Why Stablecoins — 2020: Comprehensive Overview Of Their Foundations And Future
A Deep Dive into the Fundamentals, Benefits, Risks, Implementations & Future Potential of Stablecoins.
Introduction
Recent months have ushered in rapid developments and evolution in the crypto world, with the promise of challenges and great changes still to come. One of the hottest trends in the 2020 crypto sphere is the emergence of decentralized finance (DeFi) — a new class of disruptive financial services created to programmatically borrow, lend, and use digital assets as collateral. The DeFi ecosystem is open-source, permissionless, transparent, operates without a central authority, and available to everyone. Its popularity is largely due to the fact that users around the world can easily access financial services, interacting with the ecosystem through peer-to-peer (P2P) and decentralized applications (dApps), and maintain full control over their assets. Thanks to the explosion of DeFi protocols and the demand for tokens in liquidity pools, stablecoins have experienced massive growth in the past few months. The stablecoin market cap today has hit the $18 billion mark, an impressive growth compared to its $5.4 billion overall market valuation only six months ago on March 31, 2020.
Stablecoins caught a lot of attention back in 2018 as they provided respite from the bear market that savaged bitcoin, large-cap coins and tokens alike. They continued to boom in 2019 as reputable stablecoins with the backing of banks and third-party audits built a bridge between mainstream and crypto finance. But stablecoins have experienced truly exponential growth from March 2020 and it doesn’t show any signs of slowing down yet. According to Coinbase,”[t]oday, the primary use for stablecoins are as a haven from cryptocurrency volatility and as a bridge for value transfer between exchanges. In addition, evidence of stablecoins’ use in global commerce, traditional financial settlement, and as collateral for decentralized finance (DeFi) is emerging. So as Bitcoin and Ether prices have experienced historic volatility in recent days, the larger stablecoin ecosystem has grown significantly.” A recent tweet from Coin Metrics co-founder Nic Carter also points out that the supply of stablecoins has steadily grown approximately $100 million a day in July and August 2020.
But what exactly are stablecoins and what kinds of risks or benefits do they pose? Furthermore, what challenges and changes lie in store for stablecoins in the imminent future? As the stablecoin ecosystem continues to evolve rapidly — with banks, big tech, and crypto startups all clamoring to offer blockchain-based versions of currencies — it has never been more crucial to understand the foundations and risks of stablecoins.
Quick definition: what is a stablecoin?
Stablecoins are defined as “cryptocurrencies that peg their market value to an external reference to offer price stability.” These external references are commonly a fiat currency (e.g. US dollar) or a commodity’s price, such as gold or oil. Stablecoins are designed to maintain a stable value over time, making them suitable for use as a medium of exchange and store of value.
How are stablecoins different from Bitcoin and other cryptocurrencies?
Developed by Satoshi Nakamoto in 2008, Bitcoin is the first digital currency and alleged “king” of the cryptocurrency market. Numerous altcoins (alternative cryptocurrencies to bitcoin) have since emerged, with Bitcoin and ethereum consistently remaining as some of the most commonly used cryptocurrencies. Cryptocurrencies are popular because they’re encrypted, decentralized methods of payment and trading that are often also faster and cheaper than mainstream methods. However, they tend to suffer from high volatility in valuations. This volatile nature has hindered mainstream cryptocurrency adoption and cryptocurrency’s use as a medium of exchange in daily life.
In comparison, stablecoins are less volatile because their price is pegged to a reserve asset. They provide the instant processing, security and privacy of crypto payments, while also offering a similar investment rationale of buying the actual physical underlying asset. This effectively eliminates fears or doubts over value volatility. People can also trust in its value as it has a 1:1 peg against regulated reserve assets. Unlike the bulk of cryptocurrencies that don’t have a regulated reserve backing their valuations, investors in stablecoins can be confident that their tokens will always sell for one dollar each (as an example).
