By Colin Payne
Published November 4, 2022
Stablecoins are one of the largest use cases for blockchain technology. Stablecoins are a class of cryptocurrencies that attempt to offer price stability by being backed by selected collateral or managed by an automated set of rules known as algorithm. There are four types of stablecoins:
1. Fiat stablecoins: collateralized by fiat currency(s) held in a bank account
2. Commodity stablecoins: collateralized by commodity(s), such as gold or oil
3. Cryptocurrency stablecoins: collateralized by one or more cryptocurrencies
4. Non-collateralized stablecoins: an algorithm based off supply and demand principles to maintain stable prices at all times
So, what are the origins of stablecoins? Back when the cryptocurrency industry first started, traders looking to purchase cryptocurrencies would use bank transfers to move fiat currencies between their bank accounts and cryptocurrency exchanges. This transfer process took several business days to complete, thus decreasing opportunities to trade in the markets. This friction led to the creation of Stablecoins. The first stablecoin was created in July 2014 by Bitshares called BitUSD with the goal of providing an easy and fast on/off ramp within cryptocurrency exchanges for trading. BitUSD was later collateralized by cryptocurrencies, thus causing the price to fluctuate which led to losing its parity to $USD in 2018. There have been several stablecoins created since BitUSD, with the largest stablecoins by market cap (as of October 2022) being Tether, USD Coin, Binance USD, and DAI. The increase in number of stablecoin projects has led to dramatic growth in total stablecoin market capitalization from $5.6 billion in January 2020 to $181.76 billion in April 2022. However, this drastic growth has come with a few major setbacks for the market.
The downfall of Terra
Let's take a look at Terra. Terra is a protocol that uses a swap algorithm to peg stablecoins to three fiat currencies. Before the downfall in May 2022, Terra used the cryptocurrency Luna as collateral for each of the Terra stablecoins. Luna’s market capitalization dropped from $18.6 billion on May 9th 2022 to less than $1 billion by May 19th 2022. This drop was caused by an individual selling $285 million worth of Terra’s stablecoins called Terra USD (also known as UST), which led to triggering UST to lose its US Dollar parity. UST then continued decreasing in value, causing Terra to sell the protocol’s bitcoin holdings to preserve Luna’s price. The overall cryptocurrency market ramifications of this event are drastic with several large holders of UST losing their money, billions of dollars’ worth of bitcoin being sold off on the open market (which was then amplified by other macroeconomic market conditions), and over leveraged cryptocurrency positions.
The Terra example not only fuels fear in the market but its also become a poster child for individuals to create misinformed statements that stablecoins are risky. However, much of this misconception stems from the shock of the volume of loss, and only pertains to one of 200+ stablecoins. Several of these other stablecoin issuers, such as USDC, are pegged 1:1 with the US Dollar and undergo treasury audits from external accounting firms. Not only are audited fiat stablecoins less risky than other stablecoins, they also have several global benefits:
1. Fiat stablecoins allow individuals around the world to have access to several currencies such as the Euro and Dollar. This is crucial for the millions of people under high inflation and/or currency collapse pressures.
2. Fiat stablecoins allow two parties to send cross-border transactions for a fraction of current costs using the traditional correspondent banking system. The remittance process is explained on this blog post.
3. Stablecoins offer the opportunity for users to receive higher APY in a stablecoin yield account than a traditional savings account. The United States national APY average for a savings account is 0.16% (October 2022). Stablecoin yield varies per exchange ranging from 0.15% APY to 7% APY for USDC.
Regulators around the world are actively creating governing frameworks to account for stablecoins. Senator Cynthia Lummis, also known as ‘Crypto Queen’, from Wyoming has led the regulatory conversations for cryptocurrencies in the United States. Senators Lummis, Toomey, Portman, Warner and Sinema proposed an amendment to the Infrastructure Bill in August 2021 to encompass digital asset regulatory clarity.
Legislation efforts are also underway in the European Union. The EU agreed on the Markets in Crypto-Assets (MiCA) regulation at the end of June. Although the final text is still to be published, MiCA may require stablecoin issuers to build up capital and liquidity reserves and should establish a cap of 200 million euros in transactions per day. The push for increased stablecoin oversight by governments has received mixed opinions, but at the heart of the debate, regulatory clarity will provide guiderails for innovation within the industry.
Where do we go from here?
The future of fiat stablecoins is very promising due to their uses cases of no-barrier access to global currencies, high yield savings accounts, and remittance technology with low fees. These world-changing use cases along with increased global regulatory clarity will drive continued innovation in the stablecoin market. We predict the stablecoin market will continue growing in the coming years and look forward to integrating the technology.