Word of the Week: Stablecoin
Updated: Apr 15
Why do you need to learn more about stablecoins?
The market capitalization of stablecoins issued by the largest stablecoin issuers exceeded $127 billion as of October 2021.
The current market largely consists of a few large U.S. dollar-pegged stablecoins.
At the time of publication of this report (2021), stablecoins are predominantly used in the United States to facilitate trading, lending, and borrowing of other digital assets. For example, stablecoins allow market participants to engage in speculative digital asset trading and to move easily between digital asset platforms and applications, reducing the need for fiat currencies and traditional financial institutions. Stablecoins also allow users to store and transfer value associated with digital asset trading, lending, and borrowing within the distributed ledger environment, also reducing the need for fiat currencies and traditional financial institutions. Currently, digital asset trading platforms and other intermediaries also play a key role in providing access to and enabling trading of stablecoins, as well as in the stabilization mechanisms of stablecoin arrangements.
What is a stablecoin?
Stablecoins are digital currencies recorded on distributed ledger technologies (DLTs), usually blockchains, that are pegged to a reference value such as the U.S. dollar or gold. Stablecoins are designed to reduce volatility relative to unpegged cryptocurrencies like Bitcoin. The crypto’s backing source can affect its risk level: A fiat-backed stablecoin, for instance, may be more stable because it is linked to a centralized financial system, which has an authority figure (like a central bank) that can step in and control prices when valuations are volatile.
Types of Stable coins
Fiat-backed stablecoins are described as an IOU — you use your dollars (or other fiat currency) to buy stablecoins that you can redeem later for your original currency. Unlike other cryptos, with value that can fluctuate wildly, fiat-backed stablecoins aim to have very small price fluctuations. But that’s not to say stablecoins are a totally safe bet — they are still relatively new with a limited track record and unknown risks, and should be invested in with caution. The cryptocurrency exchange Coinbase offers a fiat-backed stablecoin called USD coin, which can be exchanged on a 1-to-1 ratio for one U.S. dollar.
Crypto-backed stablecoins are backed by other crypto assets. Because the backing asset can be volatile, crypto-backed stablecoins are overcollateralized to ensure the stablecoin’s value. For example, a $1 crypto-backed stablecoin may be tied to an underlying crypto asset worth $2, so if the underlying crypto loses value, the stablecoin has a built-in cushion and can remain at $1. These assets are less stable than fiat-backed stablecoins, and it is a good idea to keep tabs on how the underlying crypto asset behind your stablecoin is performing. One crypto-backed stablecoin is dai, which is pegged to the U.S. dollar and runs on the Ethereum blockchain.
Precious metal-backed stablecoins use gold and other precious metals to help maintain their value. These stablecoins are centralized, which parts of the crypto community may see as a drawback, but it also protects them from crypto volatility. Gold has long been seen as a hedge against stock market volatility and inflation, making it an attractive addition to portfolios in fluctuating markets. Digix is a stablecoin backed by gold that gives investors the ability to invest in the precious metal without the difficulties of transporting and storing it.
Algorithmic stablecoins aren't backed by any asset — perhaps making them the stablecoin that is hardest to understand. These stablecoins use a computer algorithm to keep the coin’s value from fluctuating too much. If the price of an algorithmic stablecoin is pegged to $1 USD, but the stablecoin rises higher, the algorithm would automatically release more tokens into the supply to bring the price down. If it falls below $1, it would cut the supply to bring the price back up. How many tokens you own will change, but they will still reflect your share. One algorithmic stablecoin is AMPL, which its creators say is better equipped to handle shocks in demand.
Public and institutional stablecoins are currently used for their near-instant, 24/7, non-intermediated payments with potentially low fees. This is especially relevant for cross-border transfers, which ordinarily can take multiple days and demand high fees. Firms are also using institutional stablecoins to near-instantly move cash across their subsidiaries to manage internal liquidity, and to facilitate wholesale transactions in existing financial markets, such as intraday repo transactions. And finally, because public stablecoins are programmable and composable, they are used heavily in decentralized, public blockchain-based markets and services, known as decentralized finance or DeFi. Systems of DeFi protocols allow users to use stablecoins to directly and transparently participate in a variety of cryptocurrency-related markets and services, such as market-making, collateralized lending, derivatives, and asset management, without traditional intermediaries (Table 2 obtained from the Federal Reserve Report "Stable coins: Growth Potential and Impact on Banking").