Different kinds of stablecoins
In the rapidly evolving world of crypto, it’s important to understand a cryptocurrency and its function within the blockchain network it powers. Different stablecoins may share certain characteristics, but there are fundamental variations in the way work. Stablecoins can be separated into four categories:
Fiat-collateralized stablecoins
Fiat-collateralized stablecoins maintain the value of a fiat currency held in reserve (e.g. the US dollar) as collateral to issue a suitable number of crypto coins at a 1:1 ratio. The reserves are maintained by independent custodians and regularly audited.
Tether (USDT) is a well-known and popular example of a fiat-collateralized stablecoin. Issued by a Hong Kong-based company Tether, it emerged in July 2014 as the first dollar-pegged stablecoin that mirrors the price of the US dollar. Today, USDT’s average daily trading volume is often on par with or even exceeds that of bitcoin. It’s available on a large number of cryptocurrency exchanges and remains one of the top five tokens by market cap.
Commodity-collateralized stablecoins
Commodity-collateralized stablecoins are tied to tangible assets. The most common collateralized commodity is gold, but they can also be backed by oil, real estate or baskets of various precious metals. These types of stablecoins appeal to individuals seeking exposure to physical assets through a more accessible method that also provides greater liquidity. Commodity-collateralized stablecoins are pegged at a 1:1 ratio with their reserve assets, so one coin is typically worth one predetermined unit of its referenced commodity (e.g. one ounce of gold or one barrel of oil). The applicable commodity is frequently held with a third party that stores and regulates these assets in reserve.
PAX Gold (PAXG) and VeraOne.io (VRO) are examples of gold-backed stablecoins. Created by Paxos Standard token, PAXG is the first digital asset where each ERC-20 token is backed by one fine troy ounce (t oz) of a 400 oz London Good Delivery gold bar. The gold is securely stored in Brink’s vaults and held in custody by Paxos Trust Company. VRO is the first French stablecoin on the blockchain ecosystem that is backed by physical gold. The ERC-20 token is based exclusively on gold stored in highly secure zones, regularly audited by trusted third parties, with a full (100%) counterpart. As a result, the price of one VRO is equal to one gram of physical gold (XAUEURG) and is also effectively backed by it.
Crypto-collateralized stablecoins
Crypto-collateralized stablecoins are tokens backed by other cryptocurrencies. They are often backed by a mix of cryptocurrencies for better risk distribution, as the volatility risk is lower with a group of cryptocurrencies rather than a single cryptocurrency. This over-collateralization absorbs and withstands the potential volatility and price fluctuations of underlying cryptocurrencies.
Dai (DAI) is an ERC-20 token running on the Ethereum (ETH) blockchain that is stabilized to the value of one US dollar via cryptocurrency collateral. Multiple types of crypto assets are used to create DAI and its price is maintained through smart contracts stored on the blockchain that are publicly viewable. When the price of DAI fluctuates too far from one US dollar, automatic balancing mechanisms stabilize its price.
Algorithmic (non-collateralized) stablecoins
Algorithmic stablecoins are perhaps the most interesting because they maintain a stable value through a complex algorithm rather than a third-party asset. Using algorithmic stabilization mechanisms, token supplies are automatically expanded or contracted to maintain a stable price, similar to how central banks print banknotes to maintain valuations in the fiat economy.
As the world’s largest blockchain payment network, Terra is a quality example of an algorithmic stablecoin. Terra’s payment network is supported by a family of stablecoins, each pegged to major fiat currencies all algorithmically stabilized by Terra’s native token (LUNA). The family of Terra stablecoins achieve stability through an algorithm and underlying protocol that expands and contracts overall money supply.
Why have stablecoins become popular?
In an investigation on the impact of global stablecoins back in October 2019, the Bank of International Settlements observed: “In principle, retail stablecoins could enable a wide range of payments and serve as a gateway of other financial services. In doing so, they could replicate the role of transaction accounts, which are a stepping stone to broader financial inclusion.” With aid from the emergence of the DeFi ecosystem, stablecoins have since accomplished this and ushered in a new wave of liquidity.
