Stablecoins Face Challenges from Central Banks Worldwide
Bitcoin and other altcoins have been in the public eye for years but they’ve maintained a limited presence as a speculative novelty in the eyes of many regulators until now. In recent months stablecoins have garnered increased attention from monetary authorities and policymakers around the world which hasn’t bode well for all investors.
What are stablecoins?
Stablecoins represent a niche segment of cryptocurrencies that address some of the liquidity and volatility issues faced by traditional cryptocurrencies like Bitcoin and Ethereum.
Stablecoins are a form of digital currency that has its valuation pegged to an underlying asset, like the dollar or gold. In theory, this allows them to maintain a steady valuation, unlike traditional cryptocurrencies who face high volatility from day to day. This makes stablecoins better suited for everyday transactions, similar to traditional fiat currency.
To illustrate how this works, imagine if you were promised a fixed amount of bitcoin as payment for a transaction scheduled for a few months from now, Given the length of time between now and when you complete the transaction, it’s very possible that the value of bitcoin will change drastically in terms of its actual dollar value in either direction.
On the other hand, if you were promised dollars instead of bitcoin in that transaction, it’s probable that its value would have remained approximately the same, regardless of whether it’s completed today or six months from now.
In theory, stablecoins like Tether and USD Coin offer a solution to cryptocurrency volatility whilst offering faster and more efficient payment processing than traditional ledgers that accompany electronic cash transactions.
How are regulators reacting to stablecoins?
U.S. Federal Reserve Chair Jerome Powell stated in his testimony on July 14th, 2021, that even though stablecoins have the potential to serve as a viable alternative payment universe, they lack the appropriate regulatory framework that backs traditional money market funds and bank deposits.
To date, there are over half a dozen stablecoins being traded on major exchanges, with Tether and Binance Coin representing the third and fourth largest cryptocurrencies by market capitalization as of July 19, 2021, worth $62 billion and $42 billion respectively.
The Fed has expressed concern about the proliferation of stablecoins fragmenting the existing payment system as a private alternative. This is especially a concern given the historic dominance the greenback has held as the global currency of choice.
Additionally, the unregulated existence of these private payment systems poses a risk for consumers; they also lack the transparent contingencies like FDIC and NCUA insurance that traditional bank deposits hold. This puts stablecoins at higher risk if they’re unable to maintain their currency pegs due to market shocks.
Lack of transparency
The argument in favor of stablecoins is that they are pegged or backed by an underlying asset, whether that be fiat, precious metals or other cryptocurrencies; this is what allows them to maintain their stable valuations. In theory, the underlying “reserves” backing each stablecoin are held in deposit at a bank.
In reality, it’s extremely difficult to verify whether there are enough reserves to backup all of the stablecoins in circulation. To date, investors have largely relied on voluntary
attestations from the stablecoin issuers themselves, which disclose how much in reserves they actually hold.
These records generally remain unaudited and there are currently no regulatory requirements that require issuers to get audited. This presents an issue of trust when it comes to verifying that these pegs remain in line with the number of reserves they have on hand.
In the event of an actual run on stablecoin assets, investors may find it difficult to redeem their holdings for cash, as there are no requirements for stablecoin issuers to surrender reserves to investors if requested.
Risks of competition from Central Bank Digital Currencies (CBDCs)
The People’s Bank of China rolled out the digital yuan as its own domestic central bank digital currency (CBDC), with live trials of it currently running in major cities like Shanghai and Suzhou, and another major rollout planned for its 2022 Winter Olympics. Erstwhile, Chinese authorities continue to clamp down on private cryptocurrency mining and trading activities.
The U.S. Federal Reserve has also stated that they are actively researching both the benefits and risks of blockchain-based payment systems. Fed Chair Jerome Powell has indicated that a white paper may be released on the subject as early as September of 2021. As part of this review, the viability of a Federal Reserve-backed CBDC is certainly on the table.
Such innovations from central banks might serve to directly challenge stablecoins and other private blockchain-based payment systems. Given a potential rise in popularity of CBDCs, investors could sell off their stablecoins and flock to these new centrally-backed digital currencies due to the perceived advantage in safety they offer.
What does all this mean for crypto investors?
Individuals who buy stablecoins like Tether and USDC do so for very different reasons from those who buy traditional coins like Ether and Cardano. To date, the majority of stablecoin investors seem to hold them as a store of value during periods of market volatility, similar to how active investors may choose to swap into money market funds in anticipation of a downturn.
This contrasts with investors who purchase Bitcoin and other altcoins for growth and speculation, similar to how equity investors buy stocks.
Regardless of whether investors choose to hold stablecoins or traditional coins, cryptocurrencies still remain highly correlated as an asset class, and there is evidence that these correlations increase in times of heightened market volatility.
Consequently, any regulatory actions taken by central banks around the world could pose a significant challenge for the market in stablecoins going forward. Investors and those interested in stablecoins should maintain a cautious view and stay abreast of new developments as they arise.
Additionally, investors should be wary of stablecoin’s capacity to maintain their pegs, due to the lack of transparency surrounding their underlying reserves. Stablecoin issuers may encounter difficulty maintaining these pegs, particularly if there’s a loss of confidence in the public markets.
As with any speculative investment, take care to limit your exposure to levels you can afford to lose and conduct the necessary due diligence before entering or exiting any trade.
The writer of this piece is not a financial advisor and none of the opinions expressed within this piece should be interpreted to represent financial advice, either in favor or against the investments discussed. Always conduct your own diligence when investing.
