Visualize an inherently stable, programmable digital asset that functions as a bridge between digital and fiat currencies––this is a stablecoin. Generally backed by one or more reserve assets, stablecoins are both a store of value and a medium of exchange. Traditional financial sectors and risk-averse investors are increasingly adopting this ‘stable’ digital asset as an alternative to the volatility of the emerging digital asset class. Perhaps this is why the stablecoin market today is worth over $100 billion.
To achieve stability, stablecoins can be backed by any asset (or combination of assets) in reserve. There are three common collateralizations: fiat-backed, crypto-backed, and algorithmic. Stablecoins are deemed an ‘off-chain’ asset when not backed by another digital asset. ‘On-chain’ stablecoins are pegged to another digital asset.
Fiat-backed (off-chain) stablecoins are pegged 1:1 to fiat collateral that is in reserve with a traditional financial institution or issuer. Circulating stablecoin is expected to remain proportionate to the fiat in reserve.
Stablecoins are crypto collateralized––on-chain––when backed by other (predominantly Ethereum) assets. Crypto-backed stablecoins employ programmable ‘smart contracts’ in lieu of reliance upon central issuers and intermediaries. Smart contracts are “if-then” contracts between a minimum of two parties. If one party's needs are met, then the agreement is honored and the contract will execute on the blockchain to completion. For example, when purchasing a crypto-collateralized stablecoin like DAI, users deposit an amount of Ether (ETH) into a smart contract. From there, they’re allowed to mint an amount of DAI capped at 66% of the value of the deposited ETH. Using this ETH as collateral, users can take an over-collateralized loan of DAI.
Non-collateralized ‘algorithmic stablecoins’ are not backed by assets. The market price of algorithmic stablecoins is stabilized via protocols that are executed to mitigate inflation. These smart contract protocols regulate the amount of coin in circulation via the process of burning or minting––comparable to measures used by central banks to regulate the money supply.
Scrutiny and Regulation of Stablecoins
As traditional financial sectors and governing bodies look for ways to regulate, incorporate, and build upon the existing infrastructure of DeFi, the boundaries between transacting off- and on-chain are starting to become blurred. Though increasing investment and participation in the crypto ecosystem brings the potential for less volatility, centralization is in opposition to DeFi’s founding ideology. As stablecoins are adopted by traditional finance and increasingly subject to government oversight, regulation will continue to develop and refine the DeFi ecosystem.
Tether (USDT) and USD Coin (USDC) are currently the largest stablecoin tokens by market capitalization. Tether was recently fined $41 million dollars by the US Commodities Futures Trading Commission for misleading buyers with claims of holding cash reserves equal to one dollar for every circulating Tether coin. The investigation found Tether held a combination of off-chain and unregulated on-chain assets.
Legal action against Tether is the beginning of a movement for government oversight of digital assets, like stablecoins, adopted for off-chain use. In November of 2021, a highly anticipated report released by the President’s Working Group for Financial Markets urged congress to regulate stablecoin issuers. The report also validates the growing influence of the broader crypto ecosystem upon traditional financial sectors. U.S. regulators legitimize the danger that a run on a popular crypto token, like Tether, could pose to the U.S. economy and traditional finance. Whereas others in the industry take a position that the majority of lending in crypto is collateralized. They believe that default by Tether or Circle would be relatively contained to crypto market participants as the absence of credit lending in this industry hinders contagion.
Perhaps most importantly for proponents of stablecoins, the PWG report recognizes that crypto assets are positioned to become a mainstream means of payment. Look no further than Visa's March 2021 adoption of USDC stablecoin.
The Mainstream Adoption of Stablecoins
Traditional finance and world leaders can no longer ignore digital assets. They are responding by researching and partnering with crypto tech developers. In March of 2021, Visa became the first major payments platform to offer USDC stablecoins as a native currency option for transactions within the Visa network. To execute this, Visa partnered with Crypto.com and interfaced its network with established Ethereum blockchain developers and decentralized apps. PayPal and Chase are also buying infrastructure to integrate with the crypto landscape. Payment processors stand to benefit from relatively instantaneous settlements. Interoperability developments are facilitating the ease with which DeFi developers can potentially choose to partner with and move into traditional financial sectors. The institutionalization of assets like stablecoins signals a major turning point in the global acceptance of assets.