Use as a daily currency
As exchanges have been able to provide tokens that represent fiat currencies or reserve assets, stablecoins can be used as a daily currency for mainstream commerce (much like fiat currencies). They have the added benefit of being legally backed and secured, and are especially useful for cross-border payments as they offer secure conversions and exchanges.
Peer-to-peer (P2P) payments
Stablecoins have streamlined P2P payments, removing the presence of a third-party (banks or private financial institutions) from exchanges between two counterparties. This method of transaction is fast, low-cost, traceable and transparent, making it ideal for a wide variety of payments (loans, rent, subscriptions, etc.).
Cross-border payments and financial inclusion
The shortcomings of cross-border payments and access to transaction accounts have really been brought to light with the emergence of stablecoins. For migrant workers that have to pay high fees for slow remittances to send money back to their families, stablecoins provide a secure, fast and affordable solution. Since stablecoins have a global reach and are accessible to anyone, anytime, any day on the internet, migrant workers and their families can use digital wallets to send or receive stablecoins instantly from anywhere at little to no cost.
Asset protection and store of value
Stablecoins also offer asset protection and store of value in countries suffering from hyperinflation and crippled economies, where local fiat currencies have lost almost all their value. By exchanging fiat currencies that continue to crash in value with a stable currency, people can protect their assets from further loss and regain control over their finances.
Risks of stablecoins
The list of stablecoin benefits is appealing indeed: low costs, global reach, speed, financial inclusion, secure transactions, transparent, seamless payments, etc. According to the INTERNATIONAL MONETARY FUND (IMF), the “strongest attraction” is the network’s potential “to make transacting as easy as using social media” or instant messaging. But like anything that is in the midst of evolving, blockchain technologies and cryptocurrencies are vulnerable to and create a number of potential risks.
Securing stablecoins
Just like how processes and precautions are practiced to secure mainstream finances against theft, stablecoins and cryptocurrencies need to be kept safe with secure solutions. Since the nature of digital currencies are different from traditional ones, they need to be secured through different methods, which may feel especially foreign to new entrants to the crypto world. Blockchain has one of the most advanced forms of innate security, with Bitcoin’s employed cryptography yet to be breached. The core of its security resides with so-called “private keys”, the access keys of a bitcoin- (and by extension a crypto-) wallet. Bitcoin private key security is unbreakable with today’s existing computer power but if the challenge is moved from cracking private keys to finding and stealing them, everything suddenly becomes a lot easier for hackers. Cryptocurrencies are per definition digital, and digital solutions create keys online. Once there is even the slightest digital trace, hackers can easily find and steal private keys. It’s therefore vital for cryptocurrency owners to properly safeguard and secure their private keys with secure solutions such as cold wallets. Cold storage methods store the digital wallet on a platform not connected to the internet, effectively protecting a user’s private keys and crypto assets from unauthorized access and hackers. Currently, the most advanced and coldest hardware wallet in the digital asset space is NGRAVE ZERO. ZERO successfully secures a user’s crypto wallet with a statistically unique and random key generation process that is generated 100% offline and away from any prying eyes.
Breaking the 1:1 peg
A key structural risk of stablecoins is the possibility of breaking their 1:1 peg against underlying fiat currencies or other reserves. A great deal of trust in the third-parties that hold and regulate the applicable reserve assets are required. External audits are necessary to make sure appropriate amounts of collateral are being held, which can be a tedious and expensive process. A famous example is how Tether has yet to provide proof that it’s backed by reserves, sparking rumors and accusations that Tether Limited doesn’t hold sufficient USD reserves to back up the cryptocurrency. According to cointelegraph (Cointelegraph), “Crypto critics have long called for Tether to subject itself to an independent audit to verify the veracity of its claims, but such checks have not been forthcoming. […] Confirmation that Tether is running on a fractional reserve later came from the stablecoin operator’s lawyers, who revealed in court documents that the company only has enough cash to back 74% of its supply.”
