Why we’re not giving up on stablecoins

Opinion: Confidence in stablecoins plummeted in May 2022 as the cryptocurrency market took a dive and investors withdrew billions from the most popular stablecoin, Tether. Meanwhile another stablecoin, Terra, and its sister currency Luna also spiralled, wiping out some investors’ life savings.

But despite the failures of one or two stablecoins, not all are similarly flawed, and the recent market volatility highlights the importance of security, oversight and the regulation of crypto markets.

Most stablecoins are backed by commodities, other cryptocurrencies, or fiat currency, which is a government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. For example, if a stablecoin is pegged to the US dollar, one of those stablecoins would generally be worth around one US dollar.

The uses of stablecoins are wide-ranging, and like many other cryptocurrencies, their most powerful benefit is their programmability. For example, in a supply chain a smart contract can be created so that as goods move along the supply chain, payment for those goods occurs automatically when they’re delivered. No more waiting for weeks or months for payment.

The opportunities don’t end there. For instance, the internal revenue department (IRD), a trucking company and others involved in a project could all be programmed to be paid in a single transaction.

Another reason stablecoins are attractive is because they are generally not exposed to price fluctuations, allowing payments, including across borders, at any time without having to wait for prices to stabilise.

Also, if an individual or organisation is being paid for goods and services in cryptocurrencies, or they trade in cryptocurrencies or other digital assets such as non-fungible tokens, it’s normally faster and cheaper to use stablecoins rather than converting cryptocurrencies into fiat currency and back for the next trade or purchase.

Meanwhile, smart contracts can be coded to pay only specified organisations or individuals - this is useful in instances such as foreign aid, where there are often fears around money going to the wrong hands.

Micro-payments and social benefit payments during emergencies are also possible. Meanwhile, who receives the money and for how long can be programmed if so desired.

The benefits are so compelling that over 80 percent of central banks globally, including the Reserve bank of New Zealand, are exploring their own stablecoin version - Central Bank Digital Currencies (CBDCs).

While CBDCs vary across countries, they’d likely be backed by the issued Central Bank. The lower risk of CBDCs needs to be balanced against their utility, and while a CBDC could be used within a country, it may not work well for overseas payments if not widely used globally.

Many stablecoins are not regulated, meaning regulators are not overseeing the actual backing (reserves), and stablecoin operators can face legal liability if reserves are misrepresented.

Of the four stablecoins, algorithmic stablecoins could by far be the riskiest. Indeed, there were warnings about the algorithmic stablecoin Terra well before its collapse.

Algorithmic stablecoins are generally not backed by anything (non-collateralised).
Instead, specialised algorithms/smart contracts manage the supply of stablecoins in circulation. For example, if the stablecoin rises above the pegged currency, more stablecoins are circulated, lowering the price.

Secondly, there are stablecoins that are backed by fiat currency (fiat-collaterised). In this case, the stablecoin’s operators hold one US dollar, Euro, other currency, or mix of currencies, for each stablecoin. The fiat currency is held in a bank account or several bank accounts as reserves, giving them an appearance of safety. But questions remain about the correct representation of such bank deposits/reserves.

The third type of stablecoins are those backed by cryptocurrency (crypto-collaterised). DAI is the most prominent. To be issued DAI, the purchaser must deposit twice as much of the cryptocurrency Ether. Thus, to purchase 100 DAI, the purchaser must deposit US $200 worth of Ether. Hence, the Ether price would have to fall by over 50 percent before any action might be required to stabilise the DAI price. Another advantage is that, unlike fiat-collaterised stablecoins, the crypto-collateral can be seen by all, increasing transparency and trust.

Fourth, there’s a type of stablecoin that is backed by commodities (commodity-collateralised). These stablecoins are backed by physical assets such as gold (e.g., Digix) or even real estate. Commodity prices, however, can fall and again the operators must be trusted to hold enough commodities as reserves. People with long memories might recall the late 80s, when Goldcorp collapsed, and the stated amount of gold reserves hadn’t been maintained.

Currently, inflation, interest rate hikes, geopolitical tension and supply chain issues are affecting all risky assets including stablecoins. However, stablecoins are a convenient tool and they’re increasing in popularity and usage. As such, it’s becoming increasingly important that we have proper regulation and oversight such as auditing of reserves.