The emergence of Stablecoins in the global digital finance

The very word cryptos invokes either of these two emotions: greed or fear. Especially, the last few years and particularly into the last few months, the entire crypto tokens including the bellwether, Bitcoin are on a roll due to multiple macro, global economic and political reasons.

However, this nascent asset class (if it were to be classified as one) is notoriously volatile with prices skyrocketing and plummeting in matter of minutes. Amid this, a unique class of digital assets have emerged to provide a much-needed safety, at least relative to the others: stablecoins.

At its core, a stablecoin is a type of cryptocurrency designed to have a stable value, typically pegged to a reliable asset like the US Dollar, another fiat currency though or even a commodity like gold. Unlike Bitcoin or Ethereum whose values are driven by market speculation, a stablecoin’s primary purpose is to maintain a consistent price, making it suitable for everyday transactions, savings and as a unit of account within the crypto space.

The initialisation of a stablecoin is a deliberate process that hinges on its underlying collateral mechanism. There’re three primary models:

Fiat-collateralised stablecoins (the most common) - it’s the simplest and most widespread model. For every stablecoin in circulation, there’s an equivalent of unit of real-world currency held in a regulated bank reserve. A company (like Tether or Circle) holds say, $1mn in its bank account and then it issues 1 million tokens (USDT or USDC) on a blockchain (like Ethereum, Solana, etc.) where each token is redeemable for $1.

This is centralised, in contrary to the very blockchain tech or cryptos in nature. The stability relies entirely on the issuer’s transparency and solvency. Regular audits are crucial to verify that the reserves exist.

Crypto-collateralised stablecoin (the decentralised approach) - These are backed by other cryptocurrencies but to account for the volatility of the collateral in a smart contract, often referred to as DAI. A user wanting to mint $100 worth of DAI, would need to over-collateralise i.e., may be about $150 worth of the crypto (say Ethereum) at Maker Vault provided by Maker DAO, which is a Decentralised Autonomous Organisation which is a member-owned, internet-native community that operates as a governing body.

If the value of the collateral falls too close to the value of the DAI, the position is automatically liquidated to ensure the stablecoin remains fully backed. This provides for highly decentralised and transparent as everything is managed (smart contracts) on the blockchain. However, it’s complex and subject to sharp market volatility.

Algorithmic stablecoins (the experimental model) - these’re the most complex and often controversial. They’re not backed by any collateral but instead use algorithms and smart contracts to control the token supply, much like a central bank might manage a national currency.

If the price of the algorithmic stablecoin falls below its peg, the system will algorithmically reduce the supply (process called ‘burring’) to increase scarcity and push the price back up. Conversely, if the price rises above the peg, new tokens are minted to increase the supply and counter the price escalation. These’re highly ambiguous and purely athematic and carry significant risk as demonstrated by the collapse of TerraUSD (UST) in 2022.

Stablecoins are far from digital cash,and their utility could be indispensable. The primary use case is in trading and hedging. Traders use stablecoins as a safe haven to exit volatile positions without cashing out entirely into fiat currency, which can be a slow and expensive process.

Stablecoins form the backbone of DeFi (Decentralised Finance) They’re used for lending, borrowing and earning yield in liquidity pools providing a stable medium of exchange within the protocols that would otherwise be too risky with volatile assets.

The bigger and prospective utility is and would explode from the cross-border payments and remittances. These’re often quick and cheaper than the traditional wire transfer which are cumbersome, time taking and expensive. Also a growing number of businesses and freelancers are adopting to making payments and salaries in stablecoins for their speed, low fees and global accessibility.

The future of stablecoins could be shaped by innovation and regulation by an integration into the traditional finance. The collapse of TerraUSD and concerns over reserves of major issuers have triggered a global regulatory push. Jurisdictions like the EU with MiCA (Markets in Crypto-Assets) regulation and US GENIUS (Guiding and Establishing National Innovation for US Stablecoins)ACT are establishing clear rules for issuance, reserve auditing and consumer protection. This is bringing more legitimacy and increased institutional acceptance.

The central banks have begun exploring their own digital currencies through Central Bank Digital Currencies (CBDCs) a few years back, including RBI (Reserve Bank of India). The eINR, the digital rupee or the tokenised Indian rupee was issued in 2022. Regulations include using digital wallets for transactions, which can be person-to-person (P2P) or person-to-merchant (P2M).

The regulatory framework involves a separate governance structure for intermediaries, emphasising risk-based checks, interoperability and issuer responsibilities. Similarly, most other central banks have come up with their own regulations, though with the new ACT, US Fed seems to have put their project on the backburner.

Technological evolution could enable stablecoins to operate on faster, cheaper blockchains with enhanced programmability, enabling more complex financial product and automated payments. The next frontier is the tokenisation of the everything. The expansion into Real-World Assets (RWA) will see stablecoins pegged to assets like treasury bonds, real estate and commodities, creating a new paradigm for investing and ownership. There’re budding moves towards this with some influential players pitching for tokenisation of stocks too.

Stablecoins have addressed the question of volatility that plagued the cryptocurrencies. From their carefully engineered initialisation to their critical role in DeFi and global payments, they’ve proven their worth as a foundational technology.

While the challenges around regulation persist and the search for perfect stability model remains, the trajectory is clear. They’re not just another crypto trend but could reshape the global financial system. However, the biggest trial for the cross-border transactions to take-off in a substantial way depends upon the governments and central banks come together to accept a common protocol.

(The author is a partner with “Wealocity Analytics”, a SEBI registered Research Analyst firm and could be reached at [email protected])