The Unstable State of Stablecoins

An overview of the stablecoin market’s growth, business cases, and regulatory uncertainties (as of June 2021)

The class of cryptocurrency known as stablecoins has proven to offer numerous use cases, including lending services, high-yield savings products, and cross-border payments. Stablecoins are providing markets with transactional stability that other cryptocurrencies have not been able to deliver. Total stablecoin supply, according to research from The Block, has grown from $10 billion in May 2020 to over $106 billion in June of 2021. This growth poses benefits to society through numerous use cases, but it presents new risks for consumers and governments to consider.

Bringing Stability to Cryptocurrency

Stablecoins intend to solve a large issue among cryptocurrencies: volatility. One of the main detractors limiting Bitcoin’s mainstream adoption, specifically for consumer payments, is its volatility. That alone makes it almost impossible for the average consumer to attempt to manage and understand their purchasing power with Bitcoin along with most well-known cryptocurrencies. Additionally, to own and transact with most cryptocurrencies, there is a high level of technological and financial literacy needed by the consumer compared to owning and transacting with state-issued currency. Surveys from the past two years reflect these realities, showing low consumer adoption of cryptocurrencies, consistently under 10%. A more recent survey in 2020 from Cornerstone Advisors found that only 15% of American adults own cryptocurrency of some kind. This estimate is in line with the 2021 State of U.S. Crypto Report from Gemini, estimating only 14% of the U.S. population.

https://www.theblockcrypto.com/data/decentralized-finance/stablecoins

The stability, and growth, of stablecoins rides on the back of fiat currency in most cases. As the name suggests, a stablecoin is a cryptocurrency which minimizes, or stabilizes, volatility by pegging its price to an asset like the U.S. Dollar or a commodity with a relatively stable value. There are also stablecoins that peg their value based on an algorithm. Algorithmic stablecoins are less popular as they are less proven and have recently seen failed attempts at implementation most recently with the collapse of IRON, a stablecoin used in yield generating Decentralized Finance activities. Tether, also known as USDT, is the leading stablecoin by total market supply followed by USDC, both of which are pegged to the U.S. dollar. Being “pegged” to the U.S. dollar has been controversial for Tether as it was recently revealed that only 2.9 percent of the firm’s reserves were held in actual U.S dollars. Controversy aside, as a result of being tied in value to fiat currency, stablecoins exhibit prices that are more understandable to mainstream consumers compared to cryptocurrencies such as Bitcoin or Ether. In fact, in many cases, when a consumer views their account in a crypto firm’s mobile app, a dollar sign appears in front of the stablecoin value. It is this appearance of stability and trust along with ease of use that has made stablecoins ripe for growth. Yet, risks for consumers and the economic systems may be hidden in the unknowns of this new technology. To date, innovation is outpacing regulation.

This lack of volatility in stablecoins allows for new types of financial products for consumers across the globe. In a February 2020 speech, Bank of England deputy governor Sir Jon Cunliffe hypothesized, “There is certainly the possibility with stablecoins linked to large technology and social media platforms, that it could become mainstream for people to move from holding all or much of the money now in ‘current accounts’ at banks to holding it in ‘stablecoin’ in virtual ‘wallets’ provided by non-banks.”

Mainstream Adoption and Mainstream Risk

In recent years, over 200 stablecoins have been in development, with more than 60 making it to market. Most live coins have little market share compared to the leading three coins. The top stablecoins currently in the market as well as larger coins in development pose systemic risk on the global financial system as they grow in value and reach.

The top three stablecoins by market supply are Tether (USDT), USD Coin (USDC), and Binance USD (BUSD). The three coins are operated by firms with different corporate structures and partnerships:

  • Hong Kong-based Tether Holdings Limited operates the USDT.
  • Circle Internet Financial Limited operates USDC and according to their website “together with Coinbase and the Centre Consortium oversees the standards and protocol” of the stablecoin.
  • Paxos operates the BUSD under a limited-purpose trust charter from the New York State Department of Financial Services in a partnership with Binance a privately held company currently out of the Cayman Islands whose primary business is operating a cryptocurrency exchange.

