Stablecoins, a segment of the wider cryptocurrency ecosystem, were developed to address the high price volatility of unbacked crypto-assets. These digital currencies use stabilization tools like reserve assets or algorithms to maintain a relatively stable value pegged to official fiat currencies or other assets.
Serving as a bridge between traditional finance and the decentralized blockchain technology, stablecoins play a crucial role in facilitating crypto transactions, crypto investments, and decentralized finance (DeFi) applications like crypto lending and crypto wallets. This article explores the various types of stablecoins, their regulation, and their impact on the rapidly evolving cryptocurrency ecosystem.
Types of Stablecoins
Stabilization Mechanisms
Stablecoin stabilization mechanisms can be categorized into three main types: off-chain collateralized, on-chain collateralized, or uncollateralized/algorithmic, each with its own strengths and weaknesses.
- Fiat-backed Stablecoins
- Designed to mirror the value of traditional currencies like dollars and euros.
- Issuers claim to hold liquid assets like cash or cash equivalents to back the stablecoin 1-to-1.
- Examples: Tether’s USDT and Circle’s USDC, commonly used for trading, remittances, and lending/borrowing in DeFi.
- Crypto-backed Stablecoins
- Backed by cryptocurrencies held as collateral.
- Require over-collateralization (e.g., 150% collateral for $100 stablecoin) to ensure stability.
- Top example: MakerDAO’s DAI.
- Algorithmic Stablecoins
- Use algorithmic and incentive mechanisms to maintain price stability.
- Often operate under-collateralized without a reserve of assets.
- Example: The now-collapsed TerraUSD.
- Asset-backed Stablecoins
- Backed by physical reserves of precious metals, like Paxos Gold and Tether USDT Gold.
- Aim to provide stability through tangible assets.
Collateral Types
- Fiat-collateralized Stablecoins
- Maintain a reserve of fiat currency (e.g., U.S. dollar) as collateral.
- Examples: Tether (USDT) and TrueUSD (TUSD).
- Crypto-collateralized Stablecoins
- Backed by other cryptocurrencies as collateral.
- Value of cryptocurrency held in reserves exceeds the value of stablecoins issued.
- Example: MakerDAO’s Dai (DAI).
- Algorithmic Stablecoins
- May or may not hold reserve assets.
- Use an algorithm to control supply and maintain price stability.
- Example: The now-collapsed TerraUSD (UST).
- Commodity-backed Stablecoins
- Use commodities like gold, real estate, or metals as collateral.
- Examples: Paxos Gold (PAXG) and Tether Gold (xAUT).
| Stablecoin Type | Collateral | Examples |
|---|---|---|
| Fiat-backed | Fiat currency reserves | Tether (USDT), TrueUSD (TUSD) |
| Commodity-backed | Commodities like gold | Paxos Gold (PAXG), Tether Gold (xAUT) |
| Crypto-backed | Cryptocurrency reserves | MakerDAO’s Dai (DAI) |
| Algorithmic | No collateral, algorithm-controlled supply | The now-collapsed TerraUSD (UST) |
The most popular and largest stablecoin by market capitalization is Tether (USDT), which is pegged to the U.S. dollar at a 1:1 ratio and backed by gold reserves.
Stablecoin Regulation
Regulatory Landscape
European payment service providers are not very active in stablecoin markets due to regulatory uncertainty. Given the potential risks and cross-border nature of stablecoins, a robust global regulatory approach is essential. International standards will need to cover all relevant entities and functions in a stablecoin arrangement to ensure their stability and a level global playing field.
Regulatory oversight and concerns around stablecoin stability and reserve backing have been key issues in the crypto industry. Stablecoins continue to face scrutiny from regulators due to the rapid growth of the $130 billion stablecoin market and its potential impact on the broader financial system.
Global Regulatory Efforts
- Financial Stability Board (FSB) Recommendations
- The FSB defines a ‘stablecoin’ as a cryptoasset that aims to maintain a stable value relative to a specified asset or basket of assets, and a ‘global stablecoin’ (GSC) as a stablecoin with potential reach and use across multiple jurisdictions that could become systemically important.
- The FSB’s high-level recommendations aim to address financial stability risks posed by GSCs, both domestically and internationally, while supporting responsible innovation and providing flexibility for jurisdictions to implement their own approaches.
- The recommendations emphasize a technology-neutral approach that prioritizes underlying activities and risks.
- G20 Mandate and FSB Framework
- The Financial Stability Board (FSB) has been tasked by the G20 to coordinate the delivery of an effective and comprehensive regulatory framework for crypto-assets, including stablecoins.
- In July 2023, the FSB finalized its recommendations for the regulation, supervision and oversight of crypto-assets and markets, including specific recommendations targeted at global stablecoin arrangements.
- The FSB defines global stablecoins (GSCs) as having three key characteristics: 1) a stabilization mechanism, 2) usability as a means of payment and/or store of value, and 3) potential reach and adoption across multiple jurisdictions.