Tie to fiat currencies
Although digital currencies are pegged to government-backed fiat currencies to reduce their volatility, its tie to a fiat currency means that it risks losing value along with said fiat currencies. Many stablecoins are pegged to the US dollar, which means that they are actually centralized and their value is dependent on how banks manipulate the dollar. In simple terms, if the US dollar weakens, so will the value of stablecoins that are pegged to it. With quantitative easing, banks print money to control the supply of a currency, pushing money into the market to balance sheets and effectively decrease its value. In an environment where governments debase their fiat currencies and push interest rates to all-time lows, it’s worth reconsidering whether fiat-collateralized stablecoins are truly stable.
Regulations and policies
The world of digital currencies and developments such as the DeFi ecosystem are all still very new compared to the centuries old concept of traditional money and fiat currencies. As something new and different from mainstream finance, digital currencies introduce legal, regulatory and managerial risks that current financial laws and regulations are unable to cover or manage. As stablecoins and cryptocurrencies continue to grow and gain widespread adoption, regulators need to implement clear regulations to avoid the misuse of cryptocurrencies for terrorist activities or money laundering. In a recent virtual conference, Andrew Bailey (Bank of England’s governor) mentioned that stablecoins could offer some “useful benefits” for U.K. investors, such as reducing friction in payments. He continues with a warning that “[i]f stablecoins are to be widely used as a means of payment, they must have equivalent standards to those that are in place today for other forms of payment types and the forms of money transferred through them.”
International and global concerns
Earlier this year, the G20’s Financial Stability Board (FSB) observed that “[e]xisting financial rules, such as for payments and customer checks, generally apply in whole or in part to stablecoins and address at least some of the risks they generate.” But differences in regulatory powers and laws from country to country expose gaps in supervising cross-border stablecoins and addressing risks posed by global stablecoins. In a similar sentiment, Bailey also pointed out the need for coordinated international regulations on stablecoins: “A global stablecoin is a cross-border phenomenon. It can be operated in one jurisdiction, denominated in another’s currency, and used by consumers in a third. The regulatory response must match this.” The challenge here lies in the fact that international rules and regulations will need to be agreed upon and accepted by all participants to function consistently.
Other risks
In reaction to the rise of stablecoins, the IMF released six observations that policy makers will need to address in order to create an environment that maximizes the benefits and minimizes the risks of stablecoins. The first concerns how the dominance of central banks will be usurped with the emergence of a global scale privately run stablecoin. This point was also raised by the FSB in reference to the threat of Facebook’s Libra: “Should Libra become popular, private companies would effectively become the world’s central bank, able to determine monetary policies that would influence the economy.” While “banks are unlikely to disappear,” the people moving away from a centralized institution would force banks to innovate and provide higher interest rates. Second is that tech giants could monopolize their networks, so new standards for “data protection, portability, control, and ownership” will be required. Third, stablecoins have the potential to undermine weaker local currencies, which will affect “monetary policy, financial development, and economic growth.” Fourth, stablecoin providers need to show how they will enforce international standards to prevent the use of their networks for illicit activities. Fifth, hard currency reserves will need to carry interest even if stablecoins may not, potentially enabling issuers to “siphon off profits” from the reserve without giving returns to stablecoin users. Sixth is that policy makers will need to reinforce consumer protection and financial stability, protecting customer funds from bank runs in particular.
More recently, the European Central Bank (ECB) published a paper reviewing the current status and potential risks of stablecoins. The paper outlines three scenarios for the use of stablecoins: as a crypto-asset accessory, mainstream payment method, and as a store of value. An overview of the stablecoin risks for monetary policy include: stablecoins could make it hard to implement negative interest rates, they could reduce bank fees and commission income, stablecoin “runs” will cause issues for banks where reserves are deposited, the price of reserve assets used as collateral could be impacted, shocks that impact multi-currency stablecoins will affect holders and spread risks to other currency areas, and finally, stablecoins as a store of value will reduce demand for cash and central bank reserves, increasing demand for other collateral. The paper emphasizes the risk of stablecoin “runs” as the biggest concern since end users may need to bear the risk and bank runs could destabilize the entire financial system.
“Stablecoin ‘runs’ are one of the biggest concerns when evaluating their inherent risk”
— European Central Bank Crypto-Assets Task Force, September 2020
What is the future of stablecoins?
