What are stablecoins?
Stablecoins are digital units of value, a cryptocurrency pegged to an external reference point. This could be another cryptocurrency, a commodity, or fiat currency. By design, they are intended to provide an alternative to the inherent volatility of traditional cryptocurrencies.
Price fluctuations in cryptocurrency are beneficial to those trading them in markets. However, for those aiming to use crypto as a method of payment, the volatility is problematic. Both sides of a transaction prefer that the medium retains purchasing power.
Stablecoins saw initial use as safe havens for crypto volatility and a reserve for traders who wanted to “cash out” their trades while remaining outside the traditional banking system. This practice makes them critical to the wider cryptocurrency market. The quarterly trading volumes of stablecoins rose to around $3 trillion in 2021. Tether, the largest stablecoin on the market, is used in half of all trades of Bitcoin or Ether.
However, while a stablecoin mirrors the price of a particular currency, that doesn’t mean the equivalent reserve backs it. $10 million is a US-pegged coin might not mean the holder actually has $10 million in their account.
How could stablecoins change?
A majority of stablecoins are currently issued and minted by private companies. However, a new kind of competition has arisen in the form of central bank digital currencies (CBDCs). Many countries are testing, piloting, and developing forms of digital money controlled by regulators. A key difference between stablecoins and CBDCs is in their usage. Most stablecoins facilitate investments, while CBDCs power payments.
Stablecoins have grown on the back of the emerging decentralised finance (DeFi) sector. DeFi aims to replicate existing financial products and services using smart contracts and blockchain technology. Its goal is to provide those with an internet connection access to basic financial services – borrowing, lending, investing – without needing a bank.
It is in this marketplace – away from the traditional banking system – that stablecoins thrive. Creating financial services is difficult if the currency backing those systems is in flux, and prices could change even in the second between purchase decision and payment.
Proponents of the DeFi ecosystem believe it enables underbanked people access to products without the qualification of a bank. Market stall owners in India or Ethiopia could borrow funds using their mobile phones or store digital currency in accounts yielding higher APR than their native country’s inflation rate.
Yet the use of stablecoins is not without its risks. In May 2022, an algorithmic stablecoin called UST collapsed, leading to the loss of more than $40 billion. In reaction, the US introduced a bipartisan bill aiming to regulate the country’s digital assets (including stablecoins). The European Central Bank (ECB) and Bank for International Settlements (BIS) have also produced guidance on the coins and urged regulation.
The CBDC solution?
CBDCs could be an answer to the instability of decentralised finance. A retail CBDC would be a digital form of cash and is a direct claim on the central bank rather than a financial intermediary.
The success of any CDBC system depends on the interaction between the central bank and the wider financial ecosystem. A true retail CBDC means a payment involves a direct transfer from account to account, with no involvement from an outside bank.
Transactions are settled directly by the central bank’s reserves and logged in the central bank’s balance sheet. This is in contrast to existing faster payment systems, in which a recipient is granted their funds in close to real-time, but settlement may take longer.
Yet the application of a retail CBDC has been questioned. It would have repercussions on the existing financial system and industry structure. Central banks would be thrown into the retail banking sphere, something they may not be prepared for.
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