Stablecoins: The Pathway from Digital Asset to Shaping the Future of Finance

Stablecoins remain one of the most viable use cases of the revolutionary blockchain technology since it launched a little over a decade ago. Despite only attracting the world's attention barely five years ago, these cryptocurrency sets have surged to prominence and have gained unprecedented acceptance in the global financial world. By enabling seamless, borderless transactions within both decentralized and centralized financial ecosystems, stablecoins have become hard to ignore in the modern financial world. 

If you're wondering how stablecoins evolved from a digital asset notion to one defining the future of money, hold on to your handlebars because we're about to take you on an adventure. To get started, let's quickly teleport to the year 2014, when it all started.

History of Stablecoin: Tracing Their Remarkable Past and Boundless Future

The History of stablecoins is incomplete without referring to the front liners—BitUSD and NuBits, two of the earliest stablecoins to grace the crypto world. Using these two as a case study, let's proceed to uncover the reason why this category of digital currency was introduced in the first place.

Originally, cryptocurrency existed at least six years before the eventual debut of stablecoins in 2014. However, unlike stablecoins, the legacy cryptocurrencies such as Bitcoin and Ethereum were designed to be volatile, suggesting that, despite being addressed as a "store of value," they are susceptible to frequent and significant upward or downward movement in prices. For instance, if you bought a crypto asset for $5 and decide to sell it the following day, you may realize the new price has increased by $4 or decreased by the same. You could sell for a profit or loss of $9 or $1. 

Now, was this a hindrance to the success of cryptocurrency? Absolutely! In practice, high volatility continues to be a fundamental impediment to the widespread adoption of cryptocurrency, as it limits its practical usability. But guess what? That's where it gets more interesting. Seeing how high volatility could pose a significant hindrance, it was only logical to create a different version of this digital asset, albeit ensuring that it operates as a low-volatile if not zero-volatility. This same reason birthed the earliest stablecoins, which enjoyed a more stable value than their predecessors. 

Unlike the more recent fiat-based stablecoins, the earliest stablecoins, like BitUSD and NuBits, launched on July 21 and September 2014, were collateralized by other cryptocurrencies. Mainly, BitUSD was backed by the BitShares core token called BTS. NuBits, on the other hand, was governed by the controversial Seigniorage system.

While both stablecoins had their fair share of failure, BitUSD lost its parity to the US dollar in late 2018, with the current price floating around 80 cents, about 20% below its supposed worth. NuBits, in its case,  have had two major crashes in 2016 and 2018, respectively, leaving the token at a price below a cent—a far cry from its supposed worth of $1. At the time of writing, these two tokens are a failed attempt to create an actual stablecoin. Regardless, they forged the path for the more advanced varieties like USDT, USDC, and BUSD, as we have them in numbers today. 

How do Stablecoins Work?

Nine years after the first attempt, there are now more advanced stablecoins with zero volatility, but how was this achieved? To understand how stablecoins achieved near zero volatility is to know how the concept works in the first place. So, how do stablecoins work?

Staying within the context, what is a stablecoin? 

A stablecoin is described as a cryptocurrency whose value is pegged to the price of another asset, usually one whose value is constant, hence the term "stable." If functioning correctly, a stablecoin pegged to the US dollar, for example, should always be valued at $1. However, as established earlier, some acclaimed stablecoins are not as stable as they claim or, so, is their reality – a recent case is the TerraUSD collapse. Among other lessons, the TerraUSD collapse taught many that not every stablecoin can guarantee zero volatility, nor are they utterly immune to crashes.

Most stablecoins adopt the same underlying concept—they attempt to peg their value to an external reference. Therefore, most stablecoins adopt either of two popular systems—collateralized and algorithmic, two of which will be discussed more elaborately. Albeit, in any case, most stablecoins maintain reserve assets as collateral or through algorithmic formulas that are supposed to control supply.

Types of Stablecoins

Having established that most stablecoins adopt either of two popular systems that automatically group them into two main categories, there are, in fact, three different types of stablecoins in circulation. The most prominent type, collateralized stablecoin, is further classified into fiat-collateralized stablecoin and crypto-collateralized stablecoins. Alongside these two is the third type, known as algorithmic stablecoin. 

While these three stablecoin models have emerged to introduce stability on the blockchain, they each possess unique pros and cons, some of which will be explored in the next few sections.

Algorithmic Stablecoin

As the name implies, algorithmic stablecoin does not rely on a reserve asset to thrive. Instead, it adopts a method of keeping the stablecoin’s value by controlling the supply using an algorithm—a computer program running on a preset formula. Although this preset formula varies, most algorithmic stablecoins adopt the secondary burn and mint mechanism

Essentially, this mechanism enables a stablecoin (token A) to be pegged to another reserve asset, usually cryptocurrency (token B). In practice, token A price is typically pegged at $1 or the equivalent price of token B via the minting and burning of token B. Let’s use the now-collapsed TerraUSD as a case study. 

