Stablecoins: What are they and why do they matter?
Playing word association with cryptocurrency is likely to elicit immediate responses like: “Bitcoin”, “Ethereum”, or even “Dogecoin” - after last spring’s massive run up. But mention stablecoin and responses may be few and far between. The term may even be mistaken for an oxymoron and garner a few chuckles as cryptocurrency values are generally understood to be highly volatile. Except that stablecoins, as implied in the name, are intended to be just the opposite. Their value is designed to remain fixed over time. While that may sound like a boring coin to those more focused on trading gains, to the broader crypto community, and quite likely just about everyone else, that stability has a very real value that is gaining relevance daily. The stablecoin market has grown from $12B in July of last year to over $112B in July of this year, an increase of over 830%. On a volume basis, Tether (USDT), the largest stablecoin by market capitalization, tops all cryptocurrencies in daily activity - even Bitcoin by a 2:1 margin! In fact, the market has grown so fast that financial authorities - who so far have taken a wait and see approach to cryptocurrencies - have begun to speak with more urgency about the need for regulation.
That kind of attention and growth is certainly not boring. So what then are stablecoins and why do they matter?
A stablecoin is a cryptocurrency that attempts to create price stability in its own value. It does this by borrowing the value of another asset while keeping its coins (or tokens) outstanding proportional to value of the associated asset. While this can be performed algorithmically, the more successful stablecoins have achieved price stability by holding a reference asset in reserve. This is a known as a collateralized stablecoin. The collateral can be physical currencies (e.g. US dollar or Euro), commodities (e.g. gold), or even other cryptocurrencies (e.g. DAI). The two largest stablecoins, Tether (USDT) and USD Coin (USDC), are denominated in US dollars and maintained on a 1:1 ratio. This means, in theory at least, there is a dollar backing every coin issued. Coins are issued when dollars are converted into a coin, and destroyed when coins are redeemed for dollars.
The United States used to print types of paper currency known as gold certificates and later also silver certificates. Each type could be carried into a bank and redeemed for their stated value in either gold or silver. These were created in part to instill trust that the paper notes were really worth their printed value. Stablecoins are following a similar model today to proxy as a digital dollar.
Okay, but what about bitcoin? Isn’t that supposed to be digital cash? Yes, and it is, but its value is too high and too volatile to function as a good medium of exchange. As of this writing, a single bitcoin (BTC) is priced just below $50,000. That’s fine if you want to buy a shiny new Tesla, the math is pretty easy. It will cost you roughly 1 to 3 BTC. But what if you wanted to buy a relatively low value item like a $30 pizza? That’s .0006 BTC. Doesn’t exactly roll off your tongue does it? Also, trying to maintain a sense of fair value on items priced out to the ten thousandths (or more) decimals place would a challenge for many. Was that .006 or .0006 BTC? Volatility however, is easily bitcoin’s bigger issue. Since its (weekly, daily, hourly) valuation can be subject to large price swings, transacting in bitcoin can be a risky endeavor for any enterprise trying to stay in business. Holding a significant portion of operating cash flow in bitcoin without sufficient cash reserves could cause a cash crunch if the price of bitcoin were to plunge suddenly.
Dollar denominated stablecoins mitigate this problem by removing the volatility. They are priced at a dollar and remain valued at a dollar. In other words they keep their value. And since they are a native cryptocurrency, they can be used anywhere in the world cheaply and quickly on almost any blockchain enabled platform.
 Whether these coins have actually been sufficiently backed is still subject to much debate. Here’s a primer: The Tether Controversy.
 Similar to how a dollar can be sub-divided into 100 cents, one bitcoin can be sub-divided into 100,000,000 Satoshis. This is the smallest bitcoin unit. Our .0006 BTC pizza would then become 60,000 Satoshis. Maybe that’s better?
 It sould be noted that stablecoins are created for specific blockchain protocols. A majority are Ethereum based and built around the ERC-20 token standard. Many are simultaneously built to support other protocols as well.
Stablecoins were originally, and still are, used heavily on crypto exchanges like Binance, Kraken, Coinbase, and many others. Some exchanges either do not accept fiat currencies at all, or when they do, the process can be tedious (see Know Your Customer (KYC)and Anti Money Laundering (AML) requirements), and/or slow and costly depending on the funding or transfer method used (ACH, SWIFT, credit card). As a proxy for physical cash, stablecoins quickly get around these ‘'speed bumps’' and allow for an almost immediate settlement across any exchange.
