Stablecoins: Currency for the Digital Age?

The fast-growing world of cryptocurrencies has seen the total market capitalization of all cryptocurrencies rise from US$1 billion in 2013 to a high of US$800 billion in 2018, and continues to rise.

Stablecoins, which is a form of cryptocurrencies, have grown exponentially in the past 12 to 18 months.

Here’s what you need to know about the hottest new cryptocurrency.

What are Stablecoins?

Stablecoins are a form of cryptocurrency which, as their name suggests, aim to hold stable values or at least values with minimal volatility. According to a recent Forbes report, the total market value for Stablecoins is equivalent to the entire money supply in the world or about US$90 trillion.

Issuers of stablecoins, like most cryptocurrency issuers, proclaim the benefits of such digital currencies, including being free from the control and regulation of central authorities (and hence subject to less regulatory compliance), lower transaction fees and privacy.

This lack of regulation, however, comes at a price. The risks associated with cryptocurrencies are susceptible to higher volatility through market speculation and fraud.

Let’s look at Bitcoin to illustrate the extent of volatility. The trading price of Bitcoin was about US$1,000 in February 2017 and rose to about US$20,000 by December 2017. Six months later, in June 2018, the price crashed to about US$6,000.

Stablecoins are developed to avoid this volatility as their values are pegged to more stable assets (e.g. gold or fiat currencies) or are controlled using algorithms (e.g. currency control mechanisms). Thus, Stablecoins have the advantages of cryptocurrencies while limiting the high volatility risk of Bitcoin.

How do Stablecoins work?

Stablecoins can be divided into two broad categories:

  • Asset-backed
  • Non-asset-backed

Asset-backed Stablecoins achieve stability by pegging their coins (or tokens) to assets such as precious metals (e.g. gold), fiat currencies (e.g. US Dollar or Singapore Dollar) or even other cryptocurrencies. A well-known example of an asset-backed Stablecoin is “Tether” (₮), which tethers their digital currency to fiat currencies on a one-to-one basis (e.g. 1 tether USD₮ equals 1 USD, 1 tether EUR₮ equals 1 Euro).

Non-asset-backed Stablecoins do not have any underlying asset from which they derive their values but maintains stability through the use of autonomous algorithms which expand and contract the supply of the particular Stablecoin to maintain a stable value. This is similar to currency control mechanisms deployed by central banks, except that such algorithms are not centrally controlled.

Security and Transparency

While it sounds like a good idea to have Stablecoins backed by unit(s) of currency or asset(s), one common issue is whether the entity issuing the Stablecoin actually has a reserve of the units of currency (e.g. US Dollar or Singapore Dollar) or the requisite amount of asset (e.g. gold) for each Stablecoin in circulation.

Most Stablecoin issuing entities would have some sort of reserves but it is unlikely that they will be able to honor full redemption by every holder of the particular Stablecoin at the same time.

However, while this may sound scary, this is not much different from how banks operate (a key difference being that banks are regulated by monetary authorities and are required to maintain capital and liquidity reserves).

Transparency is another issue surrounding many Stablecoin issuers. In most cases, Stablecoin purchasers may be aware of exactly where and how their money is being stored. For most investors, knowing that their money is stored securely or with a reputable custodian would be a crucial factor in assessing the risk profile of a Stablecoin.

Further, due to the lack of regulation presently, it is sometimes difficult to monitor the activities of Stablecoin issuers. A Stablecoin issuer which conducts unlicensed or illegal activities in a particular jurisdiction may have its bank account(s) frozen by the authorities. Should such bank account(s) comprise of funds contributed by Stablecoin purchasers, they may find it difficult to recover their funds.

Payment Services Act 2019

The Payment Service Act 2019 (“PS Act”) has yet to come into force but the PS Act will regulate the issuing of cryptocurrencies as a “digital payment token service” or an “e-money issuance service” (together “Payment Services”).

Stablecoins which have their values pegged to any fiat currency will fall within the definition of “e-money” under the PS Act and those whose values are not pegged to any fiat currency may fall within the definition of “digital payment token”.

Under the PS Act, Stablecoin issuers are required to hold a licence for the provision of any Payment Services. The provisions of the PS Act aim to enhance user protection in four risk areas:

• the protection of customer moneys
• risks of money laundering and financing of terrorism
• fragmentation of the market
• lack of interoperability across payment solutions and technology risks.

A notable exclusion from the scope of the PS Act is “limited purpose e-money” which generally refers to e-money that can only be used for payment of goods and services provided by merchants from their physical stores and provided that the issuing of such “limited purpose e-money” carries low money laundering and terrorism financing risks.

For the video game industry, it should come as a relief that in-game assets or money will not fall within the definition of “digital payment token” where such in-game assets or money holds no tangible value outside of the game unless it is returnable, transferable or capable of being sold for fiat money.

The Road Ahead

The development of digital currencies and tokens have spurred new ways of doing business, changes in consumer behavior and regulatory and legislative approaches.The speed by which the changes have taken place testify to the potential of digital assets and currencies as a medium of exchange in an increasingly digital global commerce.

 

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This article was first published in September 2019 on Learn@IBF. Learn@IBF is a mobile learning app developed in conjunction with the financial services industry to provide finance professionals with bite-sized content on emerging technologies and skills.

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