Latest notable stablecoin developments
The future of stablecoins is bright as it continues to evolve at a rapid pace, with notable developments continuously popping up. Recently, P2P commerce company Origin announced its latest development: OUSD, a stablecoin that earns a yield and works like a savings account. OUSD will be backed one-for-one by the three big stablecoins on the Ethereum blockchain: USDT, USDC and DAI. The stablecoin’s reserves leverage DeFi protocols so that its balance grows without the need for an account or staking. With the launch of OUSD, DeFi experts and novices alike can earn returns without the usual hassles and complexities of yield farming. Origin is taking a bold step forward in pushing DeFi to the masses: “We believe having a reliable and desirable stablecoin that leverages the best parts of DeFi while enabling buyers and sellers to transact seamlessly will accelerate the growth of our decentralized commerce platform.”
Involvement between banks and stablecoins also continues to evolve, one step at a time. The US Office of the Comptroller of the Currency (OCC) announced in an interpretive letter that national banks and federal savings associations will be legally allowed to hold reserve currencies for stablecoins. The new guidance reads, “We conclude that a national bank may hold such stablecoin ‘reserves’ as a service to bank customers.” However, it further specifies that this only applies to stablecoins that are backed 1:1 with another currency, and in situations where the coins are held in hosted wallets. With this decision, banks will be able to verify daily whether reserve account balances are equivalent to or exceed the number of the issuer’s outstanding stablecoins.
Competition and threats for stablecoins
Despite their various benefits and current risks, the future of stablecoins is filled with potential and promise as it continues to grow and gain popularity. However, stiff competition and challenges from institutional rivals loom ahead. Fnality International’s ‘UtilitySettlement Coin’ is predicted to receive regulatory approval in the second quarter of 2021. The initiative is a stablecoin project spanning 13 global banks, spearheaded by UBS Group, which seeks to establish a network of tokenized US dollars, Japanese yen, Euros, Canadian dollars, and British pound sterling.
The advent of central bank digital currencies (CBDC) are another threat to the future of stablecoins, as they possess the potential to wipe out any demand for crypto stablecoins. The recent ECB paper also briefly outlines how CBDCs could create a scenario that makes the stablecoin “value proposition redundant (at least for domestic payments).” According to a survey in January 2020 from the Bank for International Settlements, interest in CBDCs continues to increase with over 80% of central banks now working on a digital currency. The People’s Bank of China is the current frontrunner among banks worldwide working on a CBDC, and countries like Venezuela and Senegal already have them. The US, South Korea, and the European Central Bank are also openly and actively researching the benefits and challenges of CBDCs. Even just a few days ago on 2 October, the ECB announced that it would be intensifying its work on a digital euro to ensure that “the euro is fit for the digital age.”
“The ECB is looking ‘very seriously’ at the creation of a digital euro.”
— Christine Lagarde, President of the European Central Bank, October 12, 2020
3 notable CBDC implementations
Three notable and prominent retail CBDC approaches include the Swedish Riksbank’s e-krona, the Bank of Canada’s CBDC contingency plan, and the People’s Bank of China’s Digital Currency Electronic Payment (DC/EP). The Riksbank, Sweden’s Central Bank, conducted the first publicly announced work on retail CBDCs in February 2020. Sweden is one of the least cash-dependent countries in the world, with only 1% of Sweden’s GDP currently circulating in cash. In reaction to this enthusiasm for a cashless society, the Riksbank launched a year-long e-krona (digital version of the krona) pilot project. The project simulates the use of e-krona in everyday banking activities and “[t]he main purpose of the pilot is for the Riksbank to increase its knowledge of a central bank digital krona.” In contrast to the Swedish approach, the Bank of Canada “currently has no plans to launch a CBDC.” Yet, they have begun conducting a large amount of research and work on a retail CBDC as a contingency plan to conquer two scenarios. The first scenario considers the dramatic decline or elimination of cash use, while the second is a scenario in which a private digital currency or stablecoin is widely adopted. The overall aim of Canada’s CBDC design would be to closely mimic the properties of physical cash without replacing it so that the two may co-exist. The Bank claims that building the capacity and advance preparation to issue a cash-like CBDC is critical as it will take several years to develop.
