Innovation

Stablecoins: An FAQ on these digital assets

September 9, 2021 | By Jennifer Lorentz

If you’re unwilling to take a ride on the roller coaster of volatile cryptocurrencies like Bitcoin or Ether, stablecoins might be more your speed. As their name suggests, they are a type of digital asset built to maintain a stable value — and they may just be the next generation of digital money.

With the promise of enabling faster transaction speed and increased efficiency, stablecoins may power a new wave of digitization of financial services, including micropayments, payroll, escrow, overseas remittances and foreign exchange trading.

Although stablecoins have been circulating since 2014, the demand for them has exploded over the past year. The transaction volume of stablecoins grew more than tenfold between January 2020 and January 2021, to $308.5 billion, according to a March report from The Block Research. The number of daily transactions has grown by 500% since last year.

This growth, combined with the rapid shift toward digital payments during COVID-19, has led regulators to take notice — and they’re starting to take action in shaping how stablecoins could operate in everyday banking and payment services. There’s no denying that the worlds of crypto and traditional finance are colliding. However, it’s unlikely to be a simple path of progression. Here’s what you need to know:

stable
/ˈstābəl/ • adjective

1. not likely to give way or overturn; firmly fixed, steadfast.

2. not changing or fluctuating; unvarying.

 

 

What is a stablecoin?

The term is not legally defined, but it generally refers to a type of digital asset that is issued by a private company and transferred by way of distributed ledger technology, also known as blockchain.

The difference between a stablecoin and free-floating crypto assets like Bitcoin is that the stablecoin issuer attempts to stabilize its value by linking its price to another asset, such as the U.S. dollar. For a dollar-pegged stablecoin, someone would exchange $1 for 1 stablecoin.

Stablecoins are used as a means of payment, store of value or utility. For instance, stablecoins are often utilized as a bridge between more volatile crypto assets and fiat currencies; crypto holders convert Bitcoin or Ether into a stablecoin and then to a fiat currency like the U.S. dollar, which can make it easier to spend their funds.

Stabilizing its value makes it more likely for stablecoins to be used in everyday commerce than free-floating cryptocurrencies. But it’s not that simple. One of the key outstanding issues for stablecoins centers around just how they maintain that so-called stable value — that is, the mechanisms by which these pegs are controlled and how the value is backed by real value.

OK, but then what’s a digital asset?

“Digital asset” is an umbrella term used for a variety of digital coins and tokens made to represent some form of value or contractual rights. Digital assets can include private cryptocurrencies, stablecoins and even central bank digital currencies (CBDCs — more on those later). The term can also refer to NFTs, or non-fungible tokens, which can take the form of digital art, collectibles or other kinds of digital keepsakes.

The most popular cryptocurrencies, like Bitcoin, are known as free floating crypto. Since their value isn’t tied to an asset or algorithm, they often see large shifts in price.

The most popular cryptocurrencies, like Bitcoin, are known as free floating crypto. Since their value isn’t tied to an asset or algorithm, they often see large shifts in price.


Can a stablecoin be pegged to other assets?

Yes. Of the 200-plus stablecoins in circulation, most are linked to the U.S. dollar, but there are others pegged to commodities like gold or oil, other crypto assets, or a basket of fiat currency or cryptocurrencies. Some stablecoin issuers use an algorithm to adjust its supply based on demand to help keep prices stable. Though the math is complex, essentially more coins are issued when the price goes up, and burned when the price falls.

So … is it actually stable?

Regulators generally scoff at the term “stablecoin” for promoting the presumption that the assets’ values are inherently stable, which has the potential to mislead consumers and investors. Rather, regulators refer to these cryptos as “so-called stablecoins,” because the stability of their value ultimately depends on the structure and design of their backing and governance model. In order for them to remain truly stable, the issuer must make an enforceable commitment to issue and buy back the stablecoin at the current value of the asset to which it is pegged, as well as to hold assets backing the stablecoins in circulation as collateral so that they can be redeemed at any time. The risk they could pose to consumers or to markets generally if they are not adequately collateralized is a major concern to regulators.

Collateralized … what’s that?

Collateralization is really important. It ensures that a stablecoin can be redeemed at any time. Collateralization means that a stablecoin issuer essentially has enough reserves set aside — U.S. dollars or gold, for example — in case a surge of its customers decide to sell their stablecoins. It’s not unlike a bank having enough cash in its safe in case of a bank run by its customers. This risk has prompted a movement within the crypto industry around “proof of reserves,” or “PoR,” but there is not yet a standard for doing this.

How are stablecoins regulated today?

