The Stablecoin Debate: Types of Stablecoins, Assessing Value Proposition, Stability, and Stablecoin Regulation

Stablecoin Debate: Uncertainty over stability due to parity value deviations.

The debate surrounding stablecoins has been gaining momentum since the collapse of Luna’s algorithmic stablecoin ‘UST’, which resulted in the loss of over $60 billion worth of investors’ capital. This year, the discussion has intensified even further, with regulators, especially in the US, tightening their grip on the crypto industry. 

Most notably, the SEC issued a wells notice earlier in the year to Paxos, the issuer of BUSD, marking the end of a previously successful run for the Binance stablecoin. 

But before diving into the specifics of why regulators are waging war against stablecoins and whether they will manage to weather the storm, let’s first decipher what a stablecoin coin is and the main types that currently exist. 

A stablecoin is a digital currency that is backed by a reference asset, which could be a fiat currency, a commodity like gold, or other exchange-traded financial instruments. Ideally, stablecoins are designed to maintain a stable value, although that has not always been the case, as we will highlight later in this article.

What are the main types of Stablecoins? 

While stablecoins are a relatively recent addition to the crypto ecosystem (they gained popularity during the 2017 bull run), the market has evolved to feature four main types of stablecoins: fiat-backed, commodity-backed, crypto-backed, and algorithmic stablecoins.

Fiat-backed Stablecoins 

As the name suggests, fiat-backed stablecoins are pegged to fiat currencies such as the US dollar, Euro, and GBP on a 1:1 basis. The rationale is that for every stablecoin issued, there is an equivalent amount held in fiat currency with a bank or custodian. Some of the prominent stablecoins in this category include USDT and USDC, both of which are backed by the US dollar.

Pros:

  • Mainstream Appeal: The direct link to widely-used fiat currencies makes fiat-backed stablecoins a favorite for many, bridging the traditional finance world with crypto.
  • Simplicity in Design: The value fiat-backed stablecoins ties one-to-one with recognizable assets, making them more approachable for newcomers.
  • Stability Above All: Backed by trusted and tangible assets like national currencies, the value of fiat-backed stablecoins remains more consistent compared to volatile crypto assets.
  • Safety Nets: The connection to regulated financial institutions makes fiat-backed stablecoins less of a target for crypto-specific security threats.

Cons:

  • Centralized Control: The centralized design of fiat-backed stablecoins contradicts the decentralized ethos that’s at the heart of many blockchain advocates’ beliefs.
  • Transparency Concerns: Past incidents have cast doubts about whether the claimed reserves fully back some stablecoins.
  • Regulatory Risks: Being tethered to traditional financial systems means this type of stablecoin is more exposed to governmental regulations, potentially affecting their operations.

Commodity-backed Stablecoins 

The second type of stablecoins is backed by commodities such as gold, silver, or a basket of commodities, as was the case for Meta’s stablecoin, Diem, which failed to acquire regulatory approval. But perhaps the most noteworthy example in this niche is Paxos Gold (PAXG), which is pegged to the price of one ounce of gold, currently above $1900 in the London Good Delivery market.

Pros:

  • Real-World Value: Tied to tangible assets like gold or oil, commodity-backed stablecoins provide a sense of intrinsic worth.
  • Potential Hedge: This type of stablecoin offers protection against fiat currency inflation, given their backing by commodities that often appreciate over time.
  • Diversification: Commodity-backed stablecoins allow crypto investors a unique way to diversify their portfolios by indirectly holding commodities.
  • Innovative Bridge: Merges the old (commodities) with the new (cryptocurrencies), making traditional assets more accessible to digital investors.

Cons:

  • Storage & Authenticity: Requires physical storage for the commodities and regular audits to confirm the existence and quality of the backing assets.
  • Liquidity Concerns: Not as widely adopted as fiat-backed stablecoins, which can limit easy trade and redemption.
  • Complexity: Understanding the nuances of commodity markets might be daunting for some, especially newcomers.
  • Regulatory Grey Areas: Given their novelty, there’s uncertainty about how they fit into existing financial regulations, potentially leading to future legal challenges.

Crypto-backed Stablecoins 

While it may seem unconventional to back a stablecoin with a crypto asset, considering the underlying volatility, crypto-backed stablecoins like MakerDAO’s DAI are intentionally over-collateralized. To mint DAI, users must deposit a crypto collateral, typically ETH, with a ratio of 1.5:1. This ensures that the crypto-backed stablecoin maintains a 50% over-collateralization, mitigating the risk of significant volatility swings that could lead to collateral liquidation.