TerraUSD’s price was pegged at $1 via the minting (creation) and burning (destruction) of Luna. In other words, TerraUSD had no real collateralization in place as the entire model existed solely on the algorithmic minting and burning of Luna tokens each time a UST stablecoin was bought or sold.  

While this model can thrive under stable market conditions, they are susceptible to manipulation. Also, they can easily lose parity to their pegged asset at the slightest pressure from external market forces. It’s disheartening that most algorithmic stablecoins in circulation, despite being lauded as a representation of true decentralization, have repeatedly proven incapable of delivering on their promise of stability.

Collateralized Stablecoin (Crypto-Backed or Fiat-Backed)

Collateralized Stablecoin, arguably the most prominent, relies solely on a secondary pool of collateral to maintain its value. Simply put, this particular stablecoin is pegged to another asset from which it derives its value, which is typically equal to that of the pegged asset. However, there are two types of collateralized stablecoins – Fiat-collateralized and Crypto-collateralized. While these two share a lot in common, they are quite different. Let’s find out how!

Fiat-collateralized stablecoin - This type of collateralized stablecoin is pegged to a fiat currency while maintaining a reserve. For obvious reasons, the majority of fiat-collateralized stablecoin is pegged to the U.S. dollar, primarily because it ranks top among the most stable currencies in the world. Regardless, there are stablecoin projects pegged to currencies like Euro and Pounds. Euro Coin, for instance, is Euro-backed and maintains a reserve of the same.  

That said, fiat-collateralized stablecoins often receive a lot of criticism because they are typically pegged to a reserve governed by a centralized authority, thereby contradicting the aim of decentralization as envisioned by cryptocurrency.

Crypto-collateralized stablecoin- In its own right, a crypto-collateralized stablecoin differs from a fiat alternative in that it is pegged to another cryptocurrency and maintains a reserve of the same. As a result, it is still thought to exemplify what a real decentralized asset should look like. While another cryptocurrency asset backs crypto-collateralized stablecoin and algorithmic stablecoin, the latter does not rely on a reserve.

Crypto-collateralized stablecoins, like algorithmic stablecoins, are vulnerable to algorithm manipulation because the pegged asset also functions within smart contracts across different protocols like Ethereum, Solana, or better.

Fiat-collateralized stablecoins remain the most feasible type of stablecoin, with Tether USDT, Circle USDC, and Binance BUSD, among others, charting a course for the future of digital money. 

Tether USDT, the oldest of its peers, was originally introduced as Realcoin in October 2014 and has garnered the trust of many people worldwide due to its stability and longevity. Other fiat-backed stablecoins now enjoy comparable advantages, as consumers generally prefer them to other stablecoins or cryptocurrencies. As of time of publication, the market cap of the Stablecoins sector is hovering around $125.87B, representing 11.82% of the total cryptocurrency market cap. 

Stablecoins: Risk, potential and regulation

Without a doubt, the rapid rise of stablecoins in cryptocurrency has drawn praise and criticism. While these digital assets, often pegged to traditional currencies, offer stability, as well as foster financial inclusion and innovation within the financial sector, they equally raise concerns about issuing authority, regulatory risks, and transparency. Notably, their almost unchecked growth demands careful oversight to ensure long-term stability in the crypto ecosystem. 

However, to understand what the precise issue here is, let’s highlight and weigh the risk against the potential of this digital asset class while equally evaluating the regulatory measures that could ensure orderliness throughout the industry.

Risk and Potential Associated to Stablecoins

Let’s delve into the risks. To begin with, one of the primary objectives of cryptocurrency is to achieve decentralization. However, true decentralization implies the absence of interference from centralized institutions and regulatory bodies alike. While this core principle emphasises the need for cryptocurrency to remain free from external control to safeguard its fundamental ethos of decentralization, it also poses a major risk to regulating the emerging crypto market. 

Here is the twist. The idea of regulating the crypto space was almost impossible when you approach it in a decentralized manner. This same reason inspired the emergence of CBDC and fiat-backed stablecoin, two of which defy the core principles of cryptocurrency. By affiliating with centralized entities, stablecoins, particularly the fiat-backed types, gave room for regulations, ultimately introducing true stability to the crypto market as evident across leading stablecoins like USDT, USDC and their likes. 

As much as this appears advantageous for the cryptocurrency space, depending on the lens with which you view it, it further introduces additional risks, particularly concerning the reserve entity. For instance, the success of stablecoins inherently depends on that of the pegged asset and the reserve entity at large. It further implies that stablecoins backed by traditional assets can encounter enduring challenges similar to those within the traditional financial system, such as the concentration of power within a few major institutions and unfair advantage among issuers.

Interestingly, the absence of decentralization brought about the biggest risk associated with fiat-backed stablecoins—counterparty risk, meaning stablecoin’s lack of true decentralization attracts vulnerabilities inherent in the centralized financial system.

Furthermore, because the entire operation underpinning stablecoin does not entirely exist on the blockchain, they are exposed to other risks native to the centralized financial system, including vulnerability to hacks, lack of trust and transparency. 

