What are Stablecoins?

The Federal Reserve issued a paper about stablecoins at the end of January. There’s lots of good content there, but I particularly liked the way in which they opened the discussion which I have copied here (for full report click here).

The basics of stablecoins

Stablecoins are digital currencies recorded on distributed ledger technologies (DLTs), usually blockchains, that are pegged to a reference value.4 The majority of outstanding stablecoins are pegged to the U.S. dollar, but stablecoins can also be pegged to other fiat currencies, baskets of currencies, other cryptocurrencies, or commodities such as gold.

Stablecoins serve as a store of value and a medium of exchange on DLTs, which enable stablecoins to be exchanged or integrated with other digital assets.

Stablecoins differ from traditional digital records of money, such as bank deposit accounts, in two primary ways.

First, stablecoins are cryptographically secured.

This allows users to settle transactions near-instantaneously without double-spending or an intermediary that facilitates settlements.

On public blockchains, this also allows for 24-hours-a-day/7- days-a-week/365-days-a-year transactions. Second, stablecoins are typically built on DLT standards that are programmable and allow for the composability of services. In this context, “composability” means stablecoins can function as self-contained building blocks that interoperate with smart contracts (self-executing programmable contracts) to create payment and other financial services. These two key features underpin the current use cases of stablecoins and support innovation in both the financial and non-financial sectors.

The use of stablecoins recorded on public blockchains such as Ethereum, Binance Smart Chain, or Polygon has surged since 2020. As of the end of September 2021, the circulating supply of the largest USD-pegged public stablecoins was almost $130 billion.

Current types of stablecoins

The stablecoin is a nascent, broadly defined technology that can potentially take many forms. However, note that stablecoin technologies are in their infancy with a high potential for innovation.

The current implementations of stablecoins discussed below, as well as their current status in the regulatory landscape, do not reflect all potential deployments of stablecoin technologies.

Public reserve-backed stablecoins

Most existing stablecoins circulate on public blockchains, such as Ethereum, Binance Smart Chain, or Polygon. Of these public stablecoins, most are backed by cash-equivalent reserves such as bank deposits, Treasury bills, and commercial paper.

These reserve-backed stablecoins are also referred to as custodial stablecoins, as they are issued by intermediaries who serve as custodians of cash-equivalent assets and offer 1-for-1 redemption of their stablecoin liabilities for U.S. dollars or other fiat currencies.

The full backing and soundness of some public reserve-backed stablecoins have been called into question. In particular, Tether, the largest stablecoin by circulating supply, agreed to pay $41 million to settle a dispute with the U.S. Commodity Futures Trading Commission, which alleged that Tether misrepresented the sufficiency of its dollar reserves.

Other widely used reserve-backed USD-pegged public stablecoins with varying levels of financial audits include USD Coin, Binance USD, TrueUSD, and Paxos Dollar.

Public algorithmic stablecoins

The remaining fraction of existing public stablecoins use other mechanisms to stabilize their price instead of relying on the soundness of underlying reserves. These stablecoins are often called algorithmic stablecoins.

While reserve-backed stablecoins are issued as a liability on the balance sheet of a legally incorporated firm, algorithmic stablecoins are maintained by systems of smart contracts that operate exclusively on a public blockchain.

The ability to control these smart contracts is often conferred by the possession of a governance token, a specialized token primarily used for voting on changes to protocol or governance parameters.

These governance tokens can also potentially serve as direct or indirect claim on future cash flows from the usage of a stablecoin’s protocols.

The public algorithmic stablecoin sector is highly innovative and difficult to categorize. However, one can generally think of the design of these stablecoins as based on two mechanisms: (1) the collateralized mechanism and (2) the algorithmic peg mechanism.

Collateralized public stablecoins, such as Dai, are minted when a user deposits a volatile cryptocurrency, such as Ethereum, into Dai’s smart contract protocols. The user then receives a loan of Dai (which is pegged to the dollar) against their crypto collateral, at a greater than 100% collateralization ratio. If the value of the Ethereum deposit falls below a certain threshold, the loan is automatically liquidated.

In contrast, the algorithmic peg mechanism uses automated smart contracts to defend the peg by buying and selling the stablecoin against an associated governance token. However, these pegs may experience instability or design flaws that lead to de-pegging, as exemplified by the temporary collapse of Fei, a public algorithmic peg stablecoin that briefly de-pegged after its launch in April 2021.

Additionally, some algorithmic stablecoins use a blend of the collateralized and algorithmic peg mechanisms. For example, the failed IRON public algorithmic stablecoin drew elements from both mechanisms, as its peg was partially backed by USD Coin, a public reserve-backed stablecoin, and TITAN, the governance token for the IRON Finance protocol.

Institutional or private stablecoins

In addition to reserve-backed stablecoins that circulate on public blockchains, traditional financial institutions have also developed reserve-backed stablecoins, also known as ”tokenized deposits”. These institutional stablecoins are implemented on permissioned (private) DLTs, and they are used by financial institutions and their clients for efficient wholesale transactions.

The most well-known institutional stablecoin is JPM Coin. JPMorgan and its clients can use JPM Coin for transactions such as intraday repo settlements and to manage internal liquidity. These private, reserved-backed stablecoins are functionally and economically comparable to products offered by some money transmitters. For example, Paypal and Venmo (a Paypal subsidiary) allow users to make near-instant transfers and payments within their network, and balances held at these firms are backed similarly to a reserve-backed stablecoin. The key difference is the use of centralized databases rather than a permissioned DLT.

Other potential types of stablecoins

As noted previously, the stablecoin is an incipient technology, and it is possible to imagine many ways stablecoins could be implemented throughout the global financial system. For example, payments companies could use an internal, permissioned DLT to settle payments efficiently, which would be conceptually equivalent to a stablecoin. One implementation of this is Visa’s B2B Connect system, a DLT-based payment system for wholesale interbank transactions.

