The Ultimate Guide to Stablecoins

Stablecoins have become a big part of the cryptocurrency world, and they’re set to play an even bigger role by the end of 2024. They’re a relatively new way to fight against the volatility that burdens many digital currencies. 

This guide will cover exactly what stablecoins are, the different types available, and the regulatory future they may have.

What are Stablecoins? 

Stablecoins are a type of cryptocurrency that keeps a stable value by pegging their value to a reserve of assets. For example, FIAT currency like the US dollar may be used, or commodities like gold. This is very similar to the idea that underpinned the Gold Standard, in which your US dollars would be backed by gold to ensure the value of said dollar. 

Unlike other cryptocurrencies, which can be highly volatile, stablecoins aim to offer price stability by giving them relative value. So in short, this makes them a safer option for transactions and investments.

You may be wondering why you would ever want to buy a stablecoin if the price isn’t going to shoot up and make you lots of money. But, of course, there’s more to crypto than capital gains—the coins themselves are to be used in transactions, and this gives the seller/recipient greater confidence in dealing in crypto.

So, the primary purpose of stablecoins is to combine the benefits of cryptocurrencies (like fast transactions and low fees) with the stability of traditional currencies. It’s the best of both worlds, supposedly. 

This may make them particularly useful for trading, as they allow traders to move funds quickly without worrying about sudden changes in value. They may also serve as a hedge against the volatility of other cryptocurrencies. But, we’re still in the early stages of seeing how they can be used. It might be remittance, e-commerce payments, or DeFi services…  

Types of Stablecoins 

We can put stablecoins into three main types: fiat-collateralised, crypto-collateralised and algorithmic stablecoins. Each type uses a different mechanism to maintain stability.

FIAT-collateralised Stablecoins 

FIAT-collateralised stablecoins are exactly as you may imagine. They’re backed by a pool of FIAT currency, like the dollar (the world’s reserve currency). This is typically held in a bank, ready to provide liquidity for the stablecoin holders. Tether (USDT) is a good example of this, as well as the aptly named USD Coin (USDC). 

These stablecoins maintain their value by ensuring that each coin is backed by an equivalent amount of fiat currency. For instance, for every USDT in circulation, there should be one US dollar held in reserve. This is no different to what countries like the UAE do to ensure a US dollar pegging of their own Dirham.

This 1:1 peg with FIAT currency ensures the stablecoin's value remains constant. The reserve is often audited by third parties to verify the amount of fiat held, ensuring transparency and trust, though this isn’t always the case in the blockchain space.

Technically, users can exchange their stablecoins for fiat currency directly, or the issuing entity can use the fiat reserves to buy or sell stablecoins to maintain the peg.

Crypto-collateralised Stablecoins 

Crypto-collateralised stablecoins are essentially backed by other cryptocurrencies rather than FIAT. A well-known example is DAI, issued by MakerDAO. These stablecoins often maintain stability through over-collateralisation, just to be safe. 

This means that the value of the collateral may exceed the value of the stablecoins issued. So, to issue $100 worth of DAI, $150 worth of Ethereum might be locked up as collateral. This over-collateralisation provides a buffer against price fluctuations in the collateral. 

Smart contracts manage the issuance and redemption of these stablecoins, automatically adjusting collateral levels to maintain the peg.

Algorithmic Stablecoins 

Algorithmic stablecoins essentially use smart contracts that are pre-written to control the supply of the coin. So, an algorithm is devised to maintain the currency’s value. 

Unlike fiat or crypto-collateralised stablecoins, they do not rely on a vast vat of reserves. Instead, they use a combination of algorithms to increase or decrease the supply based on demand. 

Examples include TerraUSD and Ampleforth. When demand increases and the price goes above the target, the algorithm issues more coins to bring the price down. Conversely, when demand drops and the price falls below the target, the algorithm reduces the supply to push the price up.

While it may ensure stability most of the time, there are fewer guarantees with this type of stablecoin. Many may argue it’s not truly stable because it could collapse under enormous pressure. Nevertheless, it’s more stable than most non-stablecoins, highlighting that this can sometimes be a scale of security rather than a binary thing. 

Use Cases of Stablecoins 

Stablecoins have many practical applications due to their stable value and versatility in the digital economy. 

Trading and Hedging 

Cryptocurrency trading is big and stablecoins provide a safe haven against the volatility of other digital assets. They allow you to sell other cryptocurrencies without needing to convert back to fiat.

Traders essentially use stablecoins to quickly move funds in and out of volatile cryptocurrencies with less friction. This helps them lock in gains and minimise losses during market fluctuations. 

For instance, during a market downturn, traders can convert their holdings to stablecoins like USDT or USDC to preserve value. 

Cross-border Payments 

Stablecoins facilitate faster and cheaper cross-border transactions compared to traditional banking methods. SWIFT, for example, is a somewhat dated legacy system that can be costly to use. Sometimes, funds venture through various intermediaries before they reach their destination, taking days and costing a flat fee in conjunction with an exchange rate markup (often 3%).

Sending money internationally using stablecoins though can reduce transaction fees and processing times significantly. Stablecoin transactions settle within minutes sometimes and at a fraction of the cost. 

For example, someone can send USDC to a recipient in another country who can then convert it to local currency or use it directly. This efficiency makes stablecoins attractive for remittances, particularly in African countries where there are still millions living without a bank account.

