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Focus: Stablecoins
Stablecoins: Almost as hard as coins
Bastian Stolzenberg
Director, Blockchain Assurance, PwC Switzerland
With stablecoins, the name says it all: they’re stable and hard like coins. What’s more, they can be traded quickly and easily and can be used against uncertainties such as hyperinflation or loss of real value. The token has more than one downside though. Trust in the young digital asset is low. There’s also still a lack of clear (self-)regulation, and the issuers only create partial transparency with regard to the security of the invested funds. It’s time for this to change, which requires cooperation between investors, issuers, central banks and regulators alike.
How a stablecoin works
A stablecoin is a cryptographic token. Its price is controlled by price peg mechanisms, and should deviate as little as possible from a national currency, a basket of currencies or other assets like gold and commodities. In other words, the stablecoin represents a stable asset that isn’t subject to large fluctuations; hence its name.
The stability of the most common type of stablecoin used today, ‘fiat-backed’ stablecoins, is achieved by pegging them to a fiat currency, which in most cases is the US dollar (USD). A crypto investor buys 100 stablecoins for 100USD. They must rely on the issuer to keep them safe until they change their 100 stablecoins back into 100USD. Well-known ‘fiat-backed’ stablecoins include Tether, USD Coin and Binance USD.
In addition to fiat-backed stablecoins, there are also less commonly used stablecoin types like algorithmic stablecoins and those linked to commodities (‘commodity-backed’). With algorithmic stablecoins, the stable value is maintained by an algorithm that controls the supply and demand of multiple (crypto) currencies to avoid volatility. With ‘commodity-backed’ stablecoins, tokenising a barrel of oil allows the claim to it to be traded without physical delivery. However, the token holder could request the barrel of oil in physical form at any time.
Agility as an important advantage
With stablecoins, crypto investors can reduce the volatility of their exposure by quickly exchanging highly volatile cryptocurrencies for stablecoins and then redeeming them when volatility drops. Exchanging stablecoins can be done faster and more cheaply than through the traditional financial system. This is because many exchanges and banks either prevent trading in certain cryptoassets in fiat currencies or charge higher transaction fees for them. For this reason, stablecoins are rarely held as a long-term investment. Besides this function, they are predominantly found in decentralised financial markets (DeFi), where public blockchains provide peer-to-peer financial services.
An agenda item for central banks
As custodians of money and currency, this topic has been on the agenda of central banks for some time, coining the term ‘central bank digital currency’ (CBDC). This could be interpreted as a reaction to the many stablecoins that are already publicly tradable, as stablecoins are issued almost exclusively by private sector companies, creating payment systems that are outside the control of central banks. In Switzerland, ‘Project Helvetia’ was run as a pilot. In a multi-stage process, the Innovation Hub of the Bank for International Settlements (BIS), the Swiss National Bank (SNB) and the Swiss stock exchange SIX examined possible uses of the digital Swiss franc. The panel considers this to be much more practical and production-oriented than the digital euro of the European Central Bank (ECB). Its main advantage is the central design of the infrastructure with the central service provider SIX. It is understandable that the SNB wants to establish a secure and reliable payment system before launching its own CBDC. For the time being, it therefore remains to be seen when and if the first digital Swiss franc issued by the SNB will first be traded.
Risk number 1 - lack of trust
One of the greatest risks of stablecoins is the lack of trust in the custody of the real assets used to back stablecoins, for example the custody of fiat currencies in ‘fiat-backed’ stablecoins. No comprehensive regulation currently exists, nor are there any legally required audits or the industry-guaranteed standardisation of process safety. For example, no official data is collected on how many stablecoins a provider has in circulation and whether it actually has the assets to cover its issued stablecoins. With the Markets in Crypto-Assets (MiCA) regulation the European Union (EU) became the first market to present a wide range of regulatory guidance, from unsecured cryptocurrencies and stablecoins to crypto exchanges and crypto wallets.
Given the low level of regulation, it’s no surprise that many crypto investors are reluctant to invest in the comparatively young, albeit multi-billion-dollar, market. So far, no (self-)regulation gives them the certainty that their digital money is safely invested or can be paid back at the promised price. One of the most significant projects to date – with an uncertain future – is Meta’s (formerly Facebook) Diem Internet currency, which was intended to be tied to a basket of currencies. After fierce opposition from the Federal Reserve and the US government, Meta abandoned the project and sold both the technology and the intellectual property. The expiration of the LUNA token of the Terra crypto financial ecosystem also didn’t help to build trust in algorithm-based stablecoins. The collapse of Terra triggered a landslide in the crypto market, leaving thousands of bruised investors and even more unanswered questions.
Shortly before the publication of this article, the crypto exchange FTX in the USA had to file for bankruptcy. Evidence is mounting that FTX no longer had sufficient liquid assets to repay its liabilities, including client assets under management. Even though FTX as an exchange and FTT, the token issued by FTX, are not directly comparable to the topic explored in this article, there is undoubtedly a common denominator: the creation of trust and transparency, both for investors in a crypto exchange and for stablecoin holders. Find out here how more trust and transparency could be created on a crypto exchange.
In favour of rising interest rates
We expect rising interest rates due to inflation to give a boost to the concept of ‘fiat-backed’ stablecoins. From an issuer’s point of view, rising interest rates are interesting because they can invest the assets they receive in return with a higher profit. Although they have to accept a loss in value due to inflation, this hardly affects the issuer at all since it doesn’t involve an increased obligation towards customers. Inflation could affect ‘fiat-backed’ stablecoin holders, although they hold their tokens for such a short period of time that the effects of inflation are barely noticeable. This would only be the case if ‘fiat-backed’ stablecoin investors held their cryptoassets for a longer period of time, exposing them to a loss in value. However, the number of new ‘fiat-backed’ stablecoin offerings is likely to be limited. After all, to be successful in this domain an issuer must move large volumes and take advantage of economies of scale.
Crisis-proof in a variety of ways
In uncertain times and volatile markets, stablecoins backed by stable currencies can help to hedge real assets. This is particularly interesting for investors in countries where inflation is high, such as Brazil or Turkey. Due to skyrocketing inflation rates, investors there have difficulty accessing stable currencies. Stablecoins allow them to effectively bypass the devaluation of their own country’s currency. What’s more, people from crisis areas can protect their assets with stablecoins and arrange transactions to other countries. This is because stablecoins aren’t tied to any national or supranational transaction systems, and can be exchanged on numerous exchanges. Finally, the stablecoin serves as a means of payment for people without a bank account to purchase goods via their smartphone and pay for them digitally.
Conclusion
Stablecoins have long since ceased to be a means of payment of the digital wild west. They are cryptographic assets with high stability, and are easy and quick to handle. This makes it all the more urgent for central banks to give an even greater focus to the matter and develop a clear stance on how to deal with CBDCs. The regulators also have a duty, because with the exception of MiCA, no national or global regulations or standards are yet available. The issuers of stablecoins in turn would do well to have themselves audited in the sense of self-regulation and to prove the safe custody of the deposited real assets. For their part, crypto investors should be aware of the risks of stablecoins and only buy tokens from vetted issuers, or urge them to provide greater transparency regarding the security of invested capital. This is the only way to establish trust in this highly potent market, and is urgently needed in view of the growing trading volumes.
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