Additionally, several existing stablecoin issuers and entities with stablecoin projects under development have the stated ambition for the stablecoins they create to be used widely by retail users to pay for goods and services, by corporations in the context of supply chain payments, and in the context of international remittances. The extent to which stablecoins will be used for these purposes is difficult to predict and is likely to depend on the convenience of service options, the competitiveness of stablecoin transaction costs, and users’ confidence in the stablecoin issuer, including confidence in the issuer’s ability to maintain a stable value and facilitate redemption.
Risks related to Stablecoins
Stablecoins and stablecoin arrangements raise significant concerns from an investor protection and market integrity perspective.
1. Reserve Assets often unknown
Stablecoins are generally created, or “minted,” in exchange for fiat currency that an issuer receives from a user or third-party. They are often advertised as being supported or backed by a variety of “reserve assets.” Currently, however, there are no standards regarding the composition of stablecoin reserve assets, and the information made publicly available regarding the issuer’s reserve assets is not consistent across stablecoin arrangements as to either its content or the frequency of its release.
For example, Tether, the largest stablecoin by circulating supply, agreed to pay $41 million to settle a dispute with the U.S. Commodity Futures Trading Commission, which alleged that Tether misrepresented the sufficiency of its dollar reserves.
2. Redemption Rights
To maintain a stable value relative to fiat currency, many stablecoins offer a promise or expectation that the coin can be redeemed at par upon request. Stablecoin redemption rights can vary considerably, in terms of both who may present a stablecoin to an issuer for redemption and whether there are any limits on the quantity of coins that may be redeemed. Some issuers are permitted under the terms of the arrangement to postpone redemption payments for seven days, or even to suspend redemptions at any time, giving rise to considerable uncertainty about the timing of redemptions. Users’ ability to redeem their stablecoin may be affected by other aspects of the stablecoin arrangement, including the ability to transfer the proceeds of any redemption into the banking system.
3. Legislation & Regulation
Stablecoin arrangements are not subject to a consistent set of prudential regulatory standards. The US Treasury says that even if a given issuer of stablecoin is a bank, insight into the activities of key entities in the arrangement depends on the structure of the relationship and the nature of the services, if any, provided to the issuer bank as client.
Further, it is believed that due to its less volatile nature in comparison with traditional cryptocurrencies, stablecoins may be more attractive for money launderers.
The FATF indicates potential mitigation measures adopted by VASPs could include: limiting the scope of users’ ability to transact anonymously, controlling who can access the arrangement, controlling whether/how AML/CFT preventive measures are built into the arrangement and/or by ensuring that AML/CFT obligations of obliged entities within the arrangement are fulfilled, e.g. by using software to monitor transactions and detect suspicious activity.
“When regulation fails to keep pace with innovation, vulnerable people often suffer the greatest harm” - Among the remarks of Secretary of the Treasury Janet L. Yellen on Digital Assets
Last week (April 6, 2022), US lawmakers proposed stablecoin regulation "Stablecoin Transparency of Reserves and Uniform Safe Transactions Act of 2022," dubbed the Stablecoin TRUST Act which will:
- define a "payment stablecoin,"
- authorize the Office of the Comptroller of the Currency (OCC) to create a new license specific to stablecoin issuers,
- allow insured depository banks to issue payment stablecoins.
- address state regulatory oversight of this segment of the crypto industry.
Decrypt wrote: “Perhaps most notably, those issuing stablecoins will have to publicly disclose the assets that back them—be it cash reserves or something else”.
The need for more robust regulation on stablecoins and digital assets was then echoed in the remarks of the Secretary of the State, Janet Yellen.
Now the money laundering story. Although not new, there are very few publicly known stories involving money laundering with stablecoins (news from July 2021). The news we found come from Hong Kong where 4 persons were arrested for money laundering of $155 million through cryptocurrency wallets and bank accounts.
The syndicate laundered about HK$880 million ($113 million) through cryptocurrency between February 2020 and May 2021. The group has been using three shell companies that opened e-wallet accounts with an unnamed digital asset platform to trade the stablecoin tether. It’s also important to mention that the scheme also involved money laundering involving traditional banking channels. This case highlights the fact that criminals always look for opportunities and exploit existing weaknesses.
What are your thoughts on stablecoins? Are they risky, are they suitable for money laundering or fraud?
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