Understanding Stablecoins: Uses, Risks, and Regulations

Cryptocurrencies are known for their volatility, with prices experiencing rapid and unpredictable fluctuations. This inherent instability poses a significant barrier to the widespread adoption of digital assets, especially for applications requiring price stability. Stablecoins, a novel class of crypto-assets, offer a potential solution by providing a more stable value proposition. This blog post delves into the inner workings of stablecoins, exploring their core functionalities, and the mechanisms employed to maintain their peg to a designated external reference asset.  It also examines the potential risks associated with their use, the regulatory landscape, and the challenges faced by global and regional authorities in governing these digital assets.

Defining Stablecoins and Their Purpose

Stablecoins can be defined as cryptocurrencies whose value is linked to a designated external reference asset. Different types of stablecoins can encompass the following:

• Fiat-collateralized Stablecoins: The most prevalent form of pegging involves a direct linkage to a specific fiat currency, such as the US Dollar Tether (USDT) or USD Coin (USDC). In these instances, one unit of the stablecoin typically represents one unit of the underlying fiat currency.
• Commodity-Backed Stablecoins: A less common approach involves pegging to the market value of physical commodities like gold, offering a distinct diversification option for investors. One such commodity-backed stablecoin includes Tether Gold (XAUt), backed by gold reserves.  
• Cryptocurrency-Backed Stablecoins: Crypto-backed stablecoins use other cryptocurrencies as collateral. This can be risky because crypto prices can fluctuate rapidly. To make up for this, these stablecoins are usually "overcollateralized”. For every $1 worth of stablecoin issued, there might be $2 worth of cryptocurrency backing it up. That way, even if the price of the backing crypto drops by half, the stablecoin's value is still safe. A good example of this is Dai (DAI), a stablecoin pegged to the US dollar but backed by Ethereum (ETH).
• Algorithmic Stablecoins: Algorithmic stablecoins represent a unique approach to maintaining price stability. Unlike their fiat-collateralized and crypto-collateralized counterparts, algorithmic stablecoins eliminate the need for a trusted custodian to hold reserve assets, promoting a more decentralized financial system. Instead, they leverage the power of smart contracts and economic incentives to dynamically regulate supply and demand, ultimately targeting a predetermined peg (often a fiat currency). 

The core functionality of an algorithmic stablecoin hinges on a set of pre-programmed algorithms embedded within a smart contract. These algorithms continuously monitor the market price of the stablecoin relative to its target peg. When the price deviates from the peg, the smart contract automatically executes corrective measures.

Different Types of Stablecoins: 

Type of Stablecoin

Backing Asset

Mechanism for Maintaining Peg

Fiat-Collateralized

Fiat Currency (USD, EUR, etc.)

Custodian holds reserves of the underlying fiat currency.

Commodity-Collateralized

Commodities like gold or silver

Custodian holds reserves of the underlying commodities

Crypto-Collateralized

Other Cryptocurrencies

Value depends on the collateral's value and peg maintenance mechanism.

Algorithmic

None (may have some collateral)

Smart contracts and algorithms manage supply and demand.

Why Do We Need Stablecoins?

The primary objective of stablecoins is to provide users with a cryptocurrency that exhibits the following characteristics:

• Price Stability: In contrast to prominent cryptocurrencies like Bitcoin or Ethereum, which are notorious for their price fluctuations, stablecoins offer a more predictable store of value.
• Enhanced Efficiency: Transactions facilitated by stablecoins are typically characterized by faster processing times and lower fees compared to traditional banking systems.
• Global Accessibility: The inherent nature of cryptocurrencies enables anyone with an internet connection to access and utilize stablecoins, transcending geographical limitations.

These attributes render stablecoins suitable for a variety of applications, including:

• Facilitating Everyday Transactions: Stablecoins can be employed for online purchases or for sending and receiving remittances swiftly and efficiently on a global scale.
• Hedging Against Volatility: Investors can leverage stablecoins to mitigate the risks associated with price swings in their overall cryptocurrency portfolios.
• Decentralized Finance (DeFi): Stablecoins play a pivotal role within Decentralized Finance platforms, enabling functionalities such as lending, borrowing, and engaging in various other financial services.

The Dark Side of Stability: Illicit Use of Stablecoins

Stablecoins offer a compelling vision - a cryptocurrency with the ease and speed of digital transactions but without the wild price swings. However, this ease of use can also make them attractive for illicit activities. 

The anonymity and fast transaction times offered by stablecoins make them appealing to criminals. The ability to transfer stablecoins across borders with relative ease also raises concerns about money laundering. Criminals convert ill-gotten gains into stablecoins and then move them across borders to seemingly legitimate accounts, obfuscating the trail and making it harder to track the source of the funds.

While the mechanisms maintaining a stablecoin's peg are typically automated, there's always the potential for exploitation. A large, coordinated effort to buy or sell a stablecoin in a short period could theoretically disrupt its peg, creating opportunities for manipulation.

According to our internal analysis at Merkle Science, over 0.61%, or an estimated $1.12 trillion, of USDT transactions between July 2021 and June 2024 were flagged as potentially illicit and over 6.58% of USDT transactions involved sanctioned entities during the same period. 

Compared to USDT, USDC paints a brighter picture. More than 0.22% of USDC transactions during the same period were flagged as potentially illicit and 0.005% (almost $59,073,956) of the total transacted USDC volume is suspected to be linked to sanctioned entities.

It's important to note that regulators around the world are grappling with how to address these potential risks. Finding the right balance between fostering innovation and mitigating illicit activity will be crucial for ensuring the safe and responsible use of stablecoins.

Stablecoin Regulation

The Global Push for Clarity

In 2023, the Financial Stability Board (FSB) issued a set of high-level recommendations for regulating global stablecoins (GSCs). These recommendations focus on ensuring adequate reserves, mitigating operational risks, and establishing clear oversight frameworks. Working alongside the FSB, the International Organization of Securities Commissions (IOSCO) is exploring how existing securities regulations might apply to certain stablecoins, particularly those with investment characteristics.

Regional Regulatory Responses

• United States: The US is fragmented, with different regulatory bodies staking their claim. The Securities and Exchange Commission (SEC) is looking at stablecoins as potential securities, while the Commodity Futures Trading Commission (CFTC) is focusing on those tied to commodities. Executive orders are also being explored to establish a coordinated federal approach.
• European Union: The European Commission's Markets in Crypto Assets (MiCA) framework, coming into effect in June 2024, represents a comprehensive approach. MiCA categorizes and regulates different types of crypto-assets, including stablecoins, focusing on consumer protection, market integrity, and financial stability.
• China: China has taken a stricter stance, cracking down on cryptocurrency trading and mining activities. This includes scrutiny of stablecoins, with a focus on mitigating potential financial risks.

What's Next for Stablecoins?

International cooperation among regulators will be crucial to establish consistent standards for stablecoins and to prevent regulatory arbitrage (exploiting loopholes in different jurisdictions). Regulatory frameworks need to be adaptable to keep pace with the fast-evolving world of stablecoins and other crypto-assets.

The regulation of stablecoins is still in its early stages. The coming months and years will likely see further developments as governments and regulatory bodies refine their approaches. However, one thing is clear: stablecoins are here to stay, and clear regulations are essential for ensuring their safe and responsible use in the global financial system.