The Subtle Dominance of Stablecoins: A Ruse of Stability

Digital tokens are nothing new in 2022 as the crypto market continues to fold into the traditional financial sphere. The debate over environmental hazards, regulatory policies, and technical complexities defined yesteryears. But none of these aspects succeeded in putting a damper on the popularity of the crypto market. Sure the price of bitcoin has been in a pitfall since early November. But it is has maintained its mark regardless of the skepticism. Countries continue to adopt bitcoin as a means of exchange while the crypto offerings expand; venture from derivatives market to the real estate sector. I admit, it is a rollercoaster of information; it is hard to sieve relevance from all the FUD out there. Yet, while the mainstream focus remains fixated on the flag-bearer offerings like bitcoin and ether – the two leading crypto tokens – a section of crypto continues to thrive and circumvent the hype to an extent. Stablecoins – digital tokens pegged to other assets – continue to pace adoption: almost matching the frontrunners of the crypto market.

The acceptance of stablecoins has surged in recent years. These tokens are designed for stability and are usually pegged to stable assets – like the US dollar – to maintain value over time. Stablecoins are a sharp contrast to volatile offerings like bitcoin. Over the past few years, a motley of cryptocurrencies have morphed into mainstream markets: Dogecoin, Shiba Inu, and Solana (SOL) – to name a few. However, the inherent volatility has remained a notable drawback across the range. Perversely, stablecoins maintain their value by underpinning over a stack of safer assets – usually based in traditional financial markets. Today, dozens of stablecoins are in circulation with a combined market valuation of $154 billion. While some stablecoins peg to fiat units – like USD Coin (USDC) pegged to the US dollar – it is not a thumb rule. Many tokens get pegged to commodities, gold reserves, and bonds. The basic premise underscores a diverse mix of liquid assets reserved to offer digital coins circulated across blockchain networks. Some issuers even peg stablecoins to cryptocurrencies – conflating the safer and riskier crypto markets.

The outright utility of stablecoins is obvious: trade via crypto exchanges without risking a downturn in value. Moreover, stablecoins can bypass the traditional payments infrastructure while avoiding volatility in pricing. Thus, these offerings can (at least in theory) speed up cross-border transactions, eliminate transaction costs associated with traditional banks, and allow traders to divert transactions in the crypto world without the fear of volatility. All the utilities mirror the benefits of a Central Bank Digital Currency (CBDC); without the centralized system and regulatory oversight.

Stablecoins pegged to crypto-assets like bitcoin or ether are interestingly not volatile in the short run. To avoid compromising stability, the issuers maintain a collection of crypto assets that outweigh the circulation of their tokens. Think about a central bank holding reserves of gold to back its fiat notes in the money supply. Since last year, stablecoins have impressively edged out popular cryptocurrencies in cumulative value. Tether (USDT) – the most popular stablecoin – is now behind just bitcoin and ether with a market cap of $78.5 billion. More than 69 billion Tethers are currently in circulation: at least 48 billion issued in 2021. The USDC recently crossed the $44 billion market cap to claim the fifth spot in crypto rankings while replacing Solana. It is also noteworthy that even the sharp selloff in cryptocurrencies since November has done little to dent the appetite for stablecoins. According to data from CoinGecko, BitPay Inc – one of the largest crypto payments platforms – reported a downfall in payments via popular cryptocurrencies. The use of bitcoin dropped to 65% payments from 92% in 2020. However, the stablecoins accounted for 13% of the total payments processed – barely trailing 15% ether purchases.

The main element supporting such exponential acceptance is stability over volatility. While bitcoin and ether – alongside similar crypto tokens – are popular speculative assets, the store of value is a precarious aspect: considering the steep price swings in recent months. Conversely, stablecoins are relatively stabler in value; easier to use in cross-border payments such as remittances and freelance incentives. Investors predominantly want to hold onto the popular cryptocurrencies to gamble a price hike instead of spending. According to data from Glassnode Studio, there has been a steady transfer of bitcoins from short-term to long-term accounts – ‘Hodlers’ as referred to in the crypto lingo. These “staunch bitcoin believers” maintain a strong base of hodlers who are unlikely to sell their holdings – even during a selloff.

