Stablecoins: Navigating the Challenges and Risks

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19 May 2023

Stablecoins are a form of cryptocurrency that aim to maintain a stable value by being pegged to another asset, such as a fiat currency or a commodity. Stablecoins have emerged as a popular and fast-growing segment of the crypto space, offering benefits such as lower volatility, faster transactions and lower costs than other types of crypto assets. Nonetheless, stablecoins also pose significant challenges and risks for the crypto space and the broader financial system, which require careful and coordinated regulation.
In this post, we will delve into the concept of stablecoins, their mechanics, and the implications they hold for the financial landscape. We will also provide some real-world examples and recommendations to help you navigate the challenges and risks of stablecoins.

What are stablecoins and how do they work?

Stablecoins are a form of cryptocurrency that aims to maintain a stable value, usually pegged to a fiat currency like the US dollar or a commodity like gold. Unlike other cryptocurrencies, such as Bitcoin or Ethereum, which exhibit significant price volatility, stablecoins seek to mitigate this volatility by anchoring their value to an underlying asset.

There are four main types of stablecoins:

Fiat-collateralized stablecoins: These stablecoins are backed by reserves of fiat currency, typically held in a bank account. For example, Tether (USDT) and USD Coin (USDC) are pegged to the US dollar, with each coin representing one US dollar held in reserve. The value of these stablecoins remains stable as long as the fiat currency they are pegged to maintains its value.
Crypto-collateralized stablecoins: These stablecoins are backed by a pool of other cryptocurrencies. Users deposit a certain amount of cryptocurrency, such as Ethereum, as collateral, and in return, they receive stablecoins. The collateralized cryptocurrencies act as a reserve to maintain the stability of the stablecoin. Dai, created by MakerDAO, is an example of a crypto-collateralized stablecoin.
Algorithmic stablecoins: These stablecoins do not rely on collateral and instead use complex algorithms to maintain stability. The algorithms adjust the supply of stablecoins based on various market factors, such as demand and price fluctuations. Basis and Ampleforth are examples of algorithmic stablecoins, although their success has been mixed due to challenges in maintaining stability.
Commodity-pegged stablecoins: Commodity-pegged stablecoins are a type of stablecoin that derives their value from a physical commodity, such as gold or oil, rather than being pegged to a fiat currency, providing stability through the underlying commodity’s inherent value.

What are the benefits of stablecoins?
Stablecoins offer several benefits for users and investors in the crypto space and beyond.

Some of these benefits include:

Lower volatility: Stablecoins reduce the risk of price fluctuations that affect other cryptocurrencies, making them more suitable for everyday transactions and long-term investments.
Faster transactions: Stablecoins enable faster and cheaper transactions than traditional payment systems, especially for cross-border payments and remittances.
Lower costs: Stablecoins eliminate or reduce intermediaries and fees associated with traditional payment systems, such as banks or payment processors.
Financial inclusion: Stablecoins have the potential to improve financial inclusion by providing access to digital money and payments for the unbanked or underbanked populations.
Innovation: Stablecoins foster innovation in the crypto space by enabling new use cases and services, such as decentralized finance (DeFi), which offers alternative financial solutions based on blockchain technology.

What are the challenges and risks of stablecoins?
Stablecoins face several challenges and risks that need to be addressed by regulators, developers, issuers, and users.

These include:

Regulation: Stablecoins are subject to market, credit, and liquidity risks. They may also pose systemic risks to the financial system if they become widely used and interconnected. For example, a sudden spike in demand for repayment could cause a stablecoin to “break the buck” the same way the Reserve Primary Fund did in September of 2008, which triggered a run on money market mutual funds. Regulators need to establish clear and consistent rules for stablecoin issuers and users, such as capital requirements, reserve management, consumer protection, anti-money laundering, and tax compliance. Moreover, regulators need to coordinate and cooperate across jurisdictions and sectors to ensure a level playing field and avoid regulatory arbitrage or fragmentation.

The Stability Test - How to keep the peg and avoid the plunge

One of the main challenges of stablecoins is ensuring their stability and resilience. Stablecoins rely on various mechanisms to maintain their peg to the underlying asset, such as collateralisation, algorithmic adjustment or redemption guarantees.
These mechanisms may not always work effectively or reliably, especially in times of market stress or volatility. For example, if the value of the collateral backing a stablecoin falls below the value of the stablecoin itself, or if the redemption guarantee is not honoured by the issuer, the stablecoin may lose its peg and cause losses for its holders. Furthermore, if a stablecoin faces a sudden surge in demand or supply, it may experience price fluctuations that deviate from its intended value.

Here are some cases of Real-world examples:

Real-world example: The case of Tether
A real-world example of these challenges can be seen in the case of Tether, one of the most popular stablecoins. Tether is pegged 1:1 to the US dollar and is backed by reserves held by its issuer. Yet, there have been concerns about whether Tether’s reserves are sufficient to maintain its peg and whether its reserves are transparently disclosed. These concerns have led to calls for greater regulatory oversight and transparency for Tether and other stablecoins.

