Stablecoins Market Analysis Overview
Stablecoins are a type of cryptocurrency with a unique use case. They aim to provide digitalised stability and are normally backed by a reserve asset. This reserve asset is typically a fiat currency or a commodity like gold. Stablecoins are popular as they offer the benefits of cryptocurrencies and have low volatility associated with fiat currencies. On the other hand, Bitcoin, the largest cryptocurrency by market capitalization, is known to be very volatile with 10% daily moves being considered normal by many investors. This makes Bitcoin somewhat unpractical for everyday use, as its purchasing power is quite unpredictable.
There are three main types of stablecoins. The first type is Fiat-Collateralized-Stablecoins. These are stablecoins that are backed by a fiat currency reserve. The amount of this reserve determines how many crypto coins are to be issued. Most popular stablecoins today use US Dollar reserves. The second type is Crypto-Collateralized- Stablecoins. These are backed by other cryptocurrencies, employing a specified methodology to ensure lowered volatility.
The reserve cryptocurrency used is over-collateralized, meaning that a larger amount of cryptocurrency tokens is used as a reserve for the issuing of a lower number of stablecoins. Finally, Non-Collateralized- Algorithmic-Stablecoins are not backed by any central reserve but use an algorithmic mechanism to maintain price stability through smart contracts. This can be compared to some monetary policies of central banks.
For a stablecoin to remain volatility-free in the long run, its collateral needs to be verifiable and highly liquid. Otherwise, if many holders of a particular stablecoin aim to withdraw their holdings at once, there could be significant price movements in the affected coin.
This concept is essentially identical to a bank run. Stablecoins have become essential in the cryptocurrency space and if any major stablecoins were to default, a significant liquidity shock affecting the crypto market more broadly is likely. Some may hold a stablecoin as an alternative to fiat currency, perhaps for lack of trust in the central banking system and for fear of inflation. They can also be used to complete transactions between different cryptocurrencies with greater ease.
The biggest stablecoin today is Tether (USDT). It is the third largest cryptocurrency by market capitalization ($78 Billion) and its value equals one US Dollar (see Figure 1 below). Its protocol is built on the Ethereum blockchain, like that of most major stablecoins, but has since expanded to other blockchains. Tether claims to have one-to-one reserves of the dollar for every coin issued. Recently, Tether has experienced legal difficulties concerning this statement. In October 2021, Tether was fined $41 million by New York regulators for failing to provide evidence for their reserves. While Tether never admitted to any wrongdoing, they are now subject to transparent, mandatory reporting.
Figure 1: Market capitalization of the largest stablecoins as of 31.1.2022
This case highlights one of the main current issues with many stablecoins: lack of transparency in their reserve asset backing. For a stablecoin to be fully trustworthy, regular and certifiable audits should be carried out and reserves must match the issued amount of coins. Another issue is that most stablecoins are built on the Ethereum blockchain, which is known for having significant transactional “gas” fees. This means stablecoin developers may have to migrate to other blockchains.
The second largest stablecoin by market capitalization is the USD coin (USDC). It was originally launched on the Ethereum blockchain but has since expanded to others as well. This coin is designed to constantly maintain the equivalent value of one US dollar. It is backed by cash, cash equivalents, and short-duration US treasury bonds, with the aim of constant liquidity. It was created through a joint venture between the crypto exchange Coinbase and the financial technology firm Circle.
Essentially, it provides the same service as USDT, but the two coins differ in which blockchains they are integrated. Additionally, its reserves are held in regulated US financial institutions and are subject to monthly audits certifying their legitimacy. Despite Tether’s recent efforts to commit to increased transparency concerning its reserve status, it is still surrounded by some ambiguity. This is why some investors may prefer USDC over USDT.
A particularly interesting development has recently taken part in the stablecoin space. In January 2021, a group of US banks decided to launch their own stablecoin, USDF. The members of this group dubbed the “USDF Consortium” are all backed by the Federal Deposit Insurance Corporation (FDIC). The FDIC is one of the US banking sector’s key regulators. Two members of the consortium, NBH Bank and the New York Community Bank, have recently completed the first transaction using USDF.
It is supposed to be worth exactly one dollar and aims to solve the lack of transparency of reserves for investors. The consortium is ambitiously calling on other financial institutions to become members to integrate digital assets into their services. A stablecoin backed by the major US-regulated banks may improve trust in the use of stablecoins and could potentially attract new investors or users in the cryptocurrency space.
Legislation is a significant factor that will largely affect stablecoins in the near future. US regulators, including Federal Reserve Chairman Jerome Powell and Treasury Secretary Janet Yellen, have recently confirmed their aim to impose regulation on stablecoins as soon as possible, mainly because they could be used for everyday consumer transactions in the future and thereby disrupt the current monetary order.
US regulators have not yet made a decision as to how to treat stablecoins in the monetary system. They could be classified as securities, banks, or an asset class of their own. To begin, the White House is planning to implement a government-wide strategy to regulate the digital asset and crypto market. This issue relates to the possibility of the US government beginning to offer its digital currency, in the form of a Central Bank Digitalized Currency (CBDC), which the Federal Reserve is considering.
Meta, formerly known as Facebook, had plans to unleash its own cryptocurrency onto the market. The asset was supposed to known as Diem and would have been a stablecoin. Following months of speculation, Meta has canceled the project, citing regulatory difficulties. First off, regulators were concerned about Meta’s previous scandals involving the handling of customers’ private data. Secondly, they voiced their concern regarding the size of Meta and the potential user base of Diem, which could have threatened the dollar’s dominance. It appears the social media giant will stay clear of the cryptocurrency market for now.
Stablecoins have grown to play a significant role in the crypto market and their usefulness is apparent and undeniable. Regulatory scrutiny may very well shake up the stablecoin market and could scare off potential investors. In addition, the development of CBDCs is likely to have a sizeable impact on the market, as some users may prefer government-backed digitalized currencies to stablecoins with somewhat questionable reserves. The further development of stablecoins in the crypto ecosystem will be of interest to players in the emerging, yet ambitious, cryptocurrency market.
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Citations: Stablecoins Market Analysis
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