While cryptocurrency continues to make headlines, the recent focus has been on declining valuations rather than stunning surges. Bitcoin (BTC), the quintessential decentralized crypto, is still primarily viewed as a speculative investment. Despite being around since 2010, using bitcoin for everyday small transactions remains impractical and, in many cases, unwise.
Due to their continuously changing value, decentralized cryptocurrencies like bitcoin can be somewhat risky for purchasing and merchant acceptance – as exemplified by the famous case of an individual who spent 10,000 BTC on two pizzas in the early days of bitcoin, an amount that would now be worth more than $200 million. To help combat these concerns, a distinct category of cryptocurrencies, known as stablecoins, was launched in 2014.
What is a stablecoin?
As their name implies, stablecoins are a category of cryptocurrencies engineered to maintain a fixed value. This level of stability and predictability sets them apart from other cryptocurrency varieties, including bitcoin. Stablecoins are typically tethered to a benchmark currency, such as the U.S. dollar or the euro. When someone acquires a stablecoin for $1, a corresponding coin is generated, and the dollar used as collateral is usually deposited in either a commercial bank account or short-term assets like T-bills. When the stablecoin is redeemed, the coin is effectively removed from circulation (a process known as “burning”) and the original dollar is returned. These types of stablecoins are referred to as fiat-backed stablecoins, but there are other forms as well, such as algorithmic stablecoins that seek to maintain value by dynamically minting or burning coins based on demand.
How are stablecoins used?
Holding a stablecoin in a wallet is similar to holding a paper dollar in a wallet – it may be safe, but it is not necessarily a good investment. However, stablecoins can serve several purposes:
- As a safe haven: In countries like Argentina, where high inflation and currency devaluation are prevalent, workers are challenged with preserving the value of their paychecks. Stablecoins, particularly those tied to the U.S. dollar, provide a reliable and straightforward means to safeguard earnings from volatile fluctuations. This makes them particularly popular in nations with unstable currencies, such as Venezuela and Iran.
- For efficient money movement: Cryptocurrency has emerged as a convenient channel for international money transfers. Since the onset of the Russia-Ukraine war, more than $225 million has been sent to the country in cryptocurrencies like bitcoin, ethereum and dogecoin. However, these decentralized cryptocurrencies carry the risk of price fluctuations between the sender’s initiation of the transaction and the recipient’s need for the funds. Converting these assets to stablecoins before transferring them eliminates this risk, ensuring the intended value reaches the recipient.
- For swift, “on-chain” transfers: Large-scale digital asset traders – typically institutional investors such as cryptocurrency hedge funds – must swiftly move funds in and out of decentralized cryptocurrencies to catch a rise or exit before a fall. The delay involved in transferring funds from a traditional bank account to a cryptocurrency exchange can result in significant financial losses, often amounting to millions of dollars. To mitigate this risk, these investors prefer to hold their capital in blockchain-based cryptocurrencies, which can be easily converted between different coins, ensuring agility in their investment strategies and the ability to react promptly to market dynamics.
Are there other risks to consider?
Although generally considered far less risky than other cryptocurrencies, stablecoins have experienced exceptions that reveal potential pitfalls. The most significant setback occurred in May 2022, when Terra, an algorithmic stablecoin, failed to maintain its peg to the U.S. dollar, resulting in a collapse that erased approximately $20 billion worth of circulating coins.
Terra’s failure was not an isolated incident. In January 2021, Basis Cash caused losses of $30.74 million for its investors. Another stablecoin, Titan, issued by Iron Finance, also faced a collapse – impacting notable backers like Mark Cuban, who later called for increased regulation of stablecoin issuers. Meta, the technology conglomerate which owns and operates platforms such as Facebook and Instagram, attempted to instill trust by creating a stablecoin named Libra (later rebranded as Diem). The goal was to enable Meta’s billions of individual users to conduct global financial transactions, which would potentially shake up the world banking system. However, similar to other stablecoins, it encountered strong opposition from regulators and politicians globally, eventually leading to its abandonment.
What is next for stablecoins?
With more than $120 billion minted, stablecoins have gained widespread popularity. Tether, the largest stablecoin, accounts for $11 billion of that total. The continued adoption and use of stablecoins in various sectors indicate their potential. For example, Visa recently announced its expanded stablecoin settlement capabilities, which encompass the high-performing Solana blockchain and USDC, a digital stablecoin pegged to the U.S. dollar.
In addition, PayPal’s recent entry into the stablecoin arena with the introduction of the PayPal USD – a fiat-backed, regulated stablecoin – is a notable development. With its established history in the payments industry and strong trust among consumers and regulators, PayPal’s stablecoin could potentially have a transformative impact, allowing users to store the new coin within PayPal or external wallets for flexibility and security. This opens doors for various use cases, including peer-to-peer (P2P) payments and making purchases at merchants, potentially broadening the utility and accessibility of stablecoins.
What should financial institutions be doing?
The following are considerations for financial institutions to keep in mind with the increasing popularity of stablecoins:
- Follow this segment of financial services. Stablecoins represent an evolving segment of the broader crypto industry, one that is gaining acceptance and trust – and being scrutinized by regulators. They also represent a potential competitor to regulated banking services by supporting DeFi (Decentralized Financial Services), which are banking services provided by unregulated entities.
- Monitor your customers’ activity. Some of your customers are holding stablecoins. Tracking outflow from deposit accounts to crypto exchanges should be a regular report to understand the magnitude of both the dollar volume and the number of unique customers that are participating. These same customers could be valuable to your financial institution, as they might also be early adopters of other advanced services.
- Consider potential use cases in your strategic planning. There are a few pilots of moving tokenized deposits between financial institutions that have taken place over the last few years. Tokenized deposits are a form of stablecoin moving between banks and credit unions over a private, “permissioned” blockchain. This moving of tokenized deposits is an alternative for B2B payments and cross-border payments. If B2B payments or cross-border payments are something that fits with your business model, consider participating in a pilot case of tokenized deposits in the near future.
It is imperative to keep a pulse on the latest developments concerning stablecoins. As this unique type of cryptocurrency becomes more popular and integrated into the financial ecosystem, stablecoins are likely to play a significant role in the future of digital finance.
Lou Grilli is a Senior Innovation Strategist tasked with building and shaping a superior payment and banking experience capability. Lou is currently focused on real-time payments and cryptocurrency. He participates on the U.S. Faster Payments Council and is named on a patent for the use of blockchain for loyalty programs. Lou holds an MBA from Duke and a master’s degree in Computer Engineering from the University of South Florida.
