How do stablecoins work and what do they mean for the future of money?

Stablecoins have received a lot of coverage in both the crypto and mainstream financial media recently after terraUSD (UST), at one point the third biggest stablecoin in circulation, de-pegged from the US dollar and eventually collapsed, wiping out $60 billion in value.

While unfortunate, stablecoins shouldn’t be judged on this episode alone. First circulated in 2014, they’ve gained traction by combining the stability of fiat currencies with the benefits of crypto. According to consultancy McKinsey, their utility helped quarterly transactions surpass $1 trillion in 2021.

How do stablecoins work?

A stablecoin is a cryptocurrency that is pegged to another asset, most commonly a fiat currency such as the US dollar. This peg reduces volatility compared to cryptos like bitcoin and ether.

Typically, stablecoins are backed by reserves in the same denomination or other liquid investments, but there are also stablecoins backed by gold. Various mechanisms peg stablecoins to the underlying assets:

  • Traditionally collateralized: backed one-to-one by the underlying asset. For every USDT issued (the biggest stablecoin in circulation), Tether is said to hold one US dollar
  • Crypto-collateralized: backed by other cryptos and usually overcollateralized to allow for volatility, so a buyer must, for example, deposit 1,000 ether to buy 500 DAI
  • Commodity-collateralized: backed by assets such as gold, which have become more popular since Russia invaded Ukraine
  • Algorithmic stablecoins like UST rely on algorithms to manage the supply in circulation. When the market price fluctuates from the underlying asset, the algorithm either increases or reduces the number in circulation to rebalance it

Incidentally, the United States Commodities Futures Trading Commission fined Tether in October 2021 for misrepresenting its reserves. The company countered by claiming the findings were outdated and USDT is always fully-backed, just not by cash or holdings in bank accounts bearing its name. To promote transparency, Tether publishes its reserve on its website.

What are stablecoins good for?

One of the most promising use cases for stablecoins is as a medium of exchange. Stablecoins offer the same benefits as crypto in general — they remove the need for intermediaries like payment processors which charge transaction fees, without the volatility.

Remittance is another constructive use case. Research by the World Bank shows the average cost of sending money across borders is just over 6%, a significant amount for an overseas worker supporting family back home. However, stablecoin transactions cost as little as a fraction of a cent and can take place immediately.

Stablecoins also expand access to financial services as they can be stored in a digital wallet on a smartphone, eliminating the need to open a bank account. Holders can generate a return by depositing their stablecoins in a savings account that typically pays a higher rate of interest than high street banks or by lending them to borrowers.

Why do stablecoins fluctuate?

UST provides a useful case study to understand why stablecoins fluctuate. According to blockchain data platform Chainalysis, it collapsed in three stages:

  1. Two large trades initially broke the peg after Terraform Labs, the issuer of UST, withdrew 250 million coins (in two transactions) from a liquidity pool designed to facilitate efficient trading. Holders panicked and started withdrawing funds
  2. Various attempts to repair the peg by swapping UST for other US dollar stablecoins and bitcoin only provided a temporary solution. Exchanges responded by suspending withdrawals
  3. As a last resort, holders began redeeming LUNA, Terraform Labs’ native token, for UST. This hyperinflated the supply of LUNA and drove down its value. UST subsequently collapsed

Collateralized stablecoins fluctuate too, but generally to a lesser extent. Taking USDT as an example, holders must pay a transaction fee to convert USDT to fiat, which means it may trade at a cent below its redeemable value. Conversely, it may trade at a similar premium when demand grows during periods of volatility in the crypto markets.

The differences between stablecoins and CBDCs

Central bank digital currencies (CBDCs) are another type of stablecoin, although they’re issued by a country’s central monetary authority rather than a private company. The Atlantic Council think tank has identified 105 countries that are exploring CBDCs, but they’re at different stages of development. China is one of the most advanced, having launched pilots in 21 cities.

Being issued by a central bank gives CBDCs legitimacy. They’re seen as the digital equivalent of a banknote, which reassures those new to digital currencies and concerned about the risk of fraud. And like crypto, CBDCs reduce fees by removing intermediaries, as long as the issuer absorbs the transaction costs.

In contrast, stablecoins have a first-mover advantage. And perhaps most importantly, they provide a higher degree of privacy than CBDCs, while also offering greater potential for financial innovation given they’re compatible with smart contracts.

One reason central banks have been slow to roll out CBDCs is that they’re still trying to figure out the optimal issuance model. The pseudonymity allowed by public blockchains facilitates illicit financial activity, while private blockchains could be subject to interference. Whether blockchain technology is suitable for a centrally-issued digital currency also remains to be seen, especially considering the costs involved in implementing it.

Stablecoins and the future of money

Despite the trials and tribulations experienced in recent weeks, stablecoins seem set to play an important role in the future of money:

  • They combine the stability of fiat currency with the privacy, speed, and low cost of crypto transactions
  • They have already gained sizeable traction as a medium of exchange
  • They foster innovation in financial services by providing a less volatile building block than other cryptos
  • They act as a bridge to encourage new users to adopt crypto

However, for stablecoins to achieve widespread adoption, regulators must introduce rules to protect users and ban risky practices. In the meantime, recommendations published by the Financial Stability Board in 2020 provide a useful blueprint indicating what form a regulatory regime could take. The recommendations also attempt to strike the right balance between supervising stablecoins and promoting innovation.

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