Stabilising Stablecoins

Stablecoins are on the rise. Their emergence is a logical progression in the development of crypto assets. They intend to provide the value backing, lower volatility and trustworthiness of fiat currencies with the ease of transfer and low transactional costs of cryptocurrencies. Therefore, adoption should, in theory at least, open up significant possibilities in the field of digital assets. However, there have been a few bumps along the road to widespread use.  

Stablecoins are essentially cryptocurrencies which are financially backed by either cash or other tangible assets such as precious metal whose price and supply is managed through algorithms. Where hard assets are used to provide backing, they are intended to be deposited in a provable manner with proven values and then anchored to a digital coin making use of blockchain digital ledger technology. Users are therefore assured that fluctuations in value are reduced.

A number of stablecoins have been launched, the most well-known being Tether, though there are many new entrants to the market emerging weekly.  

There are a number of stablecoin models that look to facilitate price stability. The simplest and most widely used is a coin that is collateralised by a fiat currency such as the US dollar or a commodity like gold. While the guarantee from a central entity requires a degree of centralised involvement of trusted parties  (which flies in the face of community aims to decentralise assets and create a trustless environment), 'fiat-backed' stablecoins accommodate simple investment changes and their price is directly guaranteed by provable deposits of cash as collateral. 'Commodity-backed' stablecoins are collateralised by a predetermined unit of a commodity, with precious metals a prime example due to their retention of value and long term stable prices. They allow investors to use cryptocurrencies with a greater degree of certainty than their non backed equivalents. A further alternative is a coin whose stability is backed by algorithms which regulate supply and demand to control pricing, akin to an autonomous Central Bank functionary.

This practical application may lead to stablecoins becoming a genuine alternative to fiat currency, especially in countries suffering from monetary instability or lack of good banking infrastructure. International transfers can benefit from faster transfer times and lower transaction fees particularly as new blockchain technology progresses beyond its current Ethereum based structures into faster, wide-scale Blockchain 3.0 underpinnings.

However, the growth of stablecoins hasn’t come without complications. The obvious question is “how do I know the assets backing the coin actually exist?". A high profile case in the US demonstrated that full audits would need to be carried out in order for a coin to be fully 'fiat-backed'. Trust between issuers and investors is imperative if stablecoins are to offer an effective alternative to traditional centralised payment solutions. The need to engender trust has led to issuers engaging in audits, highlighting insurance arrangements and proving transparency in response to anti-money laundering requirements. However, in the current regulatory climate this involvement of intermediaries is a necessary intervention to give assurance to investors that the underlying backing assets really do exist and have the value they claim to have. This need for proof also introduces costs and overheads to the maintenance of the stablecoin ecosystem which can erode value.

The regulation of stablecoins is not straightforward as they currently sit outside of the emerging regulatory classification discussed in my last article, 'The race to regulate'. The attention of the major regulatory bodies such as the SEC and the FCA has not yet been focused on stablecoins but a consensus is forming around the idea that the most likely regulatory classification places them in the category of either “electronic money” (if fiat backed) or “commodity” (if commodity backed) which has implications for industry compliance regimes. Certainly they do not sit too comfortably with classifications which have been adopted for crypto assets as outlined in my last article.

Last year, the SEC did focus on algorithmic stablecoins and the lack of tangible collateral they offer. It was discussed that these stablecoins might be viewed as 'swaps' which are based on the value of, or an option for the purchase of fiat currencies. This classification could lead to a requirement that issuers register their offerings and guarantee all other regulatory compliance.

Interesting developments are occurring at a daily rate and the last few months have seen a rise in companies developing stablecoins of their own. Circle, a start-up payments company with backing from Goldman Sachs and the support of Coinbase has launched a stablecoin pegged to the US dollar running on the Ethereum Blockchain to be used for trading and cryptocurrency payments. There are also reports of Facebook setting up a stablecoin online payment system in order to enhance private payments without the volatility of cryptocurrencies.

Assuming these growing pains around stablecoins can be overcome and the regime around them “stabilised” then where does that leave the future? Well, this could actually be a very interesting line of enquiry.

In the near future we could see Central Banks introducing their own digital currency or commodity backed cryptocurrency. Ultimately this could become a general purpose cryptocurrency used by consumers. One of the benefits of this would be the ability to transmit policy rates to the real economy, ensuring stability and combatting many economic challenges. J.P Morgan Chase have already unveiled their 'JPM Coin' which is redeemable for a $1 deposit at the bank. Whilst the bank are using it for transactions over the blockchain for now, they are anticipating its use via the internet in the future.

Large scale adoption by countries seeking to create a stable digital currency collateralised by a number of currencies or commodities is a real possibility. This could make one or more stablecoins mainstream and have far reaching implications for the payments industry whilst also opening up potential benefits such as greater tax receipts, money flow tracing and reduced volatility.

Stablecoins could also continue the rise in adoption with the unbanked populations around the world.

While traditional regulatory and audit structures will still need to remain to cover aspects of these initiatives, there is no doubt that stablecoins pose a major challenge to traditional banking structures and an exciting development in the world of digital assets.

Interested in hearing more about stablecoins? We're hosting an informal lunch on the 11th June as part of London Tech Week where we'll be chatting about what's happening in fintech, blockchain and regulation, as well as the challenges in the exciting crypto space. You can sign up to our lunch here.

Insight article byRem Noormohamed

Rem Noormohamed

Partner

+44 (0)7779 779 238
[email protected]

 

Insight article byTom Geen

Tom Geen

Paralegal

0333 016 3553
[email protected]