Real-world example: The case of Libra/Diem
A real-world example of these regulatory challenges can be seen in the case of Libra/Diem, a proposed global stablecoin project initiated by Facebook in 2019. Libra/Diem faced strong opposition from regulators around the world due to concerns about its potential impact on monetary policy, financial stability, consumer protection, privacy, and sovereignty. As a result, Libra/Diem had to revise its original vision and design several times to address these concerns. Libra/Diem is still awaiting regulatory approval before launching its stablecoin.

Real-world example: The case of USDC
A real-world example of these adoption challenges can be seen in the case of USDC, a fiat-collateralized stablecoin issued by Circle and Coinbase that is pegged 1:1 to the US dollar. USDC has grown rapidly since its launch in 2018, reaching over $30 billion in circulation as of November 2022. USDC has been used for various purposes, such as cross-border payments, remittances, trade finance, DeFi services, and philanthropy. However, USDC also faces challenges in expanding its user base and use cases beyond the crypto ecosystem. Some of these challenges include: lack of awareness or understanding among potential users; lack of trust or confidence in USDC’s issuer or custodian; lack of access or availability of USDC-compatible wallets or platforms; lack of clarity or consistency in USDC’s regulatory treatment across different jurisdictions; and lack of integration or interoperability with other payment systems or networks.

Real-world example: The case of DAI
A real-world example of these security challenges can be seen in the case of DAI, a crypto-collateralized stablecoin issued by MakerDAO that is pegged 1:1 to the US dollar. DAI users deposit Ethereum or other cryptocurrencies as collateral into smart contracts called Vaults, which generate DAI tokens that can be used for various purposes. Nonetheless, DAI has faced several security incidents that have threatened its stability or functionality.

Some of these incidents include:

A market crash in March 2020 that caused some Vaults to become undercollateralized and liquidated at zero bid auctions, resulting in a loss of $8.3 million worth of Ethereum for some users.
A governance attack in November 2020 that exploited a vulnerability in the MakerDAO voting system and attempted to steal $340 million worth of DAI from the MakerDAO surplus buffer.
A flash loan attack in March 2021 that exploited a flaw in the MakerDAO liquidation system and drained $14 million worth of DAI from the MakerDAO protocol.

These incidents have exposed the risks and limitations of relying on complex and untested code, decentralized governance, and third-party platforms for maintaining the security and stability of stablecoins. They have also highlighted the need for more rigorous auditing, testing, monitoring, and upgrading of stablecoin systems, as well as more effective communication, coordination, and contingency planning among stablecoin stakeholders.

The Compliance Puzzle - How to fit in the regulatory maze

Another challenge of stablecoins is ensuring their compliance with regulatory standards and requirements. Stablecoins may fall under different regulatory frameworks depending on their design, function and jurisdiction. For example, some stablecoins may be considered as securities, commodities, currencies or payment instruments, and may be subject to different rules and regulations regarding issuance, trading, reporting, disclosure, taxation and anti-money laundering. Though, some stablecoins may not fit neatly into any existing regulatory category, or may operate across multiple jurisdictions with different regulatory regimes. This creates uncertainty and confusion for both regulators and market participants, and may lead to regulatory arbitrage, fragmentation and inefficiency.

The Role of Regulation
Regulation should aim to balance the potential benefits of stablecoins with the potential risks they pose, while also fostering innovation and competition in the crypto space. Regulation should also aim to provide clarity and consistency across different jurisdictions and regulatory frameworks, while also respecting the diversity and specificity of different types of stablecoins. Regulation should also aim to promote compatibility and interoperability between stablecoins and other types of crypto assets and the traditional financial system, while also ensuring security and resilience.

The Compatibility Game - How to play well with others

A third challenge of stablecoins is ensuring their compatibility and interoperability with other types of crypto assets and the traditional financial system. Stablecoins may serve as a bridge between the crypto space and the traditional economy, facilitating cross-border payments, remittances, trade finance and other use cases. Nonetheless, stablecoins also face technical and operational challenges in integrating with different platforms, protocols and networks. For example, some stablecoins may not be compatible with certain blockchain standards or smart contracts, or may face scalability or security issues. Stablecoins may also face legal and institutional challenges in interacting with other financial intermediaries and service providers. For example, some stablecoins may not have legal tender status or recognition in certain jurisdictions, or may face restrictions or sanctions from certain authorities or entities.
Stablecoins have significant implications for the crypto space and the broader financial system, which require careful and coordinated regulation. Stablecoins may also face competition from other forms of digital money such as central bank digital currencies (CBDCs) or other private initiatives. Therefore, stablecoins need to constantly evolve and improve their features and services to meet the changing needs and expectations of the market.

Stablecoins: A Balancing Act Between Innovation and Regulation

Stablecoins are an innovative and promising form of digital money that can offer faster, cheaper, and more inclusive payment solutions. Conversely, stablecoins also face significant challenges and risks that need to be addressed by regulators, developers, issuers, and users. To realize their full potential, stablecoins need to balance innovation with regulation, ensure technical reliability and security, foster user adoption and trust, and maintain price stability.