Thus, despite leverage liquidations since early November, bitcoin prices have been relatively range-bound. The crypto industry is shaping into a bifurcated market – mainstream cryptocurrencies (like bitcoin and ether) for speculative investments and stablecoins (like USDC and USDT) for means of transaction and general decentralized payments. As crypto companies and exchanges continue to expand, transactions are growing – popularising stablecoins in the process. Albeit variance in value avoided, is the risk entirely off the table. The regulators surely don’t think so!

The surge in usage of stablecoins has pestered lawmakers for months. According to regulators, growing acceptance is problematic – since large amounts of dollar-equivalent coins get regularly exchanged without any supervision of the US banking system. It opens a route to illicit financial transactions, fraud, and money laundering. Jerome Powell – Chairman of the Federal Reserve – recently addressed the US Congress, stating: “They [stablecoins] are like money (market) funds; they are like bank deposits growing incredibly fast but without appropriate regulation.” The front-running issue stems from the concerns around the 1-to-1 parity of stablecoins. In theory, issuers of stablecoins maintain reserves of safe assets to back their coin circulation. But in reality, however, these reserves are diverse in nature – sometimes riskier than initially implied. Tether, for instance, maintains its asset reserves in US dollars, T-bills, and corporate bonds. However, a Bloomberg investigation into Tether revealed that billions of dollars in reserves also include short-term loans to Chinese companies – activities money market funds avoid due to federal regulations. Tether further accumulates a part of its asset reserves via loans to crypto companies, backed by bitcoin as collateral. While Tether vows that majority of its commercial paper has high grades from reputed credit-ratings firms, most of these supposed “low-risk loans” were never marketed to customers when launching the USDT. Thus, a sharp fall in bitcoin prices (like the 45% drop in April 2021) or bankruptcy of a few such Chinese companies could risk a default on loans; a subsequent squeeze in liquidity and a market-wide panic could trigger a bank run. These risks got underlined when regulators asked for jurisdiction over the highly decentralized market of stablecoins – and the broader crypto industry.

Today, the growing market of lending stablecoins further complicates matters. In periods of high market volatility, investors use stablecoins as leverage to speculate on other assets – like bitcoin. Lenders could easily earn returns ranging from 10% to 19% from loans as participants collateralize their holdings to speculate. This borrow and lending market inadvertently links the speculative markets to the safest crypto offerings. For instance, lenders could easily condense their reserves to 95% (even 90%) worth circulation during bouts of bullish sentiments in the crypto market. Without any regulatory supervision, issuers like Tether could dilute their reserve holdings without any penalty: all while the market assumes a 100% backing. Now imagine if Tether – with $69 billion in assets – suddenly faces an abnormal uptick in withdrawals – customers willing to exchange for US dollar. Lack of reserves could quickly spark a liquidity crunch. Even an intimation of panic could push the markets into a financial collapse. Such an occurrence would transcend borders since stablecoins have heavily expanded into cross-border payments. Thus, a financial crisis could overwhelm the global economy – because markets dealing in billions of dollars in transactions are without regulatory guidance.

Hence, while stablecoins are stable relative to their notorious counterparts in the speculative crypto markets, the sharp criticism of regulators is justified. The lawmakers are pushing regulators – including the Federal Reserve, the Treasury Department, the SEC, and the CFTC – to police these stablecoin issuers in a manner synonymous to banks and money market funds. Alongside tight scrutiny and constant supervision, robust capital requirements are also debatable. Federal investigations are already underway to disclose the liquidity positions of Tether despite a slew of assurances. Ultimately, lawmakers – even regulators – perceive these stablecoins as offerings posing a systematic risk to broader financial stability. Such regulatory steps could gradually dilute these intrinsic shortcomings associated with stablecoins. However, the decentralized nature of these coins would be difficult to justify amid a raft of legislative rules.

Syed Zain Abbas Rizvi
Syed Zain Abbas Rizvi
The author is a political and economic analyst. He focuses on geopolitical policymaking and international affairs. Syed has written extensively on fintech economy, foreign policy, and economic decision making of the Indo-Pacific and Asian region.