According to the BIS, China’s CBDC project is the most advanced amongst all CBDC projects currently in progress around the world. China’s digital yuan, officially DC/EP, is currently in its early trial stages. Initial trials have reportedly been conducted in four cities — Shenzhen, Suzhou, Chengdu, Xiang’an — and the country’s Ministry of Commerce announced in August that it would be expanding its trials to major cities across the most-developed regions. These include Hebei province, the Yangtze river delta, Guangdong province and the cities of Beijing, Tianjin, Hong Kong and Macau. Although no official start date has been announced, it’s predicted that trials will continue until at least 2023 or later. China’s steadfast commitment to advancing the development of the digital yuan, even in the face of the global COVID-19 pandemic, and desire to become the first world power to dominate the digital sphere is impressive. But security concerns over the potential to track all transactions made with the digital yuan is likely to deter other countries and international companies from using the digital currency.
In comparison to stablecoins, CBDCs could offer more consumer protection, inclusion, and security. However, opportunities, challenges and other questions associated with privacy, legal and regulatory safeguards, financial stability, and payment ecosystems are still in the exploration phase. For CBDCs to be a competent tool, a well-thought-out comprehensive digital infrastructure, effective governance, and knowledge of financial technology need to be in place. Decisions on how to design CBDCs within domestic legal frameworks and understanding of potential or associated risks still require time to be developed and assessed. It’s interesting to note that some of the risks outlined in the ECB’s paper on stablecoins are similar to concerns about CBDCs, especially regarding the displacement of banks. Despite this, steady progress in the developments of CBDC projects around the world mean that CBDCs will remain a potential worry for the future of stablecoins.
Conclusion
This article outlines the foundations of stablecoins, highlighting the reasons for its impressive growth, the potential risks and vulnerabilities that they possess, and considers current developments or threats that will influence their future.
Stablecoins have experienced truly exponential growth from March 2020, thanks to the explosion of DeFi protocols and the demand for tokens in liquidity pools. Stablecoins are less volatile than bitcoin and other cryptocurrencies because they are pegged to reserve assets, which makes them suitable as a medium of exchange in daily life. They offer a wealth of benefits that mainstream finances can’t provide as stablecoins can eliminate borders, minimise currency exchanges, and offer asset protection or store of value in countries facing hyperinflation. They’re a low cost, fast, secure, transparent, and seamless method of payment or transaction that has a global reach and promotes financial inclusion. However, like anything else that’s in the midst of growth and development, several potential risks of stablecoins have been revealed. One risk that is often overlooked concerns protecting stablecoins with secure solutions (i.e. cold wallets). The online and digital nature of stablecoins make them vulnerable to theft or loss in a different way than physical cash in your backpocket is. Complex layers of international or domestic regulations and policies also need to be ironed out in order to address numerous risks that stablecoins have introduced. Their potential to usurp the dominance of central banks is a particular concern that many are keeping an eye on. The worldwide interest in the development of CBDCs is the greatest imminent threat to the future of stablecoins as they have the potential to make stablecoins redundant. But considering the complications and intricacies of building a CBDC, it looks like it will take a few years before this competition will fully materialize. Despite their many conflicting benefits and risks, the future of stablecoins looks bright as they continue to steadily gain popularity and widespread adoption.
About the author: Ruben Merre is a repeat tech entrepreneur, polyglot, life-long learner and founder and CEO of NGRAVE, the digital asset security company behind “ZERO”, the most secure cryptocurrency wallet in the world. Since 2018, Ruben and his team have partnered up with the top tier in nanotechnology, cryptography and hardware security, as well as thought leaders such as Jean-Jacques Quisquater, famous cryptography professor and second reference of the bitcoin paper. The result: a true end-to-end solution for managing digital assets, at maximum security (EAL7, highest security certification in the world), and an intuitive user interaction.
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