryptocurrencies. Proponents of stablecoins argue that this makes them more suitable as medium of exchange.
Tether (USDT) is the largest stablecoin by market cap. At the time of writing this, it is the third largest cryptocurrency by market cap. CoinMarketCap “Today’s Cryptocurrency Prices by Market Cap” Accessed May 23, 2022.
Tether is pegged to the US dollar. According to its own reports, it backs each USDT with a certain amount of US dollars as well as other reserve assets. In theory, if a sufficient equivalent of dollars back each stablecoin unit, the peg doesn’t break even in the case of a run on the stablecoin.
Similar to a bank run, a run on a stablecoin can occur when many stablecoin holders redeem their coins for US dollars at the same time. If a stablecoin issuer doesn’t sufficiently back its coin, there might not be enough US dollars in case many stablecoin holders demand dollars at the same time.
Regulators investigated Tether in 2021. There were rumors that Tether wasn’t backed by any US dollars. Bloomberg “Anyone Seen Tether’s Billions?” Accessed May 23, 2022. Some claimed that the Tether foundation created USDT out of thin air, without any backing, and purchased bitcoin with their issued stablecoins.
This controversy was at least partially put to rest when regulators found that the Tether foundation indeed backed USDT with US dollars, yet not fully and to the extent it had claimed in the past. Fortune “Cryptocurrency Tether is fined $41 million for lying about reserves” Accessed May 23, 2022.
USDC is another popular stablecoin. The CENTRE Consortium, consisting of Circle and cryptocurrency exchange Coinbase, issues the stablecoin. Coinbase “Coinbase and Circle announce the launch of USDC — a Digital Dollar” Accessed May 23, 2022.
Similar to Tether, 1 USDC should always equal 1 USD. Circle achieves this by backing its USDC tokens with dollars.
This ensures that in case of a run on the stablecoin, holders can redeem their coins for US dollars. However, similar to the fractional reserve banking system, some stablecoin issuers don’t back their coins to 100% with US dollars.
As long as only a percentage of stablecoin holders redeem their coins for dollars, this isn’t a problem. But if everyone were to demand dollars in exchange for their stablecoins at the same time, this could lead to the stablecoin losing its peg and collapsing.
In other words, collateral-backed stablecoins are only as stable as the reserve ratios they maintain.
Collateral-backed stablecoins are just one form of stablecoin. Some other stablecoins aren’t backed by US dollars, despite claiming to maintain a peg to the US dollar.
These stablecoins use complex algorithms and arbitrage opportunities to keep their value pegged to the US dollar.
Two notable algorithmic stablecoins lost their peg to the US dollar and collapsed in recent years. The first one was Iron, with its counterpart Titan. Iron should maintain its peg through a coin called Titan. In June 2021, Iron lost its peg to the US dollar. CoinDesk “In Token Crash Postmortem, Iron Finance Says It Suffered Crypto’s ‘First Large-Scale Bank Run’” Accessed May 23, 2022.
Another algorithmic stablecoin called Terra (UST), with its counterpart Luna, faced a similar collapse. On May 9th 2022, the Terra stablecoin lost its peg to the US dollar. TradingView “UST / USD” Accessed May 23, 2022. In the following weeks, both tokens lost most of their value.
This resulted in panic and caused a run on Terra. Terra holders withdrew their coins from the Anchor protocol at a large scale. Following this, the value of Terra plunged to around $0.06. This meant, Terra holders only got six cents on the dollar.
The Luna token, which aimed to back Terra, lost most of its value as well. This triggered a death spiral. The falling value of Luna further pushed down the price of Terra and vice versa.
Over $40 billions of value was wiped out in a matter of days, sending shock waves through the cryptocurrency market.
Stablecoins are different from Central Bank Digital Currencies (CBDCs), which many central banks have started exploring. Federal Reserve “Central Bank Digital Currency (CBDC)” Accessed May 23, 2022. Stablecoins are privately-issued cryptocurrencies.
Governments issue CBDCs. In other words, CBDCs are similar to stablecoins but instead of maintaining their parity to traditional currencies, they aim to completely reform or replace traditional fiat currencies like the US dollar.
Instead of backing a CBDC with traditional US dollars, the CBDC itself becomes a new form of fiat currency.
