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The rise in stablecoins and their uses globally has shown us that stablecoin can be a major player in financial markets. In tandem with Central Bank Digital Currencies (CBDCs), stablecoins present a tangible use for blockchain technology, and we are even starting to see their uptake in governments, including the recent backing by the United States financial regulator.
Naturally, with this increase, there are bound to be new risks and uncertainties. Since Sila is intuitively involved with stablecoin, and our platform facilitates the use of the SilaUSD stablecoin in business use cases, we believe in tackling these risks head-on.
Let’s dive into the potential risks, benefits, and regulations surrounding stablecoin.
Developed off the rise of the cryptocurrency, stablecoins represent a stabilized digital currency on the blockchain that is backed by a physical asset. Stablecoins are cryptocurrencies whose value is verified because of an outside asset, like the U.S. dollar, a modified stable price, or gold. Private entities globally can create stablecoins, making it one of the only decentralized and usable currencies. And now, stablecoins are allowed to be used as digital assets in federally regulated banks.
The stablecoin, also referred to as a stablecoin node, was created because cryptocurrencies were too volatile. Markets for cryptocurrencies rise and fall in large amounts in a matter of hours, and this diverges drastically from common market behaviors associated with fiat currencies. Stablecoins were created to provide some sort of financial backing, and they operate based on self-executing code, smart contracts.
Smart contracts, which are operated on the Ethereum blockchain, are blockchain agreements that ensure that a financial transaction goes through. Therefore, a stablecoin that is created through a smart contract is ensured to be liquidated with the asset associated with that currency, should the collateral (the cryptocurrency value) decrease and the amount is to be redeemed.
Following the release of the Bank for International Settlements’s Working Paper, financial institutions have discussed the potential risks associated with allowing stablecoins as a store of value. The European Central Bank (ECB) suggests that they pose serious threats to financial security, worried that because the cryptocurrency relies primarily on technology, banks and other financial institutions have limited control over the verification process.
Within this debate is, of course, the issuing party. The acceptance of stablecoins by banks means that they are putting their trust in some third-party firm to perform verification checks. Now that banks have the green light to start using stable coins, they are still unsure of what the right move would be: build their own stablecoins (which comes with a load of overhead) or work with well-placed existing providers (and risk privacy and other counterparty risks that come with it).
For example, stablecoins have no identifiable issuer or claim, diminishing financial trust, stability, and liquidity. In these ways, stablecoins do not necessarily perform like money, which makes it difficult for financial institutions to manage it like money. Primarily, the ECB is worried that stablecoins could “trigger a large shift of bank deposits to stablecoins, which may have an impact on banks’ operations and the transmission of monetary policy.”
Because the introduction of the stablecoin could be widespread, all at one time, and it does not operate entirely like money, there is a lot of unpredictability around it. Runs could be triggered if an issuer can’t guarantee a fixed value of the stablecoin or if it is not able to absorb losses.
Outside of this, there are larger risks at play. Many of the questions around stablecoin have to do with know your customer (KYC) and identity verification in financial transactions. Stablecoins drastically inhibit this and therefore add a grievous amount of administrative pressure on financial institutions to rectify this. Other risks include putting the infrastructure in place to handle it, which could be susceptible to malicious attackers.
Banks are also worried about the rise of global technology firms becoming a major player in the financial industry. There could be increased competitiveness and technological autonomy, which adds unforeseen risks and challenges to stabilizing the use of stablecoin. While healthy competition is good, too much competition might damage trust and harm consumer choice, encouraging consumers to choose stablecoins and/or financial products that are actually untrustworthy and misuse consumer data and personal information.
The emergence of distributed ledger technology (DLT) has proved that centralized systems can rely on private entities and technology. With these potentials, there are bound to be new market developments, but when will they be here and how quickly they will develop, we cannot account for.
Blockchain transactions with stablecoin have the potential to improve financial trustworthiness and enable novel forms of digital exchange. However, the usability of stablecoin globally is giving rise to uncertainty. While regulation (discussed below) will take time to figure out, experts know that the global potential for open markets, open banking, and banking accessibility through stablecoin technology will provide financial access to millions who didn’t have it before.
Stablecoins also have the option of decentralizing and replacing national currencies, which have largely dictated the financial health and function of a country. With the feasibility of the stablecoin, more people can get their hands on money that is not corrupt and will not lose value, a serious issue in countries like those in South America currently. Dai stablecoin cryptocurrency, for example, aims to be as close in value to the US dollar as possible. The use of this stablecoin as a global medium of exchange could change the way that many around the world are able to use money.
Arner, Auer, and Frost (2020) discuss the possibility of the global stablecoin, which appears to have a much different projected trajectory than those currently in circulation. They find a distinct difference between existing stablecoins, which operate in the smart contract and propose automated financial products, and global stablecoins, which offer new, online forms of exchange. Global stablecoins have the potential to offer 24/7 availability, borderless exchange, simple integration with non-financial services, and fractionalization.
Regulation is undoubtedly one of the biggest challenges associated with stablecoins. Arner, Auer, and Frost (2020) suggest that regulatory responses will need to differ depending on the functionality of the stablecoin; however, there is some evidence that all stablecoins will need to be regulated for both global use and for use on a smart contract. This could pose some administrative challenges and force the slow down of stablecoin uptake in major financial markets.
Additional means of regulation include embedded supervision, whereby the token or node is automatically monitored by the blockchain so that firms don’t need to collect, verify, or manage data. Embedded supervision is just that—embedded into the tokenized market. This regulatory framework could read the market’s ledger and drastically reduce the amount of manual supervision. We think that regulatory supervision could drastically reduce the impact of challenges present in stablecoins and would offset some of the risks.
Another important factor to note is that CBDCs, which are already emerging central bank digital currencies, are argued to come with many of the same benefits of stablecoins without the inherent risks. They are believed to be more effective digital currency solutions and can do much the same that stablecoins do.
Of course, one of the biggest issues with CBDCs is that they are slow to develop. Banks have introduced CBDCs but we are still not seeing their use for the public. Banks might want to latch on to CBDCs as a more stable currency, but that means they lose control of stablecoins. However, there may well be an interconnection between CBDCs and stablecoins, which allows for better user verification within financial markets while maintaining open markets and global accessibility.
With the rise of stablecoins and more uses of digital ledger technology, we are seeing more regulated industries using stablecoins, DLT, blockchain, and smart contracts (through the use of non-fudgible tokens or NFTs).
Now, as financial markets begin to sort out these regulations, there will undoubtedly be evolutions in the regulation of stablecoins, which could make it harder to manage and less accessible.
What will be interesting to see is whether or not banks will move forward with stablecoins and CBDCs equally or if they will need to impose tighter verification regulations on something like the CBDCs in order to provide monetary trust.