Are Stablecoins Stable - Praxis
Are Stablecoins Stable

Are Stablecoins Stable

Recently, there has been increased scrutiny on the role and relevance of the near-$200 billion market of stablecoins. How stable are they really? The short answer – they’re not.

 

Central to this discussion is the emergence of stablecoins as a critical component of the digital asset revolution designed to mitigate the volatility inherent in cryptocurrencies. The erratic price swings of Bitcoin, such as its surge from under $5,000 in March 2020 to over $63,000 in April 2021 followed by a 50% drop, highlight the need for stability in digital currencies for both buyers and sellers.

Consequently, the collective market capitalisation of stablecoins has surged to almost $200 billion.

The Rise of the Stablecoin

The integration of stablecoins into the broader financial ecosystem is deepening. Beyond their role in facilitating retail cryptocurrency trading and supporting decentralised finance (DeFi) through liquidity provision and leveraged borrowing, they are increasingly embraced as a method of payment. With features such as 24/7 trading and near-instant settlement, stablecoins seem to offer a compelling alternative to conventional payment systems, transcending geographical boundaries and time constraints.

However, to function effectively as a medium of exchange, what a currency must primarily offer is stability – assuring its users that its value will remain relatively constant in the short term. Stablecoins aim to address this challenge by pegging their value to fiat currencies like the US dollar or through algorithmic mechanisms, aiming to become an attractive medium of exchange and a reliable bridge between digital assets and traditional financial systems.

They are primarily of three types:

  • Fiat-collateralised stablecoins maintain reserves of fiat currency, such as the US dollar, to back their value. Tether (USDT) and TrueUSD (TUSD)are good examples –both backed by US dollar reserves.
  • Crypto-collateralised stablecoins, on the other hand, are backed by other cryptocurrencies, with the value of the reserve cryptocurrency exceeding that of the stablecoins issued. Notable examples include MakerDAO’s Dai (DAI), which is backed by Ethereum and other cryptocurrencies.
  • Algorithmic stablecoins use algorithms to control their supply, aiming to stabilise their value without relying on reserve assets. However, the credibility of algorithmic stablecoins can be challenged during market crises, as evidenced by the price volatility of the TerraUSD (UST) algorithmic stablecoin in May 2022.

The adoption of stablecoins has witnessed exponential growth in recent years, driven by their utility in facilitating seamless and efficient transactions on blockchain networks. Moreover, their integration with decentralised finance (DeFi) platforms has unlocked new avenues for financial innovation, including lending, borrowing, and yield farming, thereby democratising access to financial services on a global scale.

This has not gone unnoticed by major financial institutions and regulatory bodies either. Recognising their potential to enhance financial efficiency and inclusivity, companies like Visa and PayPal have integrated them into their payment infrastructure, underscoring the growing acceptance of stablecoins as legitimate financial instruments – perfectly capable of handling cross-border transactions and remittances.

Questionable Stability

Despite increased adoption, the Bank for International Settlements (BIS) has on several occasions warned of potential stablecoin risks, cautioning that unchecked interlinkages with stablecoins could transmit cryptocurrency-related risks to traditional banks and established financial institutions.

An independent study using high-frequency data to assess absolute and relative stability of stablecoins revealed significant price fluctuations, most likely influenced by Bitcoin’s volatility, with correlation between stablecoin metrics and Bitcoin time-series data suggesting high interdependence. Yet, a parallel quasi-natural experiment did find stablecoins have a marked impact in raising Bitcoin trading volume(many a cynic would consider that the primary motive).

In response, governments and regulatory bodies are intensifying efforts to mitigate systemic risks and close regulatory loopholes while still leveraging the transformative potential of this innovative technology. There is a pressing need to address any arbitrage opportunities that may arise if the regulatory framework for stablecoin business models is less stringent than that for traditional commercial banks, notes KPMG.

Industry participants have also been asked to prioritise cybersecurity and risk management practices to safeguard against potential threats and vulnerabilities.

Most strikingly however, another, more recent, BIS study uncovered a notable divergence among various stablecoin types. Fiat-backed stablecoins demonstrated superior adherence to their pegs compared to counterparts backed by crypto-assets or commodities. While stablecoins primarily aim for reduced volatility relative to cryptocurrencies like Bitcoin, hurdles persist, even among fiat-backed variants. Only a select few, such as Tether and USD Coin, consistently maintain deviations below 1 percent. However, fluctuations beyond anticipated bands persist, questioning the stability concept. The study also sharply highlighted the pivotal role of pegged currency selection. Stablecoins tied to USD and euro outperform those linked to other currencies or volatile assets like the rupiah and Turkish lira.

Ultimately, the analysis underscored the fundamental challenge: stablecoins, despite their name, grapple with inherent instability. This further raises concerns regarding their reliability as secure stores of value or mediums of exchange in the dynamic digital finance landscape going forward.

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