- The FSB has agreed on 10 high-level recommendations to promote consistent and effective regulation, supervision and oversight of GSCs and stablecoins with the potential to become GSCs across jurisdictions, in order to address the potential financial stability risks they pose.
Regional and National Approaches
| Jurisdiction | Regulatory Approach |
|---|---|
| United States | – Ongoing debate over whether stablecoins like BUSD, USDT, and USDC are securities or commodities, with the SEC and CFTC each claiming jurisdiction. – The Clarity for Payment Stablecoins Act of 2023 proposes a regulatory framework for payment stablecoins, including criteria for issuers, bank-like regulations for federal nonbank issuers, and a 100% reserve backing requirement. |
| European Union | – The EU’s MiCA framework regulates two types of tokens: Asset-Referenced Tokens (ARTs) and E-Money Tokens (EMTs), with specific requirements for each. |
| Singapore | – Developing a stablecoin policy framework, with the MAS-regulated StraitsX issuing a Singapore Dollar stablecoin. |
| Japan | – Will only allow banks and trusts to issue stablecoins, starting in June 2023. |
| Dubai | – VARA regulator demands registration, reserve backing, and financial reporting for virtual asset activities. |
The FSB’s recommendations support responsible innovation and provide flexibility for jurisdictions to implement domestic approaches, while also calling for enhanced international cooperation, coordination and information sharing.
Role in Cryptocurrency Ecosystem
Stablecoins as Liquidity Providers
Stablecoins have become critical to liquidity in crypto-asset markets, accounting for around 90% of the total stablecoin market. The largest stablecoins like Tether (USDT), USD Coin (USDC), and Binance USD (BUSD) provide most of the liquidity in decentralized finance (DeFi) applications.
Facilitating Transactions and Trading
- Stable Store of Value: Stablecoins play an important role in the crypto markets by providing a stable store of value and medium of exchange, which helps facilitate trading and transactions.
- Reducing Volatility: Stablecoins can help reduce volatility in the crypto markets and provide a safe haven for investors during periods of market turbulence.
- Cross-Border Payments and Remittances: Stablecoins can be used for cross-border payments and remittances, as they offer faster and cheaper transactions compared to traditional financial systems.
Stablecoin Market Growth
The total market capitalization of stablecoins has grown significantly in recent years, reaching over $150 billion as of 2022. Some of the major stablecoins include USDC, USDT, DAI, and BUSD.
| Year | Total Value Settled with Stablecoins |
|---|---|
| 2022 | Over $7 trillion |
| 2023 (Projected) | Up to $9 trillion |
This projected growth highlights the increasing adoption and importance of stablecoins in the crypto ecosystem.
Key Roles in the Crypto Ecosystem
Stablecoins play several key roles in the crypto ecosystem, including:
- Increased liquidity
- Better price stability
- Improved decentralization
- Increased usability
- Enhanced security
Notable examples of stablecoin use include payment and remittances, DeFi, e-commerce, gaming and virtual reality, investment, and central bank digital currencies (CBDCs).
Addressing Volatility and Facilitating Transactions
Stablecoins were developed to address the high price fluctuations of unbacked crypto-assets and use stabilization tools like reserve assets or algorithms to maintain a stable value. This stability makes stablecoins more suitable for common transactions compared to highly volatile cryptocurrencies.
However, stablecoins fall short of the requirements needed for practical means of payment in the real economy, with slower transaction speeds, higher transaction costs, and limited redemption possibilities compared to traditional payment systems.
Potential Risks and Challenges
Despite their growing importance, stablecoins pose potential risks to financial stability through various contagion channels, including financial sector exposures, wealth effects, confidence effects, and their use in payments and settlements. The recent crash of TerraUSD and temporary de-pegging of Tether highlight that stablecoins are not as stable as their name suggests.
Stablecoin investors tend to ‘run’ from riskier stablecoins following negative shocks and move toward stablecoins they perceive as ‘safer’, with the definition of ‘safe’ depending on the type of shock. Collateralized stablecoins are susceptible to runs if there is a loss of confidence in the ability to maintain the peg, while uncollateralized stablecoins rely on market participants’ belief in the long-run peg.
When a stablecoin pegged at $1 drops to $0.99, it hits its ‘depegging threshold’ – the value needed to spark investor runs, similar to specific thresholds in money market fund regulations.
Conclusion
Stablecoins have emerged as a pivotal force in the cryptocurrency ecosystem, bridging the gap between traditional finance and decentralized blockchain technology. By addressing the volatility challenges of unbacked crypto-assets, stablecoins facilitate transactions, trading, and the growth of decentralized finance applications. However, their rapid expansion and potential systemic implications have drawn regulatory scrutiny, prompting efforts to establish robust global frameworks and oversight measures.
As the stablecoin market continues to evolve, striking the right balance between innovation and risk mitigation will be crucial. International cooperation and coordinated regulatory approaches will play a pivotal role in ensuring the stability and integrity of these digital assets. Ultimately, stablecoins’ ability to navigate regulatory challenges while maintaining their core value proposition will shape their long-term impact on the future of finance.
