A stablecoin is a cryptocurrency that is linked to the price of another asset. The first attempt to peg a cryptocurrency unit price to a non-crypto asset was made by Mastercoin (2012), which failed. Tether (USDT) is the first recognized official stablecoin, and it is still in use. Stablecoins are a type of token that does not change in price a lot, and they are better than typical cryptocurrencies because there is less risk of it losing value. Not all stablecoins are based on fiat money; some are backed by precious metals or other cryptocurrencies.
Stablecoins have attracted criticism. Since their inception, regulations, project failures, transparency, and degrees of centralization have plagued stablecoins and have drawn harsh rebukes. The G-20 warned that stablecoins have the power to severely disrupt local economies. ECB President Christine Lagarde promised to closely monitor stablecoins to “stay ahead of the curve.” (Brave New Coin) Other concerns include mispriced pricing feeds and whether stablecoins should be classified as commodities or securities. Since 2019 there have been 119 stablecoin projects, with 66 going live and 24 ceasing operations. Two-thirds of them are failed attempts to have gold-backed stablecoin tokens. Besides regulation and failures, transparency is another concern. The most infamous controversy of transparency is Tether, which first gained scrutiny when known as Realcoin. A 2014 audit by the New York Attorney General revealed that Realcoin was also co-owned by Bitfinex cryptocurrency exchange. There are claims that Tether isn’t completely open about its dollar reserves. The firm that issues the cryptocurrency is facing a lawsuit. Finally, stablecoins might be too centralized – since a stablecoin is connected to another asset and relies on a holding company to back it (except for cryptocurrency-backed stablecoins, to an extent).
Despite the difficulties and scandals linked to stablecoins, their progress continues. Most people use them as a stop-gap measure to protect their crypto value without cashing out, earn interest, or maintain their fiat value equivalent while transferring between different cryptocurrencies. You can buy different types of stablecoins for use in cryptocurrency trading. These coins serve many purposes, and you should choose the one that is best for you.
Different Types of Stablecoins
A fiat-backed stablecoin is a cryptocurrency that is linked to the price of paper currency. Most stablecoins are based on the U.S. dollar, and Tether, TrueUSD, PAX, LBX, Peg, Gemini Dollar, and Circle are well-known ones. Typically, they’re tokens backed by dollar reserves controlled by the company that creates them. Regular audits are required to ensure that the firm has adequate reserves.
Commodity-backed stablecoins are based on the current market value of physical commodities. Every unit of a commodity in the corporation’s reserves is represented by a token. Stablecoins are often sold in fractional quantities, such as half a unit or a quarter of a unit (0.50 and 0.25, respectively). Gold-backed crypto tokens are popular commodity stablecoins. Some examples are Digix Gold, PAX Gold, Tiberius Gold, SwissRealCoin, and Galaxy Coin.
A crypto-backed stablecoin works like a fiat-backed one. But instead of paper currency, the collateral is stored in cryptocurrency. The target price of this type of stablecoin is usually tied to the price of a fiat currency like dollars or euros. Collateral cryptocurrency is purchased or sold by smart contracts to guarantee a stable price. Dai is a stablecoin backed by Ethereum and other cryptocurrencies; its price target is always a dollar. When Dai begins to move significantly away from one dollar, smart contracts stabilize the price.
Non-collateralized stablecoins, also known as “seigniorage shares” and “algorithmic stablecoins,” are the most decentralized. They are “backed by math,” using smart contracts to maintain market supply and keep its price pegged to another asset (usually a fiat currency). Ampleforth is an example of a non-collateralized stablecoin that uses algorithms to maintain a stable value, to find equilibrium between supply and demand so that value remains the same.
Regulations and Impacts
There are ongoing debates about how to classify stablecoins. The United States government is considering ways to classify them as securities; however, most stablecoins don’t meet the so-called “Howey test.” There are worries about non-banks issuing stablecoins, with specific advice for non-bank firms who do not wish to be licensed as a bank. (Clifford House, p. 7). Australia, China, Hong Kong, and Japan treat them as financial products and scrutinize them accordingly. Singapore is starting to take a more specific approach in regards to stablecoins. The EU doesn’t have particular cryptocurrency regulations, but member states might have various requirements. In the UAE, stablecoin regulation depends on the zone you’re located in; their Central Bank hasn’t yet placed limitations on stablecoins.
There’s a fear that stablecoins could disrupt global financial markets. A G7 paper stated their “potential to become global pose risks beyond those of small-scale stablecoin arrangements.” (bis.org/cpmi/d187.pdf) The group emphasizes that consumer and investor protection is crucial. “…regulatory (as well as legal) clarity is needed to protect consumers and investors and see that sufficient information and disclosures are available.” Because developed nations have begun regulating stablecoins, the likelihood of causing havoc in financial markets continually decreases. The tokens aren’t wild financial cowboys; they’re subject to regulations.
Since there are some rules in place for stablecoins, how can you research them?
First, look at the audit statement. Find the auditor. It is crucial to research their reports and reputation. Then you need to compare the findings of their conclusion with how many collateralized assets the issuer has reported. If there are significant differences, you will need to ask more questions before buying any tokens.
The second step is to study the holding firm’s reputation. A single issuer that guarantees reserves is less secure than a group of institutions backing a stablecoin (which is the case with Tether vs. TrueUSD).
The CFTC released a document in the United States that summarized important factors and legal treatment of a stablecoin.
The organization suggested that people think about the following questions:
- Is the coin fully backed by and redeemable for the underlying? Is it a digital representation of the underlying?
- How are the underlying custodied?
- If physical assets, how are they traded?
- Can there be substitutions of underlying?
The organization also issued this statement about stablecoin backing:
“Any fiat currency stablecoin or commodity-backed stablecoin 100% backed by the referenced fiat currency or commodity and that serves as a currency substitute may be considered a payment instrument under state money transmitter laws particularly if there are full redemption rights.”
Issuers and exchangers of stablecoins that promise to let people redeem their coins would “likely” need to register with FinCen (the Financial Crimes Enforcement Network) and get a license from the state. Stablecoins backed by precious metals, or other commodities might fall under state laws related to commodity dealers.
Other types of stablecoins, such as crypto-backed and non-collateralized tokens, may be categorized as securities. There should be a prospectus available to read. Plus, this makes the tokens subject to state/federal security laws. Check your state’s legal requirements to determine their legal status and whether organizations are complying with investment security laws.
That is all there is to know about stablecoins. These crypto instruments are still being developed and expanding; there will be more varieties in the future. In addition, new legislation will be implemented to regulate their usage.