Stablecoins have been gaining recognition in the cryptocurrency world as a viable asset class. But what exactly are they, and how do they affect you? We take a look at stablecoins, their features and the risks associated with them, and discuss what makes them attractive to investors.
Stablecoins are a type of cryptocurrency the value of which is pegged to a stable asset, such as gold or a fiat currency, which gives it greater stability than conventional cryptocurrencies like Bitcoin. Broadly speaking, there are two types of stablecoins based on how their value is stabilised:
- Collateralised stablecoins: These maintain and are backed by collateral held in a reserve; they could be fiat collateralised (backed by a fiat currency, usually the US dollar), commodity collateralised (where the value of the stablecoin is pegged to the value of precious metals such as gold or silver, or even crude oil), or crypto-collateralised.
- Algorithmic stablecoins: These may not necessarily hold reserve assets; their value is kept stable by controlling supply through a pre-set algebraic formula.
Because they’re less susceptible to price fluctuations, stablecoins offer enhanced transparency within payment processing and increased security for customers. This makes them ideal for use in business finances and market predictions. Despite market fluctuations their value is pegged, and there are no associated storage costs. In addition, they’ve quickly become an efficient payment choice worldwide due to their lower transaction fees and faster transfer times when compared with traditional payment methods.
The global race for stablecoin dominance
Alongside increasing demand for these types of assets come greater opportunities for users looking to invest or trade in cryptocurrencies without the volatility which has come to be associated with the sector. In recent years, stablecoin trading volumes have increased steadily, and market capitalisation has tripled within five months. There are now numerous stablecoins – for example tether - being used for daily payments and transfers by consumers, businesses and even governments around the world.
Increasingly the global economy is digital, and more countries are adopting digital currencies in order to stay competitive. According to the IMF, Asia and the Pacific region are at the forefront of the Central Bank Digital Currency (CBDC) exploration, fostering financial inclusion and creating new value-added in cross border economies. The People’s Bank of China (PBOC), the central bank, encourages citizens to use the digital yuan by rolling out activities to promote it. Another country that has been active in the CBDC space is Sweden. The Swedish central bank, the Riksbank, has been exploring the use of a digital version of the Swedish krona and has conducted several pilot tests on the e-krona project. The UK government has also joined the global race by considering the introduction of a digital pound as a long lead time activity.
Risks of stablecoins: Money laundering and terrorism financing concerns
Numerous solutions to providing legal certainty when transacting with cryptocurrencies have been proposed – most prominent perhaps being KYC/AML regulations, which require customers performing transactions using certain types of assets to verify their identities first through extensive documentation processes. The US Treasury department’s National Strategy for Combating Terrorist and Other Illicit Financing addresses stablecoin AML/CFT risks to “[ensure] that stablecoins have a proper AML/CFT framework and that there are sufficient resources to support domestic supervision.” A report by ACAMS outlines the The Financial Action Task Force (FATF)’s concerns about the risks posed by stablecoins in money laundering and terrorism financing, due to their anonymity, worldwide reach, and potential for being used to launder funds. With the possibility of mass-adoption, these risks could be heightened, as widespread use could make it easier for criminals to exchange and use stablecoins in illegal transactions.
A report by the IMF on regulating the cryptosystem predicts that in the absence of robust regulatory frameworks, prudential, conduct and payment system related risks will increase in the stablecoin ecosystem, potentially leading to instability. Solutions such as Smart contracts , which facilitates transfer between two parties when pre-determined conditions are met all while allowing the controlling authority more visibility into how tokens are being used within the system, are now widely used. This allows greater control over who can access and use given currencies without sacrificing user privacy.
It's clear that the concept of digital currencies is quickly gaining traction around the world and this trend doesn’t seem likely to slow down any time soon. However, there is still a long way to go before stablecoins achieve full legitimacy as true alternative currencies. As more countries begin embracing this technology, we can expect new applications and use cases for these assets that look set to bring greater economic freedom and opportunity.
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