There are other examples of stablecoins, both in the market and in development, but few have been monitored and scrutinized as much as Facebook’s yet to be launched Diem, formally known as Libra. Libra was conceived by Facebook in 2017 and has evolved with the establishment of the Libra Association, now rebranded as the Diem Association, to oversee the currency’s development and management. To be clear, the association is a separate legal entity outside of Facebook. But at one point, U.S. legislators asked Facebook to put the project on hold due to uncertainties of the impact that the digital currency may have in the market including concerns over the company’s reputation for issues around data privacy. But over time, the project moved forward. The association has dozens of members that support the development of Diem, including Coinbase, Uber, and Shopify. Diem has spent the past few years reinventing what it will look like with the most recent announcement that it will move its operations to the United States from Switzerland, partnering with Silvergate Bank to be the exclusive issuer of the Diem USD stablecoin and manager of the Diem USD reserve. Most reports now assume Diem will be piloted at some point in 2021. Diem also states that it plans to integrate with central bank digital currencies if they become available.

In addition to the numerous types of stablecoins, the business and consumer use cases for stablecoins span the financial markets from traditional banks to decentralized financial services. The use cases can be categorized into three areas:

  1. Traditional financial institutions (TradFi) consisting of banks, payments firms, and brokerages.
  2. Centralized financial institutions (CeFi) operating in the crypto space.
  3. Decentralized financial services (DeFi) operating in the crypto space.

All three areas have implemented stablecoin business use cases and consumer products that did not exist just a few years ago.

In the TradFi space, Visa has made significant progress leveraging the Ethereum blockchain, having recently completed its first successful settlement transaction in March of 2021. Visa partnered with Crypto.com, with the partner sending USDC to Visa’s Ethereum address. And it’s not just Visa that sees potential in stablecoins. At the “2021 Blockchain 50 Symposium: Crypto Goes Corporate” event hosted by Forbes, panelists from ING, Visa, and J.P. Morgan all agreed that stablecoins may be valuable for cross-border transactions, as well as creating a tool for fintechs and new firms to develop financial products. J.P. Morgan has launched the JPM coin, which some argue is not a true cryptocurrency, yet it shares the basic characteristics of a stablecoin. The coin enables J.P. Morgan clients to transfer U.S. dollars held on deposit with J.P. Morgan in real-time. It is a permissioned, shared ledger system solving problems like slow cross-border payments.

In CeFi, cryptocurrency transactions are handled through a central exchange with technology managed centrally by firms. Some of the most well-known CeFi firms include Coinbase, BlockFi, and even the stock trading app Robinhood. There are numerous firms and products in the CeFi space, which is beginning to bridge the gap from crypto to mainstream consumers, with investors and savers looking for financial products that yield higher returns. Stablecoins provide the low volatility that consumers are used to while having the appearance of being denominated in U.S. dollars, with firm’s like Circle even referring to USDC as a “digital dollar” in their marketing regardless of the fact that it is not actually a US dollar.

One example of such a product is from BlockFi, offering a product that mimics a high-interest savings account at a traditional bank. The difference is the yield and the fact that the asset is not U.S. dollar backed by FDIC insurance. As of the time of writing, consumers can earn over 8% APY by holding USDC and other cryptocurrencies at BlockFi compared to less than 1% APY for most bank certificates of deposits — technology differences aside, the higher APY is a strong incentive for consumers if it can be maintained by the crypto firm. In a March 2021 interview with Coin Central, BlockFi management shared that their Phase 3 growth initiatives include, “Focus on global expansion and expand the addressable market to include users that may not ever want to own crypto,” and “Heavily utilize stablecoins to provide traditional banking products on blockchain rails.” In other words, BlockFi wants to take crypto mainstream without mainstream understanding crypto through the use of stablecoins.

