What is Stablecoins: The New Age Digital Money

Welcome to my blog post on stablecoins. If you are interested in learning more about these new forms of digital money, you have come to the right place. In this post, I will explain what stablecoins are, how they work, and why they matter for the future of finance based on the insight from a recent paper by the Bank for International Settlements (BIS). The paper titled "Will the real stablecoin please stand up?" by Anneke Kosse, Marc Glowka, Ilaria Mattei and Tara Rice analyses the performance and risks of stablecoins. By the end of this post, you will have a better understanding of this fascinating topic and hopefully feel inspired to explore it further.

What is Stablecoins?

Stablecoins are a type of crypto-asset that aims to maintain a stable value relative to a specified peg. A peg is a reference point that determines the value of the stablecoin. For example, a stablecoin can be pegged to the US dollar, the euro, gold, or another cryptoasset. The idea is that stablecoins can offer the benefits of crypto assets, such as fast, cheap, and secure transactions, without the drawbacks of price volatility, which can make them unreliable as a means of payment or store of value.

The Mechanism Behind Stablecoins: How Do They Maintain Stability?

There are different ways to achieve stability in stablecoins, depending on the type of stablecoin. According to the BIS paper, there are four main types of stablecoin:

🔵 Fiat-backed Stablecoins

These are stablecoins that claim to be backed by assets denominated in a fiat currency, such as the US dollar or the euro. For example, Tether and USD Coin are two popular fiat-backed stablecoins that are pegged to the US dollar. The idea is that the issuer of the stablecoin holds a reserve of fiat currency in a bank account or a custodian, and promises to redeem the stablecoins for the fiat currency at any time and at par value. This way, the stablecoin can maintain its peg to the fiat currency, as long as the issuer has enough reserves and is trustworthy.

🔵 Crypto-backed Stablecoins

These are stablecoins that claim to be backed by other crypto-assets, such as Bitcoin or Ethereum. The idea is that the issuer of the stablecoin holds a reserve of cryptoassets in a smart contract, and uses algorithms or protocols to adjust the supply and demand of the stablecoin to keep its price stable.

🔵 Commodity-backed Stablecoins

These are stablecoins that claim to be backed by commodities, such as gold or silver. For example, PAX Gold and Tether Gold are two commodity-backed stablecoins that are pegged to the price of gold. The idea is that the issuer of the stablecoin holds a reserve of the commodity in a vault or a custodian, and guarantees to redeem the stablecoins for the commodity at any time and at par value. This way, the stablecoin can maintain its peg to the commodity, as long as the issuer has enough reserves and is credible.

🔵 Unbacked Stablecoins

These are stablecoins that do not claim to be backed by any reserves, but rather seek to maintain a stable value through, for instance, algorithms or protocols. For example, TerraClassicUSD and sUSD are two unbacked stablecoins. The idea is that the stablecoin can maintain its peg by matching the demand and supply of the stablecoin, without relying on any collateral.

The Performance and Risks of Stablecoins: A Reality Check

The BIS paper analyses the performance and risks of stablecoins. The paper finds that:

Stablecoins are not always stable: The paper shows that, while stablecoins backed by fiat currency, commodities, or other cryptoassets have generally been less volatile than traditional cryptoassets, such as Bitcoin, not one of them has been able to maintain parity with its peg at all times. This is true regardless of the size or type of the stablecoin. Moreover, there is currently no guarantee that stablecoin issuers can redeem users’ stablecoins in full and on demand. For these reasons, the stablecoins in circulation today do not meet the key criteria for being a safe store of value and a trustworthy means of payment in the real economy.
Stablecoins are affected by market events and regulatory actions: The paper also shows that the performance and stability of stablecoins have been influenced by various events and developments in the cryptoasset market and the regulatory environment. For example, the paper highlights how the collapse of TerraUSD, the bankruptcy of FTX, the closure of Silicon Valley Bank, and the interventions of crypto exchanges have had a significant impact on the price, volatility, and market capitalisation of stablecoins. The paper also discusses how the regulatory responses to stablecoins have varied across jurisdictions and authorities, and how they have implications for the safety and efficiency of payment systems and financial stability more broadly.
Stablecoins face significant data gaps and challenges: The paper also points out some of the limitations and challenges of the data and analysis on stablecoins. The paper notes that more data are needed to better understand the uses and users of stablecoins, as well as their potential risks and benefits. Without such data, it is difficult to assess the impact of stablecoins on the smooth functioning of payment systems and financial stability. The paper also acknowledges that the stablecoin market is dynamic and evolving and that new types and features of stablecoins may emerge in the future, posing new challenges and opportunities for policymakers and regulators.

Key Takeaways: What You Need to Know About Stablecoins

Stablecoins are a type of cryptoasset that aims to maintain a stable value relative to a specified peg, such as a fiat currency, a commodity, or another cryptoasset.
There are four main types of stablecoin, depending on whether they claim to hold a pool of reserve assets to back their value, and if so, the type of these reserve assets: fiat-backed, crypto-backed, commodity-backed, and unbacked.
Stablecoins have not been able to keep their value stable at all times, and there is no guarantee that users can redeem their stablecoins at par value and on demand. Therefore, stablecoins do not meet the criteria for being a safe store of value and a trustworthy means of payment in the real economy.
Stablecoins are influenced by market events and regulatory actions, which can affect their price, volatility, and market capitalisation. The regulatory responses to stablecoins vary across jurisdictions and authorities and have implications for the safety and efficiency of payment systems and financial stability.
Stablecoins face significant data gaps and challenges, which limit the understanding and assessment of their uses, users, and risks. The stablecoin market is dynamic and evolving, and new types and features of stablecoins may emerge in the future.

P.S. What do you think is the most interesting or surprising finding from the BIS paper? Share your answer in the comment section and let’s start a conversation.

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

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