Stablecoins are far from the revolutionary ideals of crypto creators and are not without risk
When it launched in 2009, the crypto revolution was about much more than finance. The financial crisis has shaken people’s faith in banks and the governments that bailed them out. For those who want to avoid traditional institutions and find alternative ways to make payments, Bitcoin and the innovative blockchain technology behind it have promised to decentralize and democratize financial services. Power would be placed in the hands of the people – this remains a compelling vision.
The problem was that speculators quickly crowded the market. Instead of spending bitcoins and other crypto assets, speculators simply hoarded them in the hope that prices would rise higher and higher. Crypto assets have struggled to prove their potential as a payment instrument and have instead become a speculative punt. The creation of thousands of other volatile “altcoins” – many of which are nothing more than get-rich-quick schemes – has made the use of crypto assets for transactions even more problematic. After all, how do you pay for something with an asset that isn’t a stable store of value or a reliable unit of account?
A stablecoin is a crypto asset that aims to maintain a stable value against a specified asset or pool of assets. These assets can be a monetary unit of account such as dollars or euros, a basket of currencies, a commodity such as gold, or unsecured crypto assets. This stability can only be achieved if a centralized institution is in charge of issuing (minting) and redeeming (burning) these crypto assets. Another centralized institution (a custodian) must hold corresponding reserves (usually fiat currency issued by governments) that back each unit of stablecoin issued.
Centralization of finances
This evolution is in contradiction with the original vision. Rather than decentralizing finance, many stablecoins have centralizing characteristics. Instead of moving away from fiat currencies, most types of stablecoins fundamentally depend on these currencies to stabilize their value. Rather than disintermediating markets, they lead to new centralized intermediaries, such as stablecoin issuers (who hold data on their users), reserve managers (usually commercial banks), network administrators (who can change network rules), exchanges and wallets. (which can block transactions). In fact, given the transparency of blockchains and the need to comply with anti-money laundering rules, stablecoins may offer less privacy than existing payment rails.
If stablecoins oppose elements of Bitcoin’s original vision, why do they exist and what are they for? Stablecoins are primarily used to allow users to stay in the crypto world without having to withdraw cash in fiat currency. They are used to buy non-backed crypto assets as well as to access and operate in decentralized finance (DeFi). They have been a key part of the growth of the crypto asset and DeFi markets.
In some emerging markets and developing economies, dollar-denominated stablecoins may become popular as a store of value and as a hedge against inflation and currency depreciation. From the perspective of users, this so-called cryptography offers a way to protect financial interests in the face of macroeconomic pressures and weak financial institutions. When unregulated, stablecoins can circumvent controls on the free movement of capital while complicating macroeconomic management by the central bank.
For some, stablecoins represent the future of payments. After all, in many economies most of the money in circulation is not central bank money, but commercial bank money issued by individuals. Additionally, blockchains have the potential to increase the speed and reduce the costs of services traditionally offered by banks, especially cross-border remittances. It can be argued that stablecoins will be the private currency of the future.
This vision comes with some challenges. First, not all stablecoins are stable. In fact, most stablecoins fluctuate around their desired value rather than sticking to it rigidly. Some stablecoins can deviate significantly from their desired value. This is especially true of algorithmic stablecoins. These tokens aim to stabilize their value through an algorithm that adjusts issuance in response to demand and supply, sometimes combined with support via unbacked crypto assets. However, these tokens are extremely risky. They are susceptible to unanchoring in the event of a large shock that is self-sustaining once it has started, as TerraUSD’s experience shows.
This stablecoin suffered a peg failure in mid-2022 after bank-like runs by users. The collapse of TerraUSD, then the third-largest stablecoin, triggered significant ripple effects across the entire crypto market. A similar contagion in the future could go far beyond crypto markets: many stablecoins hold reserves in traditional financial instruments, and exposure to crypto assets among traditional financial market participants has increased.
Second, the distributed ledger technology that underpins stablecoins has not been widely tested from a payment perspective. These technologies could make cross-border remittances and wholesale payments a bit more efficient, but they may not offer significant advantages over domestic payment systems, especially in advanced economies.
While financial inclusion is often touted as a benefit of stablecoins, most users are educated, relatively young, and already have bank accounts. Unless transactions are made off-blockchain, which further distances stablecoins from traditional crypto ideals of transparency and decentralization, they can sometimes be more expensive than alternatives such as mobile or electronic money. These non-crypto alternatives increased financial inclusion in Kenya from 14% to 83% between 2006 and 2019.
Finally, regulatory barriers may appear. Regulators of national payment systems may not allow stablecoins to serve as a payment instrument for purchases of goods and services and to integrate with national payment systems. Additionally, stablecoins (and the broader crypto universe) are not yet regulated for conduct and prudential purposes in many jurisdictions. Although certain anti-money laundering rules may apply, users are not protected if something goes wrong. Users could face significant losses without recourse to compensation if, for example, fraudulent stablecoins were issued, issuers claimed their stablecoins were guaranteed but were not, stablecoins were stolen, or users couldn’t access their stablecoins or trade them at par.
Stablecoins allow users to stay in the crypto universe without having to withdraw money in fiat currency.
Given the risks they pose, some authorities have sought to regulate stablecoins in a manner similar to traditional financial institutions, with different rules depending on their business models, economic risks, and economic functions. For example, when stablecoins are not issued by banks and are used for small-scale payments, issuers may be subject to adjusted payment regulations. Where stablecoins have fewer liquid reserve assets and are used for investment purposes, issuers may be subject to requirements similar to those applied to securities.
One of the proposals put forward by many authorities is to apply banking-like regulation to stablecoins, especially if they become more widely used for payments. If that happened, stablecoins would themselves become the banks that crypto assets were meant to replace.
Any innovation that gives people more choice, reduces the power of too-big-to-fail institutions, and increases access to financial services should be explored. With the right regulations in place, stablecoins could grow to play a valuable role in providing these benefits, but they cannot do it alone. And they are far from the revolutionary vision of the creators of crypto.
Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.