In other words, it doesn’t maintain a peg. Some believe that stablecoins don’t have a future because once governments rolled out their CBDCs, stablecoins will be outlawed. Others argue that if governments provide citizens with digital fiat currency, there won’t be a need to use privately-issued stablecoins.
Critics of CBDCs are concerned about their privacy implications. Those in favor of privately-issued stablecoins believe that stablecoins can’t be controlled and surveilled the same way a CBDC can, giving stablecoins a compelling use case even after central banks have rolled out their CBDCs.
The Terra stablecoin crash showed that sometimes stablecoins aren’t stable at all. Similar to banks, private stablecoin issuers are subject to risks that can lead to the loss of customer funds.
After a long history of panics and bank runs, president Roosevelt introduced the Federal Deposit Insurance Corporation (FDIC) in 1933. Federal Deposit Insurance Corporation “History of the FDIC” Accessed May 23, 2022. Today, the government insures all bank deposits up to $250,000.
The same doesn’t apply to stablecoins. When Terra holders saw the token lose its peg to the dollar and plunge to zero, this led to a great deal of pain and despair.
Some investors lost all their life savings. They believed the stablecoins they bought would always be redeemable for an equivalent amount of US dollars.
However, issuers of collateral-backed stablecoins pointed out that not all stablecoins are created equal. CoinDesk “First Mover Asia: Terra’s Difficult Post-Collapse Path: VCs Backing Away, Regulators Jumping on Stablecoins” Accessed May 23, 2022. Algorithmic stablecoins are inherently more risky. Some called for a clear distinction between collateralized, overcollateralized and algorithmic stablecoins.
Regulators have long expressed their concerns about stablecoins. Many have called for regulation of the stablecoin industry.
Beginning of 2022 president Biden signed an executive order that assigned several agencies the task to look into cryptocurrencies. White House “FACT SHEET: President Biden to Sign Executive Order on Ensuring Responsible Development of Digital Assets” Accessed May 23, 2022. The goal of the executive order is to understand the risks and opportunities of cryptocurrencies and provide a regulatory framework.
Stablecoin regulation moved into the spotlight again after the collapse of Terra. One of the worries is the systemic risk of stablecoins for the broader financial system.
In the case of Terra, many decentralized applications (dApps) used the Terra blockchain and token as their foundation. Broader financial services and ecosystems built on top of a stablecoin can increase the systemic risk of a stablecoin collapse and cause contagion.
Whether and how stablecoins, CBDCs and other cryptocurrencies can coexist and how they will be regulated is still an ongoing process. But since stablecoins directly compete with the US dollar and CBDCs they will likely face more regulatory pressure.
After the Great Depression, Roosevelt restored faith in the banking system by introducing FDIC insurance. It’s aim was to protect depositors from bank runs and bank failures they might cause.
Similarly, it is possible that stablecoin issuers need to maintain certain backing requirements and provide insurance to token holders in the future. These and other precautions might become part of a regulatory framework for stablecoins moving forward.
|↑1||TradingView “Bitcoin / U.S. Dollar” Accessed May 23, 2022.|
|↑2||CoinMarketCap “Today’s Cryptocurrency Prices by Market Cap” Accessed May 23, 2022.|
|↑3||Bloomberg “Anyone Seen Tether’s Billions?” Accessed May 23, 2022.|
|↑4||Fortune “Cryptocurrency Tether is fined $41 million for lying about reserves” Accessed May 23, 2022.|
|↑5||Coinbase “Coinbase and Circle announce the launch of USDC — a Digital Dollar” Accessed May 23, 2022.|
|↑6||CoinDesk “In Token Crash Postmortem, Iron Finance Says It Suffered Crypto’s ‘First Large-Scale Bank Run’” Accessed May 23, 2022.|
|↑7||TradingView “UST / USD” Accessed May 23, 2022.|
|↑8||Federal Reserve “Central Bank Digital Currency (CBDC)” Accessed May 23, 2022.|
|↑9||Federal Deposit Insurance Corporation “History of the FDIC” Accessed May 23, 2022.|
|↑10||CoinDesk “First Mover Asia: Terra’s Difficult Post-Collapse Path: VCs Backing Away, Regulators Jumping on Stablecoins” Accessed May 23, 2022.|
|↑11||White House “FACT SHEET: President Biden to Sign Executive Order on Ensuring Responsible Development of Digital Assets” Accessed May 23, 2022.|