As stablecoins allow CeFi firms to create savings account-like products which are familiar to consumers, other products using non-stablecoin cryptocurrencies in time may be more appealing and comfortable for consumers to adopt. For example, Coinbase has launched a Visa® debit card and BlockFi is in the process of launching a Bitcoin Rewards Credit Card. While it may take years for Coinbase and BlockFi to reach full mainstream adoption, the faster that crypto firms enter the traditional banking market, the stronger their position will be when crypto and TradFi consumer markets overlap in the mass market. The more that crypto firms design products to look and feel like traditional banking products, the easier the transition to crypto will be for mainstream consumers across the globe. But an easy transition to crypto does not mean a risk-free transition. It will be important for consumers to understand that stablecoins are in fact not fiat currency and have personal and systemic risks that are not mitigated via the global monetary system in a way that many traditional banking products have been.

A more emerging area of cryptocurrency in which stablecoins play a large role is DeFi. Unlike CeFi, in DeFi there is not a centralized company that takes custody of the consumer’s funds. Instead, a company or group of developers creates a protocol, using blockchain-based financial technologies built on open source software governed by a community. In DeFi, stablecoins are used in the processes of liquidity mining, yield farming, and lending and borrowing. Benefits to consumers in using DeFi services include the privacy retained by not needing to provide personal information to perform transactions and the ability to maintain custody of funds rather than a bank or crypto firm taking custody. To use DeFi, consumers only need to set up a cryptocurrency wallet and connect it to DeFi services without providing any personal information or passing the typical Know-Your-Customer processes administered by TradFi anf CeFi firms.

Two of the more popular DeFi apps are MakerDAO and Compound, both of which facilitate DeFi borrowing, lending, and saving. MakerDAO is also the creator of the Dai stablecoin which is pegged to the U.S. dollar. DeFi is the newest area in crypto, with some experts, such as Simon Taylor of consulting firm 11:Fs, believing it may take another five years or more to reach mainstream adoption. It also faces challenges as there is debate over how decentralized DeFi actually is and a growing number of recent attacks on DeFi protocols that drained an estimated more than $160 million in May 2021 alone. And as previously mentioned, the collapse of the IRON stablecoin has sparked increased criticism and calls for regulation. Still, DeFi continues to grow along with the use of stablecoins, attracting venture capital funding to fuel its development from notable firms such as a16z and Coinbase Ventures and even Mark Cuban. To date, stablecoins have fueled DeFi’s growth which does not appear to be waning, with new stablecoins designed for DeFi continuing to attract funding such as the Unbound Dollar’s recent $5.8 million fundraising round.

The global growth potential in stablecoin usage across financial services is not going unnoticed. In a 2020 speech, European Central Bank executive board member and Italian economist, Fabio Panetta, said in reference to stablecoins, “They could be used by the big techs to offer innovative payment solutions that work both within and across national borders. While stablecoin initiatives are still in their infancy, they should be carefully analysed as they could radically transform the payments landscape.” This analysis by governments, firms, and consumers should not only focus on the benefits but also the risks of a system moving to crypto-based accounts. As Mr. Panetta hints, we are likely to see governments, Central Banks, and industry all playing their parts analyzing opportunities and risks, acting to move stablecoins into the future.

An Unstable Regulatory Environment

Regulation of cryptocurrency varies around the world by country from effective bans in China to different implemented regulations in the United Kingdom, Singapore, and Canada. Other countries including Brazil and the United States have proposed national regulations being considered by their governments.

Analyzing the global cryptocurrency regulatory environment is a daunting task. For the purpose of understanding stablecoin regulation with a short-term perspective, the proposed regulation in the United States is a good onramp given that the world’s leading stablecoins are all pegged to the U.S. dollar.

In a speech on May 20, 2021, Federal Reserve Chair Jerome Powell addressed the change in global payments and specifically stablecoins, “Therefore, as stablecoins’ use increases, so must our attention to the appropriate regulatory and oversight framework. This includes paying attention to private-sector payments innovators who are currently not within the traditional regulatory arrangements applied to banks, investment firms, and other financial intermediaries.”