Pros:

  • Decentralized Nature: Crypto-backes stablecoins operate without central authority, preserving the core ethos of most cryptocurrencies.
  • Overcollateralization: Typically backed by more than their worth in cryptocurrency, providing a cushion against price fluctuations.
  • Transparency: Leveraging blockchain’s transparency, users can verify the backing assets in real-time.
  • Open-Source and Community Driven: Many are governed by community decisions, ensuring that changes benefit the ecosystem at large.

Cons:

  • Volatility of Collateral: The underlying cryptocurrencies can be volatile, potentially affecting the stablecoin’s stability.
  • Liquidation Risks: Rapid market downturns can lead to automatic liquidation of the collateral.
  • Smart Contract Vulnerabilities: Reliance on software means they are susceptible to bugs or vulnerabilities in their smart contracts.
  • Complex Mechanisms: The algorithms and systems maintaining the peg can be complex, making them less accessible to the average user.

Algorithmic Stablecoins (Non-collateralized) 

Last but not least, algorithmic stablecoins, touted as the most “decentralized,” are not backed by any collateral. Instead, they rely on an algorithm that adheres to the basic laws of demand and supply to maintain a stable value. However, despite their advantage over collateralized stablecoins, they are yet to achieve a significant breakthrough. 

The closest was Luna’s UST, which ended up triggering the collapse of several crypto firms, including the infamous Three Arrows Capital amongst other major crypto companies. 

Pros:

  • Fully Decentralized: Algorithmic stablecoins do not rely on centralized collateral, staying true to the decentralized ethos of cryptocurrencies.
  • No Overcollateralization: Unlike crypto-backed stablecoins, there’s no need to lock up more assets than the stablecoin is worth.
  • Scalable: Built on decentralized blockchains such as Ethereum, there is potential for limitless supply adjustments without needing to increase collateral.
  • Innovative Stability: Uses algorithms and smart contracts to automatically expand or contract supply, ensuring price stability.

Cons:

  • Unproven Long-Term Stability: Still relatively new, with concerns about their ability to maintain a peg during extreme market conditions.
  • Complexity: Their stability mechanisms can be intricate, potentially confusing the average user.
  • Confidence Dependent: Relies heavily on user trust; if confidence drops, it can lead to rapid devaluation as was the case with Luna’s UST stablecoin.
  • Regulatory Uncertainty: Given their innovative nature, they might face unclear or evolving regulations.

Stablecoin Market Cap and Volumes at Multi-Year Lows 

With the crypto market taking a nosedive over the past year, the stablecoin market cap and volumes have also been on a downtrend. According to the most recent report by CCData, the total market capitalization of stablecoins stood at $127 billion in July; this is the lowest it has been since August 2021.

Monthly volumes are also drying up, save for June, which saw an uptick following Blackrock’s Bitcoin spot ETF application. As of mid-July, the monthly volumes were at $219 billion, which is roughly 10% of the total crypto market cap as of writing.

Image source: CCData 

Tether (USDT) Continues to Lead the Pack 

While several stablecoins have emerged to serve the growing demand for stable assets in the crypto ecosystem, USDT remains the most dominant stablecoin. It recently recorded a new all-time high market cap of $83.8 billion and now accounts for over 65% of the stablecoin sector. Notably, Tether, USDT’s issuer, also had a good run in Q2 2023, reporting $3.3 billion in excess reserves and $1 billion in profits.

USDC follows at a distant second, while BUSD fell off the hook from its all-time high market cap of $23 billion in December 2022, after Paxos halted BUSD minting in February 2023.

Image source: CCData 

Will Decentralized Stablecoins Live Up to the Hype? 

As mentioned earlier, decentralization is the most fundamental feature of the digital asset industry. However, decentralized stablecoins barely account for 0.5% of the total stablecoin sector. According to the most recent statistics, the total market cap of decentralized stablecoins in July 2023 was $7.52 billion, far below the $34.4 billion witnessed in April 2022.

That said, the big question is: will decentralized stablecoins live up to the hype? While several have proven reliable, including Maker’s DAI stablecoin, inherent challenges such as reduced capital efficiency stemming from the over-collateralization requirement have been major hurdles to their adoption.

Nonetheless, it’s worth highlighting that some interesting developments are emerging. One of them is Aave’s GHO stablecoin, which was recently deployed on Aave’s V3 marketplace and reached a milestone of $2.5 million in market cap within two days.