Other uses include:
- Using it as a store of value or a safe haven when markets become extremely volatile. A bearish trader expecting the market to go down could liquidate their other crypto holdings and park it in a stablecoin. This could preserve gains until markets start rising again.
- Similarly, a citizen in a high inflation environment (ex. Venezuela) could put their government backed cash into a stablecoin to preserve their purchasing power.
- Sending money quickly and cheaply overseas to friends or family.
More recently, Dencentralized Finance (DeFi) platforms like Maker, Compound, Aave have gained in appeal and utility because stablecoins can be used in those environments to earn higher returns than what could be earned by holding an equivalent amount of cash in a traditional savings account or money market fund.
Probably the biggest potential, though it that has yet to be realized, is if businesses start to use stablecoins in commerce. By controlling volatility risk, stablecoins offer a viable payment option that can be quicker and easier than existing payment channels while also promising lower fees. Visa and Mastercard have capitalized this opportunity and begun to offer USD Coin as a settlement method on their networks. Even JP Morgan is experimenting with its own stablecoin for use in global payments.
Benefits of issuing a stablecoin
Businesses obviously exist to make money and stablecoin issuers are no different. Though few are upfront about their monetization strategies, some of the economic incentives driving their issuance are easy enough to identify.
- Provide liquidity - Stablecoins help cryptoexchanges with transaction settlement. This means more people can execute trades, they can do so with greater frequency, and it makes it easier for them to stay engaged with the exchange over longer periods of time. All of these elements translate into more fee opportunities for the exchange. Given the benefits, cryptoexchanges clearly have every incentive to not only support stablecoins but even to assist with their creation. Tether and Bitfinex share many of the same executives and Coinbase and Circle have formed a joint venture to create and heavily promote USD Coin.
- Skim off interest rates - Tether (USDT) and USD Coin have a combined market capitalization of roughly $100 billion. As collateralized stablecoins, the collateral is either deposited or invested somewhere earning a rate of return. Unlike money market funds that payout earnings as interest to share holders, most stablecoins do not compensate their holders.
- Cash-in or cash-out fees - This appears to be an uncommon approach as Tether seems to be one of the few (only?) stablecoin issuers offering direct fiat deposits or withdrawals. Their fee schedule indicates a required $100,000 transaction minimum and fees based on the greater of $1000 or 0.1% of the transaction amount. Maybe there is a little extra money to be made in the low volume, high dollar value transactions?
While a little dated, other examples and additional insight can be found on Blockchain Capital’s post; The Business of Stablecoins.
Businesses that experience network effects generally accrue outsized gains and advantages over their competitors. Apple, Amazon, Facebook, Google, and Youtube have all benefited from network effects and stablecoin issuers can too. Jeremy Allaire, the CEO of Circle and one of the companies behind USD Coin, penned a company update that he envisions Circle to become a National Digital Currency Bank with USD Coin circulating as a national currency in the US. That’s certainly an ambitious goal, and its realization may even give new meaning to the term “too big to fail.”
Regulation on the horizon
In the US and around the world, cryptocurrencies have so far largely operated in a regulatory gray area. Some of this is because the underlying technology is still generally not widely understood, but also because cryptocurrency uses and applications are continually evolving. Different cryptocurrencies exist for different purposes and as of yet, there is no comprehensive framework or even agreement on how to assess the value they confer upon their holders. In broad brushstrokes, it can be said that cryptocurrencies are the result of a tokenization process to manufacture a digital assest. That asset may grant access to certain goods or services, be used as a payment vehicle for certain transactions, or even designate ownership and/or other rights upon the coin or token holder. Clearly not all cryptocurrencies are alike and so from a regulatory perspective they can’t just be lumped into a single bucket. From a taxation perspective maybe it’s a little easier, the IRS has largely decided to treat all cryptocurrencies as property, and the accounting industry - without any crypto specific guidance to date - has defaulted to recording them as intangible assets.
Collaterallized stablecoins however, are tangible. Dollar denominated coins are fully intended to be a digital equivalent of physical dollars and they have a very realistic chance of being used in everyday commerce. This has not been lost on federal regulators. At a conference on stablecoins in July, Janet Yellen, the Treasury Secretary, noted “the need to act quickly” to ensure there is an appropriate U.S. regulatory framework in place and Jerome Powell, the chairmen of the Federal Reserve, went as far to say they should be regulated “in comparable ways” to bank deposits and money market mutual funds.