One of the main concerns from a regulatory perspective is that stablecoins currently do not come with the same consumer protections as traditional currency including cash and bank deposits. Fundamentally, the firms creating stablecoins are not building in risk management measures from a systemic perspective. Rohan Grey, Law Professor and author of the proposed U.S. STABLE Act, highlighted three main priorities for regulating stablecoins that delve into systemic risk:

“Priority one: stablecoins are not as safe as they seem and when they collapse, they bring everyone else down with them. Priority two: as long as they give the impression of being the functional equivalent of safe money, they will always create a perverse incentive for people to have bad money chase out good money, and people will always drive into these places right until the illusion of safety is dispelled. Priority three: all risks need to be understood from a systemic perspective, and individual stablecoin issuers are not responsible for, nor are they structured to think as stewards of the whole system. So wherever that line is between privacy and law enforcement, transparency and freedom, it is not a line that individual stablecoin issuers are equipped to draw on their own.”

- Rohan Grey, primary author of the STABLE Act

The STABLE Act, with the expertise of Mr. Grey, was introduced to the United States Congress in December 2020 by Congresswoman Rashida Tlaib (MI-13), Congressmen Jesús “Chuy” García (IL-04), and Chairman of Task Force on Financial Technology Rep. Stephen Lynch (MA-08). The act aims to protect consumers from the risks presented by emerging digital financial instruments such as Facebook’s Diem and other stablecoins. The regulation would require stablecoin firms to obtain a banking charter and FDIC insurance or maintain reserves at the Federal Reserve among other requirements.

Mr. Grey argues that stablecoins are an example of “shadow money” or in other words, something that “walks and talks like public money” which in most cases is the U.S. dollar. He makes sure to differentiate that stablecoins are masquerading as public money while other cryptocurrencies such as Bitcoin and Ether are true forms of private money that should be treated differently by regulation. He questions the intent of the creators of stablecoins given that most are created by relatively small groups of individuals but used by millions of consumers without the protection of regulation. There is a serious question as to whether or not stablecoin issuers understand the systemic risks involved let alone can they manage the risks without the economic levers that central banks across the world can pull.

Stablecoin issuers focus on the fact that their coins are backed by enough assets to provide liquidity. Mr. Grey believes that is not the primary focus needed to manage the risk of stablecoins, choosing to reframe the focus, “The wrong question is, are there enough assets backing this stablecoin? The right question is, is an asset-backing approach to safety actually going to guarantee safety?” The latter question forces decisionmakers to analyze risk on a deeper level.

When held under the microscope, stablecoins appear similar to fiat currency and traditional banking products, mainly because they are technically designed to replicate fiat currency in a digital form with less friction from the current banking system. The proposed regulation in the U.S. is designed to protect consumers in a manner consistent with banking regulations.

“We have already regulated banking for this exact reason. We already have limits on who can engage in the business of banking without a license and the point is that those limits should apply to stablecoins. On one hand, the argument is ‘we don’t think stablecoins are the same as banking instruments,’ and on the other hand, the argument is ‘we think everyone should be able to engage in banking activity without a license.’ Different people have different contention with regulation. My point is, these should be regulated like banks.”

-Rohan Grey, primary author of the STABLE Act

An Unknown Future for Stablecoins

As consumers gain more confidence in cryptocurrencies and begin to trial products built with stablecoins that behave like mainstream financial products but with higher yield, crypto may be poised to see larger market share gains into the traditional checking, savings, and investment account product markets offered by most banks. The future looks to hold a path of growth for stablecoins as younger generations view cryptocurrencies such as Bitcoin more favorably and claim that they are more inclined to use Bitcoin in the next five years compared to their older counterparts, as explained in Blockchain Capital’s 2020 Crypto Survey. Yet, with the spectrum of business cases spanning from traditional banking all the way to decentralized finance paired with inconsistent regulation and risks to consumers, the future of stablecoins remains unknown.

Another unknown factor that may converge with, or replace stablecoins altogether, is the development of Central Bank Digital Currencies (CBDC). The rapid development of stablecoins is being seen as a motivator for central banks to launch CBDCs around the world. In the coming years, consumers will continue to see stablecoin products brought to market and potentially merging with CBDCs as technology and regulation evolves.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation from, nor promoting any company referenced in the article. I have no business relationship with any company mentioned in this article. All information provided is for informational purposes only and should not be deemed as a financial recommendation.

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Kelly Robert Chambers

Kelly Robert Chambers

FinTech executive exploring blockchain and digital money. I write to learn. Connect with me at www.linkedin.com/in/kellyrobertchambers/