Stablecoin and its implications

In recent times, Tether has been in the spotlight with regard to the holding of its reserves backing its crypto coins. Tether is a stablecoin – stable because one Tether is supposed to be backed by one US dollar. This is a new revolution where cryptocurrencies are backed by fiat currencies, other digital currencies and algorithmic contracts and not used merely as instruments of speculation. But how does stablecoin work? And more importantly, does a stablecoin equate to stability in the crypto world? We will look to discuss some of these points in this article.

Functioning and benefits of stablecoin

Tether is a fiat-collateralized stablecoin and provides a good illustration of how a stablecoin works. Tether Holdings Ltd., which issues the digital currency, takes in USD from crypto traders and credits their crypto wallet collectibles with an equivalent Tether amount. On receipt of Tether, these traders can transact on the price of cryptocurrencies on crypto exchanges. Once the trader wants to monetize their tokens held in safe crypto storage, Tether Holdings will exchange them for the equivalent USD amount. This is possible due to the reserve assets backing Tether which will enable the user to receive funds on redemption of tokens. The Tether mechanism is convoluted but was required because banks were hesitant in doing business with crypto companies, both domestic and foreign.

The primary benefit of holding stablecoin is lesser volatility as compared to holding other digital currencies, due to the backing of reserve assets. Other advantages include greater security, more inclusive access to financial services, lower transaction costs compared to traditional banking services and real-time availability of funds.

Types of stablecoin

Fiat-collateralized stablecoins are most popular as they are primarily backed by fiat currencies e.g., Tether and TrueUSD which are backed by dollar deposits and have values equivalent to that of one US dollar. Fiat-collateralized stablecoins may also be backed by other forms of collateral e.g., commodities like gold, silver and oil, however dollar reserves are the most common collateral form. Another type of stablecoin are crypto-collateralized stablecoins which are backed by other cryptocurrencies. Since the reserve cryptocurrency may also be volatile, these stablecoins are overcollateralized – that is, large number of crypto tokens are maintained in reserve and lower number of stablecoins are issued. An example is DAI which is backed by Ethereum and is also pegged against the US dollar. Lastly, non-collateralized stablecoins don’t use any reserve but include a working mechanism, like a central bank, to maintain a stable price. An example is the dollar-pegged basecoin which uses a consensus mechanism to increase or decrease the supply of tokens on a need basis.

Regulation of stablecoin

In recent times, there has been increased scrutiny on the reserve assets which are not being fully disclosed by stablecoin issuers. It is being speculated that, in case of a run on stablecoins, there may be prudential risk (where issuers struggle to sell assets to meet redemption requests) and the implications may extend into traditional financial markets. In October 2021, IOSCO stated that stablecoins should be regulated as financial market infrastructure alongside payment systems and clearing houses. The proposed rules would specifically target stablecoins that are deemed systemically important and that have the ability to disrupt payment and settlement transactions. Regulatory oversight is also being touted as necessary for stablecoins to comply with anti-money laundering policies, tax compliance and sanctions. In this regard, US lawmakers have suggested that stablecoin issuance can be limited to insured banks as this will give regulators and government agencies greater jurisdiction over their operations, risk management and capital and liquidity standards.

Final Words

Stablecoin has grown massively and, with its current market size of US$130 billion, it has the potential to bridge the gap between cryptocurrencies and traditional industries. However, there are potential concerns with regard to whether stablecoin can actually deliver sufficient asset-backed collateral in the event of mass redemption requests. The worry is that this can spill over into financial markets and stablecoin owners need to be more forthcoming with information so as to ease market fears. Acceptability of stablecoin among different banking businesses is increasing and, with a burgeoning crypto market, stablecoins looks to have the ingredients to succeed as a reliable means to invest in digital currencies. So, do you think the “stable” part of stablecoin is justified? Check it out and take a call on whether it’s investment-worthy!