Over the past few years, the wait-and-see approach from regulators has dramatically changed. Don’t blink an eye or you’ll miss a new regulator weighing in or refreshing their position. As in the broader digital asset industry, regulation of stablecoins is extremely fragmented. Depending on the design and intended function of the coins, stablecoins may be prohibited from use for certain functions like payments (Turkey) or by banks (India, China, Indonesia). Increasingly, digital assets are being regulated under existing banking, money transmission, payments and securities/futures regulations (U.S.), and many regulators have amended or are looking to amend existing rules to cover activities involving digital assets (U.S., U.K., Singapore, South Africa). In some circumstances, legislators have enacted new digital-asset-specific regulations (Switzerland, Gibraltar) or are looking to do so (EU).

Trying to navigate this jigsaw puzzle of regulation makes it incredibly challenging to innovate with legal certainty. Many markets, including the U.S., the U.K. and the EU, are ramping up their regulatory efforts, and the European Central Bank has already said that stablecoin issuers should be subject to “rigorous liquidity requirements” — essentially requiring a lot of cash reserves — and believes it should have veto power over stablecoins in the euro zone.

A stablecoin ties the value down to an asset, like the U.S. dollar, to prevent the same price shifts seen in free-floating crypto.

A stablecoin ties the value down to an asset, like the U.S. dollar, to prevent the same price shifts seen in free-floating crypto.


Wait, aren’t those same central banks considering issuing their own digital currencies?

Yes. Many central banks have been eyeing the rise of both free-floating cryptocurrencies and stablecoins with concern because most believe that, if left unregulated, stablecoins have the potential to destabilize a financial system and risk another worldwide recession like we experienced in 2008. If stablecoins aren’t properly regulated, there’s concern from governments that they could also enable criminals and tax cheats.

Central bank digital currencies would be equivalent in value to a country’s legal tender (dollar bills, for example) and are designed to be used the same way — as a medium of exchange to buy and sell goods and services, just like private stablecoins. But unlike private stablecoins, CBDCs would be issued by a country’s central bank (like dollar bills) and would carry the same guarantee as paper currency.

Stablecoins just sound like the digital money I already use in my banking app. What’s the difference?

It’s a great question, and unfortunately the answer is not yet clear. In some ways, stablecoins could act exactly like digital money today, to buy goods and services.

But there are a few major differences stablecoins could bring to the table. First, rights and protections — stablecoins may provide a completely different set of rights around the ability to redeem and what consumer protections are in place if they suddenly can’t be redeemed. Second, transparency — allowing users to see all transactions. And finally, programmability – the ability to add new features or automation since stablecoins are software, not just a digitized form of paper money.

Regulators and legislators around the world are evaluating whether stablecoins fit into a preexisting money-like category or whether stablecoins represent a totally new type of money in need of a new regulatory framework.

Who are the major players in the stablecoin world?

The most popular stablecoins by total value — Tether, USDC and Binance — have been issued by crypto-centric companies and projects. Some believe that this will soon change, with more traditional financial institutions expected to launch their own stablecoins, which may just be new digital versions of the commercial deposits that exist today. There are already signs that this may be the case in the U.S., Canada and Russia. But even if banks don’t issue their own stablecoins, it’s likely there will be increasing integration of stablecoin-related services within traditional banks via crypto-bank partnerships.

I’ve heard about concerns with Tether. What’s going on there?

Tether is by far the most popular stablecoin, with a market capitalization of more than $68 billion. However, many news stories have come out about the lack of transparency of Tether and its parent company and whether Tether has in fact backed its stablecoin with real assets.

In response, Tether has made efforts to publicize audits of its reserves to prove it didn’t simply create new tokens out of thin air and has enough reserves in case people want to convert their Tether back to a fiat currency like the U.S. dollar.

Regardless, the situation highlights how new the stablecoin industry still is and why regulators are continuing to take a hard look at these assets and how they ultimately are backed. And this is prompting other issuers to increase transparency around the reserves backing their respective stablecoins.

What about Facebook’s work on a stablecoin, called Diem (formerly Libra)?

In 2019, Facebook announced its plans to launch a universal digital currency tied to a basket of national currencies through the Libra Association, which included members in banking, payment processing, venture capital, nonprofits and tech platform giants. But it quickly faced considerable regulatory and political scrutiny, and many companies that were expected to join Libra left the project.

In late 2020, Facebook rebranded Libra as Diem, and it has since scaled back its plans for a single global currency. It now plans to launch a stablecoin pegged to the U.S. dollar with Silvergate Bank, based in California. Recent news reports indicate the initiative continues to face regulatory challenges, so the status of the launch of the Diem stablecoin is unknown. Meanwhile, Facebook appears to be charging ahead through its subsidiary Novi, which has positioned itself to be the Facebook wallet for stablecoins.

Jennifer Lorentz, senior managing counsel, law, franchise and integrity