Kryptolesson #18

What are stablecoins?

Cryptoassets such as bitcoin were originally envisioned to disintermediate large financial institutions by addressing some of the challenges in the traditional financial system, such as high transaction costs, reversible transactions and a lack of privacy. However, they hit a roadblock, especially with respect to price volatility which initially slowed down adoption given their limited suitability as a medium of exchange or unit of account.

Stablecoins are designed to have low price volatility. They are cryptographic tokens that run on public blockchains such as Ethereum and aim to track the value of sovereign currencies such as the US dollar. Importantly, stablecoins are far more than crypto’s answer to the volatile nature of cryptoassets. To some extent, they combine the low volatility characteristics of sovereign currencies like the US dollar or the euro with advantages of public blockchains. Put differently, they allow for globally and permissionless transactions with fast finality in a stable currency and practically unlimited amounts. What’s more, public blockchains that power stablecoin payments operate year-round, 24/7, with virtually no downtime. Contrast this with the traditional banking system, where international transactions remain subject to expensive and lengthy cross-border payments ↗ of maximum US dollar amounts and blocked transactions, especially for retail payments such as remittances.

This is not to say that all stablecoins have entirely freed themselves from financial institutions. The bulk of stablecoins are redeemable for actual dollars in bank accounts, akin to cryptographic bearer assets that cannot be recovered if lost or stolen. Some stablecoins are backed on a 1:1 basis by digital sovereign currencies in a bank account, others are collateralized by portfolios of riskier, albeit higher-yielding assets such as government or municipal bonds, commercial paper, corporate debt or even bitcoin. And others still rely on an algorithm to defend a peg to a sovereign currency.

Stablecoins were originally created as a value-added service for market participants on crypto exchanges that wanted to de-risk their exposure to cryptoassets without having to fully convert them back to sovereign currencies. Not only have stablecoins broken out of this niche, but they have paved the way for the explosive growth of decentralized finance (DeFi) and have been integrated by large payment providers such as Mastercard ↗ and Visa ↗. Elsewhere, Facebook’s Diem ↗ project aims to build its own blockchain-based stablecoin payment system.

Total stablecoin supply has grown to more than $112 billion ↗ as of July 2021, increasing by almost 1,000% within less than one year. Overall on-chain stablecoin volumes exceeded $750 billion dollars in May. Given this surge in volumes, calling stablecoins one of blockchains’ breakthrough applications, or “killer apps”, is not an exaggeration.

Different stablecoins use different strategies to achieve price stability, with some being centralized while others are decentralized. When it comes to categorizing stablecoins, several high-quality frameworks have been published, such as those by Clark, Demirag, and Moosavi (2019) and by Carter and Walsh ↗ (2020). The former paper uses a taxonomy that distinguishes between stablecoins that are backed (directly or indirectly) by different assets and those that use intervention mechanisms (through money supply or asset transfer) to maintain their peg. The latter paper distinguishes between stablecoins that offer convertibility into assets held in reserve and synthetic stablecoins that cannot be redeemed for assets held in reserve.

Today’s stablecoin landscape is dominated by centralized, convertible tokens such as Tether (USDT), USD Coin (USDC) and Binance USD (BUSD). These traditional stablecoins are pegged against a sovereign currency such as the US dollar and offer full convertibility. In addition, this group uses a full-reserve approach where the stablecoin issuer holds liquid reserves with a custodian bank equivalent to 100 percent of the value of the tokens in circulation.

In contrast, synthetic and decentralized stablecoins such as DAI or TerraUSD (UST) stand out from traditional stablecoins in that they are algorithmic and not a convertible claim on some underlying reserve asset. Instead, their peg to the U.S. dollar is typically achieved with the help of smart contracts, either through overcollateralization or are actively managed by expanding and contracting money supply.

Needless to say, the rise of stablecoins has alerted regulators, central banks and governments. At their 2019 meeting in Chantilly, G7 Finance Ministers and central bank governors argued that stablecoins raise serious regulatory and systemic concerns, particularly given their global and potentially systemic impact. While members of the US Federal Reserve have repeatedly pointed to the potential benefits ↗ of private sector stablecoins, other policymakers such as the European Central Bank have warned ↗ that a widespread adoption of stablecoins could have severe implications for monetary policy or financial stability.

Photo by Seyed Ahmadreza Abedi