Stablecoins and the Future of Money

The collapse of TerraUST (UST) earlier this month has raised questions on the future and viability of stablecoins. UST was a different kind of stablecoin compared to the likes of Tether (USDT); however, there have been similar issues associated with USDT in the past over its reserve backing. The importance of stablecoins within the cryptocurrency space cannot be understated. They help minimize volatility and allow users to seamlessly trade between assets without dealing with banks and exorbitant fees.

Stablecoins also serve as the backbone of DeFi. They allow investors to generate yield on their investments without suffering from the inherent volatility. It should be noted that these yields far outweigh what one can get from holding fiat in a savings account, and this makes DeFi more appealing despite a few risks associated with the space.

The appeal and convenience of stablecoins have resulted in the market growing to a valuation of over $160 billion, and these assets continue to play an integral role when it comes to borrowing, lending, and trading digital assets. However, ongoing issues regarding reserve backing and implosions, the kind seen with TerraUST, have left many wondering how stable these assets are. This piece will explore what regulators have in store to protect the average user. But, first, let us look at the different kinds of stablecoins available in the market.

Understanding Stablecoins

According to Gemini, “stablecoins offer a way to bridge the gap between fiat currencies like the U.S. dollar and cryptocurrencies. Because they are price-stable digital assets that behave somewhat like fiat but maintain the mobility and utility of cryptocurrency, stablecoins are a novel solution to crypto volatility: price stability is built directly into the assets themselves.” They fall into four primary categories, identifiable by their underlying collateral structure: fiat-backed, crypto-backed, commodity-backed, and algorithmic.

Fiat Backed Stablecoins

Fiat-backed stablecoins are the most common and well-known stablecoins today. They are considered off-chain assets since the underlying collateral is not another cryptocurrency. They have fiat currency backing such as USD, Euro, GBP, Yen, etc. They are the simplest stablecoins you will come across, usually with a 1:1 ratio backing. If an issuer has $5 million of fiat currency, it can only distribute 5 million stablecoins. A few good examples include USDC, GUSD, BUSD, etc.

Crypto Collateralized Stablecoins

These are considered on-chain assets since another cryptocurrency backs them as collateral. Smart contracts are used to maintain the balance instead of a central issuer. To acquire this kind of stablecoin, you have to lock your cryptocurrency into a smart contract first. DAI is a good example achieved through collateralized debt position (CDP) via MakerDAO, which secures assets as collateral on the blockchain. Another important thing to note is that this kind of stablecoin is over-collateralized to buffer against price fluctuations.

Commodity-Backed Stablecoins

These stablecoins are backed using physical assets such as precious metals, oil, and real estate. These stablecoins facilitate investments in assets that may otherwise be out-of-reach locally. The most popular commodity to be collateralized is gold. Good examples include Tether Gold (XAUT) and Paxos Gold (PAXG). However, it is important to remember that these commodities can and are more likely to fluctuate in price.

Algorithmic Stablecoins

These stablecoins do not use fiat, crypto, or commodities as collateral. Instead, they achieve price stability by using specialized algorithms and smart contracts that manage the supply of tokens in circulation. A good example is TerraUST.

Regulators’ Take on Stablecoins

Stablecoins are the backbone of the crypto industry, and regulators are aware of this. However, regulating decentralized assets has proven to be a problem for regulators around the globe. The UST collapse that saw Tether drop under $1 for a while is said to have caused panic among US authorities who, for a while, have known that regulation is the only way out. In the past, we have witnessed federal authorities such as Gary Gensler, Jerome Powell, and Janet Yellen call for quick action when it comes to regulating stablecoins.

The recent UST collapse where many individuals lost their lifesavings highlights the need for some regulation to protect the average consumer. Speaking about the incident, Yellen claimed that even though stablecoins do not pose a systematic risk to financial stability, they are growing out of control. She went on to add, “they present the same kind of risks that we have known for centuries in connection with bank runs.” Thus, she urged Congress to approve federal regulation of stablecoins by the end of this year.

UK regulators have also been monitoring stablecoins. According to a government spokesperson, “the government has been clear that certain stablecoins are not suitable for payment purposes as they share characteristics with unbacked crypto assets.”

It is believed that the UK plans to bring stablecoins within the scope of electronic payments regulation, and this could see issuers such as Tether and Circle be supervised by market watchdogs. Additionally, the EU plans to bring these assets under strict regulatory oversight.

What is clear is that regulators understand crypto is here to stay. They also realize the crucial role stablecoins play within the ecosystem; thus, regulation appears to be the logical way to protect the average consumer while avoiding the stifling of innovation within the financial industry.