The Different Classes of Crypto Stablecoins and Why It Matters – Economist Writing Every Day
Last month, the Biden administration issued a Executive Decree outlining some ambitious priorities and goals regarding government initiatives and future regulations regarding cryptocurrencies.
These goals can be abstract as:
1. Protect investors in the crypto space
2. Mitigate systemic risks related to innovations
3. Provide equitable access to affordable financial services
4. Ensure responsible development of digital assets
5. Limit illicit use of digital assets
6. US Central Bank Digital Currency (CBDC) Research Design Options
7. Promote American leadership in technology
These stances generally seem reasonable and moderate, and have been welcomed by the cryptocurrency community, which had feared a more restrictive stance. (China, for example, has completely banned the use of cryptocurrency).
Why be afraid of stablecoins?
Here I would like to focus on #2, “Mitigate Systemic Risks from Innovations”. Although so-called stablecoins are not explicitly mentioned in the executive order, it is understood that they represent a key area of concern for regulators.
A stablecoin usually has its value pegged 1:1 to a major national or international currency such as the US dollar or Euro, or to a commodity such as gold, or even to other cryptocurrencies. In practice, most of them have generally held on to their ankles pretty well. So what’s not to love about them? Why would they be seen as more of a threat than, say, bitcoin, whose dollar value is all over the map?
I think the reason is that market players count on them by maintaining their parity (for example) with the dollar. These coins are used as substitutes for the dollar in billions of dollars of transactions and depend on their value. The total value of used stablecoins is almost $200 billion and growing rapidly. If a major stablecoin somehow crashes, it could lead to significant instability, which regulators don’t like.
Four Main Types of Stablecoins
Stablecoins can be categorized by how their “tether” is held:
(1) Tied to fiat currency, maintained by a central stablecoin issuer
The largest US-based stablecoin is USD Coin (USDC), which is backed by major financial institutions. There is every reason to believe that there is actually a dollar behind every USDC. The Gemini Dollar (GUSD) is smaller, but also strives to gain trust. Its issuer, Gemini, operates under the regulatory oversight of the New York State Department of Financial Services (NYDFS). This is bragging“The Gemini dollar is fully backed at a one-to-one ratio with the US dollar. The number of Gemini dollar tokens in circulation is equal to the number of US dollars held in a bank in the United States, and the system is insured by FDIC deposit insurance as a preventive measure against money laundering, theft, and other illicit activities.”
So far, so good. The huge smelly elephant in the room here is a stablecoin called Tether. Tether is the largest stablecoin by market capitalization (at $79 billion), and is widely used as a substitute for the dollar, mainly in Asia. He was widely criticized as a shady, unaudited operation, operating from shifting offshore locations to avoid regulation (and prosecution). There are justified doubts as to whether the claimed 1:1 dollar support for Tether is really there. Tether somehow leaked its support reserves in the form of a sparse circular diagram. Very little was in the form of cash or even ‘escrow’. Some were in the form of “loans” to who knows what counterparties. The majority of their holdings were “commercial papers”; but nobody can find any trace of tether-related commercial paper in all the rest of the financial universe (it’s become a kind of Game for financial journalists trying to be the first to actually locate all legitimate Tether assets).
So, Tether alone may warrant regulators’ concern. Additionally, without diving too deep into the subject, a plethora of financial institutions and tech companies are beginning to issue their own stablecoins, which again are supposed to be as good as cash, and therefore vulnerable to abuse. .
(2) Commodity-backed stablecoins
Tether Gold (XAUT) and Paxos Gold (PAXG) are two of the most liquid gold-backed stablecoins. Other coins are tied to things like oil or real estate. The holder of these coins is dependent on the coin issuer to have the claimed support.
(3) Cryptocurrency collateral (on-chain)
It is difficult to explain in a few words how this type of part works. A key point here is that your stablecoins are backed by other top cryptocurrencies (such as Ethereum), with the process taking place entirely on the decentralized blockchain via smart contracts. A standout coin here is DAI, an algorithmic stablecoin issued by MakerDAO, which seeks to maintain a one-to-one relationship with the US dollar. It is primarily used as a way to lend and borrow crypto assets without the need for an intermediary, creating a permissionless system with minimal transparency and restrictions.
Unlike the two types of stablecoins discussed above, you are not dependent on the honesty of a central issuer of the stablecoin. On the other hand, Wikipedia Remarks:
The technical implementation of this type of stablecoins is more complex and varied than that of the fiat-collateralized type which introduces a greater risk of exploits due to bugs in the smart contract code. Since tethering is done on-chain, it is not subject to third-party regulation creating a decentralized solution. The potentially problematic aspect of this type of stablecoins is the change in collateral value and the use of additional instruments. The complexity and non-direct support of the stablecoin can discourage use, as it can be difficult to understand how the price is actually secured. Due to the nature of the highly volatile and converging cryptocurrency market, very significant collateral must also be maintained to ensure stability.
(4) Unsecured Algorithmic Stablecoins
The price stability of such a coin results from the use of specialized algorithms and smart contracts that manage the supply of circulating tokens, similar to a central bank’s approach to printing and destroying currency. It is a less popular form of stablecoin. The FEI algorithmic coin has proven unstable at launch, although it has since reached an approximate parity with the dollar.
Stablecoins are an important and rapidly growing practical financial item.
These coins present a different type of risk because (unlike Bitcoin or Ethereum) users are dependent on them holding a certain amount of value.
For coins backed by major fiat currencies or commodities, the risk is introduced by the need to depend on the honesty and competence of centralized coin issuers.
For non-centralized stablecoins like DAI and FEI, there are risks associated with having their protocols work automatically.
We can therefore understand the federal government’s insistence on imposing regulations in this area. That said, it doesn’t seem to me that the current system is so broken that the federal government needs to step in to fix it in a major way. The main sleazy player in all of this is Tether, who everyone knows is sleazy, so caveat emptor (and the vast majority of Tether transactions happen outside of the West, in the dark areas of East Asia).