We may also see exchanges and clearinghouses rely on stablecoins or stablecoin-like products for transacting in tokenized financial markets.

Use cases and growth potential of stablecoins

Robust use cases are driving the current growth in various forms of stablecoins. The most important current use case of stablecoins is their role in transacting in cryptocurrency on public blockchains.

Investors often prefer to use public stablecoins instead of fiat balances to trade cryptocurrency, because this allows for near-instantaneous 24/7/365 trading without relying on non-DLT payment systems or custodial holdings of fiat currency balances.

Digital markets Stablecoins are used to trade digital assets and serve as an onramp from fiat currency to digital assets recorded on blockchains.

Payments Stablecoins are used to facilitate fast peer-to-peer and cross-border payments. They also hold the potential for new payment innovations, such as programmable money.

Internal transfers and liquidity management Institutional stablecoins facilitate transfers of funds within a firm and allow efficient movement of internal cash across subsidiaries to manage liquidity risk and regulatory requirements.

DeFi The programmability and composability of stablecoins currently supports decentralized, blockchain-based cryptocurrency markets and services, known as decentralized finance or DeFi.

Protocols allow for market making, collateralized lending, derivatives, asset management, and other services.

Besides their use in crypto trading, both public and institutional stablecoins are currently used for their near-instant, 24/7, non-intermediated payments with potentially low fees.15 This is especially relevant for cross-border transfers, which ordinarily can take multiple days and demand high fees.

Firms are also using institutional stablecoins to near-instantly move cash across their subsidiaries to manage internal liquidity, and to facilitate wholesale transactions in existing financial markets, such as intraday repo transactions.

And finally, because public stablecoins are programmable and composable, they are used heavily in decentralized, public blockchain-based markets and services, known as decentralized finance or DeFi. Systems of DeFi protocols allow users to use stablecoins to directly and transparently participate in a variety of cryptocurrency-related markets and services, such as market-making, collateralized lending, derivatives, and asset management, without traditional intermediaries.

As of September 2021, about $60 billion in digital assets were staked (locked) in DeFi protocols.

Future growth potential

The defining features of stablecoins, their cryptographic security and programmability, support the robust use cases that are currently driving the usage of existing public and institutional stablecoins. However, these features have the potential to drive innovation beyond current uses cases, which are mostly confined to cryptocurrency markets, certain peer-to-peer payments, and institutional liquidity management by very large banks.

Looking forward, stablecoin technologies may see diverse implementations and drive innovation in several growth areas: more inclusive payment and financial systems, tokenized financial markets, and the facilitation of microtransactions for technological advancements such as Web 3.

More inclusive payment and financial systems

Stablecoins have the potential to spur growth and innovation in payment systems, allowing for faster, cheaper payments.

Because stablecoins can be used to transfer funds near instantaneously peer-to-peer between digital wallets for potentially low fees, stablecoins may lower payment barriers and exert pressure on existing payment systems to provide better services. This is especially important for cross-border transfers, which can take several days to clear and carry high fees.

These fees and delays are a burden on low and middle-income countries, which receive financial support from remittances. Stablecoins may also support a more inclusive financial system through the growth of DeFi, which likely requires stablecoins as a necessary building block.

It should be noted that DeFi faces serious challenges, including a complex user experience, a lack of consumer protection, frequent hacking, protocol dysfunctions, and market manipulations.

Additionally, virtually all DeFi protocols only support the trading or lending of cryptocurrencies or non-fungible tokens (NFTs).

Should DeFi protocols mature beyond the current state and become integrated with the broader financial market to support real-world economic activities, DeFi could encourage a more inclusive financial system that allows investors to directly participate in markets without intermediation.

This growth in DeFi would likely drive growth in the usage of stablecoins.

Tokenized financial markets

Additionally, stablecoins may play a key role in tokenizing financial markets. This would entail converting securities into digital tokens on DLTs and trading and servicing them with stablecoins.

For delivery-versus-payment (DvP) transactions, such as security purchases, a tokenized market would allow for real-time settlement at very low costs. This could increase liquidity, transaction speeds, and transparency while reducing counterparty risk, trading costs, and other barriers to market participation. This might especially benefit certain asset classes, such as real estate, by allowing for fractional ownership of tokenized assets and more transparent price discovery.

For payment-versus-payment (PvP) transactions, such as a cross-currency swap, tokenization would also allow for near-instantaneous execution instead of the market’s current conventional T+2 framework, in which a swap’s payments are settled two business days after the swap is struck.

Moreover, for both kinds of transactions, tokenized financial markets would benefit from the programmability of DLTs, which could automate security servicing and regulatory requirements such as required holding periods.

If financial markets were to become partially or completely tokenized, this would likely drive further growth in stablecoin usage.

Next-generation innovations

Finally, stablecoins hold the potential to support next-generation innovations.

One example of such an innovation is Web 3, a possible move away from centralized web platforms and data centers towards decentralized networks. Under this paradigm, Internet services and social media platforms would shift their revenue from advertisements to microtransactions, facilitated by the advent of efficient, integrated online payment systems.

One could imagine, for example, a search engine or video streaming platform supported by near-instant micropayments of stablecoin instead of advertising revenue and the sale of user data.

If this shift in web services were to take hold, it would likely drive further growth in stablecoins.

In conclusion, the current usage of stablecoins is primarily driven by cryptocurrency trading, limited peer-to-peer payments, and DeFi. Looking forward, stablecoins may see further growth through their facilitation of more inclusive payments and financial systems, the tokenization of financial markets, and possible next-generation innovations such as Web 3.

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