Why do they care so much? Well, here’s a few reasons:
Preserve control over monetary policy
Traditionally a country’s central bank is responsible for determining the country’s monetary policy. These policies help expand the country’s economy, promote job growth, and maintain price stability by taming inflation. In the US, the Federal Reserve plays this role. It has supervisory and regulatory authority over banking institutions and implements some of its policies through a process known as fractional reserve banking. This helps to expand and contract the nation’s money supply. Stablecoins currently exist entirely outside of this system. Should they become generally accepted as a form of payment, that could become a problem for any central bank focused on fostering financial stability in its economy.
Consider this: In 2019, Facebook announced plans to create its own stablecoin named Libra. While the original vision never came to fruition in part because of governmental scrutiny across the world, a revamped offering named Diem is currently in the works. Ranked by active users, Facebook and its related properties occupy 4 out of the top 5 slots in a worldwide ranking of social networks. That’s billions of people that could potentially use its stablecoin. Compare that to the US population of only 330 million and the potential power dynamic over central banks around the world becomes a little more clear.
Protect against fraud and financial calamities
The 2008 Financial Crisis in the US had many interrelated causes that cascaded into a contagion across financial markets. Many people may recall the collapse of Lehman Brothers during this time, but few are familiar with the ripple effect it had on money market mutual funds (MMMFs). The Reserve Primary Fund, once one of the oldest and largest MMMFs in the US, was holding $785 million in Lehman commercial paper that became essentially worthless overnight due to Lehman’s failure. This caused the fund to “break the buck”, a colloquialism indicating the fund’s assets were valued on a per share basis less than $1. For a prominent mutual fund this was a first and it devastated trust in the other MMMF’s, triggering panic selling across the industry. Fearing a run could happen on other mutual funds, the federal government stepped in with the Temprorary Liquidity Guarantee Program (TLGP) to restore faith and guaranteed the other mutual funds would remain valued at $1 per share.
The thing is; Tether, USD Coin, and other stablecoins look a lot like a mutual fund. They take in “deposits” and issue coins/tokens as a mutual fund would with shares. However, unlike mutual funds and other deposit accounts that are heavily regulated, stablecoins have no such restrictions or regulations placed upon them. Are Tether and USD Coin fully backed 1:1 with deposits as both have repeatedly claimed? There’s no mechanism in place to independently verify their assurances so the market basically has to take their word for it. While both have issued attestations (Tether, USC Coin)“proving” their reserves exist, the makeup of the reserves and lack of qualitative details hasn’t exactly quieted criticism of either (Tether, USD Coin).
While stablecoins have yet to reach the level of importance mutual funds and other deposit accounts currently play in broader financial markets, they have the potential to do so at an equal or even greater capacity and that is what has regulators concerned.
 A follow up post exploring the resemblance between dollar backed stablecoins and money market mutual funds and the potential for regulation is available here.
Central Bank Digital Currency (CBDC)
In light of the various benefits and threats posed by stablecoins, central banks around the world have been weighing whether they ought to issue their own digital currencies. As of July 2021, 81 countries representing over 90% of global GDP were exploring central bank digital currencies (CBDC). China has already launched a pilot of a digitized Yuan DCEP/DCNY and the US is still considering the relative merits of its own ‘FedCoin’ issuance.
What would a CBDC look like? Hard to say with certainty, but a consortium of central banks and related organizations have been working together to define a set of foundational principles and core feaures. Some advantages a CBDC could have over current stablecoins is they would likely be considered legal tender in their country of issuance and be generally regarded as a safer asset given their issuance and backing is directly from a government. Businesses looking for a faster and less costly ways to settle payments are likely to find a lot of value transacting with a CBDC. A properly designed CBDC could also promote financial inclusion and even enhance monetary policy by providing real time data. Just how much data is collected and visible by whom however, will be a real sticking point. Few people would like the government having insight into every purchase they make (… not sure why Facebook’s Diem should be view any differently, but that’s another story…).
Part of the original lure with cryptocurrencies was that they represented money independent of politicians and governments. A CBDC is clearly incompatible with that notion but it also shows that a much wider audience has begun to take cryptocurrencies seriously. By removing volatility from their risk profile, stablecoins became a good store of value and a viable liquidity option in an array of applications and markets. Whether CBDCs take over this role remains to be seen. With the world moving closer to a cashless future and cryptocurrencies representing a form of programmable money that the current infrastructure does not and can not support, it really doesn’t matter. Eitherway, a cryptocurrency representing digital cash is coming our way soon.