Stablecoins are tied to fiat currencies to make them less susceptible to price volatility and maintain their pricing stable. A computer algorithm is also used by certain stablecoins to keep their value relatively stable. As stablecoins do not require leverage to produce liquidity, they will be a significant new instrument for monetary regulators. However, the design type of the stablecoin, the intricacy of these arrangements, and the degree of adoption will impact financial stability.

How do stablecoins maintain stability?

Stablecoins are digital assets that are intended to resemble the value of fiat currencies such as the Dollar or the Euro. They enable customers to send money throughout the world inexpensively and quickly while maintaining price stability. Cryptocurrencies like Bitcoin and Ether (the native currency of the Ethereum blockchain) are  technologically speaking fantastic as vehicles of exchange. However, the volatility in their value has made them high-risk investments that are not appropriate for making payments. Coins can be worth much more or less than what they were once the transaction settles despite their relatively short transaction times.

Stablecoins, on the other hand, have no such issue. These assets have minimal price movement and closely reflect the value of the underlying asset or fiat currency they are pegged to. As a result, they act as dependable safe-haven assets on the middle ground between fiat and crypto currencies in times of market volatility.

A stablecoin can maintain its stability in various ways, each of which uniquely approaches unit pegging. Some of the most prevalent varieties of stablecoin are listed below.

Crypto-backed stablecoins

The fundamental distinction between crypto-backed stablecoins and fiat-backed stablecoins is that a cryptocurrency (like Bitcoin) is utilized as collateral. However, cryptocurrencies are digital, thus,  the issuance of units can be handled via smart contracts. The most well-known stablecoin in this category is DAI, which employs this approach. This is accomplished through MakerDAO's use of a collateralized debt position (CDP) to secure assets as collateral on the blockchain.

Although user-trust is lessened with crypto-backed stablecoins, it should be noted that voters establish a monetary policy as part of their governance systems. This implies that you are not required to put your trust in a single issuer, but rather that all network participants will always operate in the users' best interests. Users lock their cryptocurrency inside a contract that issues the stablecoin in order to obtain it. They pay stablecoins back into the same contract later to obtain their collateral back along with any interest. The mechanisms that enforce the peg differ depending on the system's design.

To summarize, participants are incentivized to keep the price consistent using a combination of game theory and on-chain algorithms.

Fiat-backed stablecoins

Stablecoins that are directly backed by fiat currencies at a 1:1 ratio are the most popular. Stablecoins with fiat collateral are sometimes known as fiat-collateralized stablecoins. A central issuer (or bank) keeps a certain amount of fiat cash in reserve and issues tokens in proportion.

For example, the issuer could have a million dollars and distribute one million dollar tokens. Users can freely trade them as they would tokens or cryptocurrencies, and holders can redeem them at any moment for USD equivalents. Tether (USDT), the Gemini Dollar (GUSD), and True USD (TUSD) are some of the most widespread examples in this category.

There is clearly a significant level of counterparty risk here that cannot be mitigated: the issuer must be trusted at the end of the day. For months, questions regarding stablecoins, particularly Tether, have circulated in the financial industry: Is Tether as stable as it should be? Because of the company's ambiguous relationship with the Bitfinex exchange, alleged participation in influencing the price of Bitcoin, and the company's inability to perform a promised audit demonstrating enough reserves supporting the Tether token, Tether Limited, and the Tether cryptocurrency are controversial. As a result, the user has no way of knowing with certainty whether the issuer has funds in reserve. However, when it comes to publishing audits, the issuing business can try to be as transparent as possible, but the method is far from foolproof.

Furthermore, Tether's value fluctuates by a few cents between exchanges, allowing experienced traders to make quick profits by purchasing discounted Tethers and selling them for $1 elsewhere. Additionally, market liquidity would undoubtedly dry up if Tether were to collapse or suffer a sizeable regulatory crackdown, and many individuals could lose a lot of money.

Algorithmic stablecoins

Stablecoins supported by algorithms are not backed by fiat or cryptocurrency. Instead, algorithms and smart contracts govern the supply of the tokens released to maintain their peg. Empty Set Dollar (ESD) and Ampleforth (AMPL) are the leading algorithmic stablecoins in terms of market capitalization. The algorithm for ESD is meant to keep its price at 1 USDC, which is pegged to the US dollar. Their monetary policy is functionally similar to that of central banks in managing national currencies.

If the token price falls below the price of the fiat currency it follows, an algorithmic stablecoin mechanism will cut the token supply. If the price rises above the value of the fiat currency, additional tokens are released into circulation, inflating the stablecoin's value.

Non-collateralized stablecoins are a term used to describe this type of token. They are collateralized, but not in the same ways as the preceding two entries, therefore this is technically inaccurate. In the event of a black swan occurrence, algorithmic stablecoins may have a pool of collateral to deal with extremely volatile market movements.

Impact of stablecoins on monetary policy and financial stability

Stablecoins offer a variety of risks to the existing financial system, including credit and liquidity problems. If not created and controlled appropriately, these could jeopardize financial stability, hamper monetary policy, and eventually impair actual economic activity. This is accomplished by exacerbating existing banking sector vulnerabilities and enhancing shock transmission across borders. These effects could be amplified if stablecoins become generally recognized and used as a means of payment for public use globally.

There are still many unanswered questions about the financial stability consequences of a globally utilized stablecoin. The design type of the stablecoin, the intricacy of these arrangements, and the degree of adoption will  impact financial stability. More serious financial stability risks may arise if stablecoins become widely used. For instance, a permissioned network, which is less prone to money laundering and terrorist funding threats, would have distinct (less) risk implications than a permissionless network. 

Stablecoin adoption on a large scale could lead to further privatization of money, putting it beyond the jurisdiction of monetary authorities and undermining trust in the current monetary system. This could have a severe impact on the effectiveness of fiscal monetary policy as imposed by government institutions of a country and, as a result, have significant disruptive implications on the entire global financial ecosystem. How stablecoins are utilized as a store of value, a means of payment, or a unit of account will have a significant impact on monetary policy. This also ties back in with how the stable currency is tied to the various underlying asset(s).

Furthermore, increased competition—either from new private sector entrants or, more effectively, from the government via a CBDC—is the real issue. While regulators cannot repair the system's flaws in the process of regulating stablecoins, they can frame the issue in that light. The broader picture is that stablecoins have exploded in popularity because of their distinct speed and efficiency advantages. The banking system has not been sufficiently modernized, and financial inclusion has not been adequately addressed through launched CBDCs worldwide yet. Changes in regulation may be required to allow for more competition and innovation from the private sector.

This article was prepared by the author. The views expressed in this article are the author’s own and do not necessarily reflect the views of the Digital Euro Association.”