Image source: Kaiko

The Stability of Stablecoins: A Bone of Contention 

Whether stablecoins are stable or not has sparked heated debates over the years, and while it is arguable that leading stablecoins like USDT and USDC have mostly maintained parity with the dollar, that has not always been the case. Looking at the charts, even the most liquid and reliable stablecoins have deviated from the dollar at one point.

Image source: Kaiko

Of course, in their defense, stablecoin issuers, especially Tether, have maintained that all of the USDT in circulation is fully backed and can be redeemed upon request. However, based on their reserve holdings, where 15% is invested in risky assets such as Bitcoin, Gold, and secured loans, there is still a significant risk of deviation should this basket of investments take a massive hit.

This was partly the case with USDC, which recently found itself at a crossroads following the collapse of Silicon Valley Bank (SVB), one of the banks holding its cash collateral. It is also interesting to note that USDC’s slight depeg back in March also affected the DAI stablecoin, which is heavily intertwined with USDC.

That said, the debate on whether stablecoins are guaranteed to remain stable boils down to the reference asset backing a specific stablecoin. A less volatile asset backing means more stability and vice versa. 

A New Form of Money 

Despite the concerns surrounding the stability of stablecoins, it is quite evident that they have a solid value proposition within and outside the crypto market.

For starters, stablecoins have emerged as the main trading pairs on centralized exchanges, accounting for 76% of the share volume, as fiat currencies slowly fade out. This shift is mostly due to the hard stance taken by regulators and the clamping down on on-ramping avenues.

But even more intriguing is how stablecoins are being adopted in the global financial system as a form of borderless money and a store of value. According to estimates by Citibank, the stablecoin market and other digital forms of money could attract as much as $5 trillion worth of global assets by 2030.

It is also worth noting that some central banks are considering labeling stablecoins as a form of money, with the latest remarks coming from Fed Chair Jerome Powell during his testimony at the US House Financial Services Committee’s semi-annual monetary policy. He stated that, “We see stablecoins as a form of money.”

“The central bank is and will always be the main source of trust behind money. Stablecoins essentially borrow that trust from the underlying issuer, and in many cases, these are dollar stablecoins, so they’re really borrowing that trust,” added Powell. 

PayPal’s Leap into Stablecoins: A Major Industry Impact!

Payments giant PayPal has in August 2023 launched a dollar-backed stablecoin, PayPal USD (PYUSD), in collaboration with Paxos Trust Company. The company had signaled its intention to venture into the stablecoin arena back in January 2022 and recently made good on its word with the PYUSD rollout scheduled for the coming weeks.

This ERC-20-based token will first be made available to eligible users in the US, allowing them to move the token to external wallets, facilitate peer-to-peer transactions, make payments at PayPal-supported checkouts, and switch between cryptocurrency holdings and PayPal USD.

This move is significant for both the traditional finance industry and the crypto industry. The former has long been opposed to the adoption of cryptocurrencies, but with PayPal’s recent move, we’re likely to see more financial service institutions integrating Web3.

As for the crypto industry, PayPal’s reputation as a payment service provider brings the much-needed credibility to spur the adoption of stablecoins. Moreover, the crypto industry has a higher chance of converting new users, given that PayPal had over 420 million active accounts in Q1 2022.

Stablecoin Regulation 

As mentioned in the introduction, the rise of stablecoins and their potential to disrupt the global financial system has not gone unnoticed by regulators. To this end, several jurisdictions are in the process of drafting or implementing stablecoin operational guidelines.

In Europe, the recently approved MiCA bill, set to come into action in 2024, lays out a number of stipulations for stablecoin issuers. The first requirement is that stablecoin reserves should be “legally and operationally segregated and insulated.” Additionally, the transaction limit has been capped at 200 million Euros per day.

Meanwhile, the UK, which is currently positioning itself as a potential crypto hub, recently approved a set of rules, granting the UK Treasury powers to oversee stablecoin activity.

“The government’s position is to start with those most stable, least volatile coins likely to be used by intermediaries as a settlement currency and then we will go forward and consult from there,” noted Economic Secretary to the Treasury Andrew Griffith. 

In the United States, the House of Representatives recently passed a comprehensive stablecoin regulatory framework along bipartisan lines. Republicans unanimously voted for the bill, which was also supported by a few Democrats, bringing the total vote to 34-16.

China, on the other hand, has maintained its tough stance against cryptocurrencies. The authorities recently arrested employees of Trust Reserve, a company that issues the Chinese yuan-pegged stablecoin CNH Coin (CNHC) and had recently secured over $10 million in a funding round that attracted notable investors, including KuCoin, Circle Ventures, and IDG Capital.

 

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