Decentralised Finance (DeFi) 

In the decentralised finance (DeFi) ecosystem, stablecoins are very important. When seeking a loan or a serious financial product, the last thing you want is to denominate it in a currency that is terribly unreliable.

So, they are used as collateral for loans, as a medium of exchange in decentralised exchanges and even for yield farming, where users earn interest by providing liquidity. 

Platforms like MakerDAO allow users to lock up stablecoins as collateral to borrow other cryptocurrencies. This functionality enables users to access liquidity without selling their assets. Additionally, stablecoins are used in liquidity pools on platforms like Uniswap, where users can earn fees by providing stablecoin liquidity. 

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Regulation and Legal Considerations 

Regulation of stablecoins is evolving, with significant developments in the UK aimed at ensuring consumer protection and financial stability. Here’s an overview of the regulatory landscape:

Current Regulatory Landscape in the UK 

In the UK, stablecoins fall under the regulatory purview of the Financial Conduct Authority (FCA) and the Bank of England. The Financial Services and Markets Act 2023 provides the legal framework for regulating fiat-backed stablecoins, meaning that the FCA is having an increased involvement in the market to uphold some integrity.

This Act empowers the FCA to oversee the issuance and custody of stablecoins. The FCA aims to ensure that providers of such stablecoins maintain robust governance and manage risks effectively. Ultimately, its aim is to protect consumers’ funds. 

The Bank of England focuses on systemic risks and oversees payment systems that use stablecoins, meaning there is dual regulation.

FCA's Proposed Regulations 

The FCA has proposed several measures to regulate stablecoin issuers and custodians. These include requirements for the segregation of client assets and comprehensive risk management practices. 

The FCA mandates that stablecoin custodians keep clients’ stablecoins separate from their own assets and maintain accurate records. Additionally, they must implement effective controls to prevent misuse, fraud and poor administration. 

The FCA also proposes operational resilience standards, requiring stablecoin issuers and custodians to ensure their systems and processes are secure. 

Global Regulatory Context 

Globally, regulatory approaches to stablecoins vary quite widely. In the United States, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) play a big role in overseeing the activities. 

The European Union has introduced the Markets in Crypto-assets (MiCA) regulation, which sets out comprehensive rules for crypto assets, including stablecoins, that are similar to the UK. 

Risks and Challenges 

Unfortunately, there are some concerns regarding stablecoins. While crypto is incredibly volatile, people are at least hyper-aware of these risks - not to mention the FCA’s promotional regulations that force providers to be clear about the risks at hand. But with stablecoins, there’s a different perception, and so they need to be watertight if they are to follow through with their own claims.

Centralisation Risks 

Centralised stablecoins, such as Tether (USDT), pose some level of risk due to their reliance on a single entity to manage reserves. This centralisation can lead to issues of trust and transparency, as users must rely on the issuer's claims about reserve holdings. 

If the issuer fails to manage the reserves properly, it could lead to losses. Regular audits and transparency reports are essential to mitigate these risks.

For example, Tether claims to have a 1:1 backing, but they’ve been subject to scrutiny here as not all the reserves are held in cash, but many are in corporate bonds, treasury bills, and so on. Their ability to manage liquidity so far has meant it’s been stable, but there are always questions of whether they could effectively manage a mass sellout.

Regulatory Risks 

Stablecoins face significant regulatory risks too. Although it’s a good thing in most ways to have better oversight, it may come at a cost. Providers are having to jump through different hoops with constant updates, and we are yet to fully normalise. The last thing stablecoins need is an unstable environment, even though it’s a necessary growing pain of becoming legitimised.

Technical and Security Risks 

Stablecoins, like all digital assets, are vulnerable to technical and security risks. Smart contract vulnerabilities and cyberattacks can lead to loss of funds. For instance, flaws in the code of a stablecoin platform could be exploited, leading to a breach. It is crucial for stablecoin projects to undergo rigorous security audits and continuously update their protocols to protect against such threats. And then, of course, there are the risks associated with the exchanges themselves, which have been dropping like flies over the past couple of years.

There are also some socio-economic concerns too. Yanis Varoufakis criticises stablecoins for reinforcing existing power structures as opposed to addressing systemic economic inequalities. He argues that stablecoins, rather than decentralising finance, may lead to a form of "techno-feudalism" where a few large players control the entire financial system. Varoufakis believes that stablecoins do not offer a true solution to economic instability or inequality, but instead replicate the flaws of traditional financial systems.

Future of Stablecoins 

Stablecoins have significant potential for growth and adoption because they feel like we get to have our cake and eat it. Their stability and efficiency make them suitable for many applications, from everyday payments to complex transactions. It opens the door to more efficient systems like concert tickets, in which blockchain can be used to distribute and manage ticket seating automatically, and stablecoins can better facilitate those global payments (and refunds).

In the financial sector, stablecoins could transform cross-border payments. They can, in theory, be cheaper and faster, but also enhance the efficiency of trading and settlement processes. Ultimately, their stability may give customers more confidence to use them in a transactional way. The same goes for DeFi products too, which could be something that neobanks turn to.

Looking ahead, the future of stablecoins lies in their regulation. If strict enough standards are upheld regarding proof of their collateralisation and reserves, we may see some “stablecoins” stop marketing themselves as stable because they cannot meet the new requirements. This, then, will also raise questions over whether stable-enough coins are indeed enough.

If you have any questions about stablecoins, get in touch with our team today.