Now, let’s swing to the other side of things - the potential of stablecoins and the role they play in shaping the future of finance.

Stablecoin and the Future of Money

Merely judging from what has been said, it is not hard to tell that stablecoin is a perfect blend of the decentralized and centralized economy. This category of assets combines the onchain attribute of blockchain technology and the stability of centralized economy to deliver the promise of true stability that the decentralized economy seeks. But it doesn’t stop there! 

The financial world is undergoing a rapid shift. Unless one wants to live in denial of reality, it is apparent that the decentralized economy has a place and, more importantly, a huge role to play in modern finance. While it is also glaring that the decentralized economy is still far from sustainable, the emergence of stablecoins has brought new hope to that course. Besides bridging the gap between the decentralized and centralized financial world, stablecoins are redefining the definition of money and financial technology at large. 

In the crypto realm, stablecoin provides a familiar and reliable unit of account whilst establishing trust and encouraging wider adoption, whether by purchasing goods and services or aiding borderless payment. Moreover, it provides a familiar entry point for individuals or projects interested in exploring cryptocurrencies without completely abandoning traditional financial instruments. In addition, stablecoin provides a more secure reserve for other crypto projects that seek to rely on a more stable source. 

On the other hand, stablecoins play a pivotal role in the realm of traditional finance. To provide some context, the foundational technology underpinning cryptocurrencies, namely blockchain, has established an entirely new paradigm for the modern internet. Consequently, it is gradually becoming imperative for organizations across diverse sectors to incorporate blockchain into their existing systems to align with global technology standards. 

While this imperative also extends to banking institutions, one compelling use case for embracing this emergent technology is the adoption of stablecoins and other stable cryptocurrencies, including Central Bank Digital Currencies (CBDCs). Thankfully, stablecoin provides a common ground for traditional finance to interact with the decentralized economy. 

In today’s financial landscape, one way that these closely-knit worlds are embracing stablecoins is through on-chain index tokens. Described as a diversified portfolio of crypto assets represented as a single token, index tokens such as nealthy allow investors to have a stake in multiple crypto assets, including a wide array of stablecoins merely investing in a single token. It's like opting for a buffet of delectable dishes instead of placing all your bets on a dish you may not enjoy.

Generally, stablecoin’s ability to combine the benefits of cryptocurrencies with price stability makes it a valuable tool for facilitating efficient and inclusive financial systems, improving cross-border payments, and driving innovation in the DeFi space. However, it's equally essential to address regulatory concerns and ensure transparency in stablecoin operations to maintain trust and stability within this evolving financial landscape. What are the regulatory measures in place to ensure seamless co-existence and orderliness in the traditional and decentralized financial words?

Stablecoin and Arising  Regulatory Concerns

Without looking too far, one major regulatory concern surrounding stablecoins is the potential threat to financial stability. Having established that earlier, decentralization and regulation do not go quite well together,, which poses a significant limitation for the wider adoption of cryptocurrency. What’s the way forward you may ask?

In a predominantly democratic world that relies heavily on centralized authority, embracing an unregulated currency may be perceived as both obtrusive and counterproductive. Regardless of the merits of the idea, it could struggle to reach its full potential. Moreover, attempting to blend the concept of DeFi with features of traditional finance in the form of stablecoins may not be a sufficient solution.

For instance, it’s not a mere assumption that the rapid adoption of stablecoins could lead to large-scale capital flows in and out of these assets, which may not always align with traditional monetary policy goals. This misalignment could affect interest rates, exchange rates, and capital markets, potentially leading to financial instability and systemic risks. To mitigate this concern, regulators are exploring the idea of central bank digital currencies (CBDCs) as a more controlled and stable form of digital currency that can work in harmony with existing monetary policies.

Another area of concern revolves around consumer protection and investors’ risk exposure. Considering the relative novelty of stablecoins and the potential for issuers to mismanage reserves or engage in fraudulent activities, there's a heightened risk for users and investors alike. Events such as the FTX debacle and TerraUSD’s crash have taught many not to be over-reliant on the promises of cryptocurrency and even stablecoins.

Judging from the obvious, loss of funds due to insolvency or malicious actions can have severe consequences for individuals who rely on these digital assets for daily transactions or investments. Hence, the need for regulatory intervention cannot be overemphasized. Regulators, however, are looking to establish robust safeguards, transparency requirements, and reserve auditing standards to protect consumers and investors in the stablecoin space and the crypto ecosystem at large. 

In the long run, the outcome of these regulatory efforts will be instrumental in determining whether stablecoins can realize their full potential in reshaping the future of money and finance or if they face more significant limitations and scrutiny in the years to come.

Rounding Up

It is clear as a broad day that stablecoins are here to stay, considering their inevitable role in shaping the future of digital money and finance as a whole.

Beyond bridging the gap between decentralized cryptocurrencies and the stability of traditional currencies, stablecoins will transform our perspective of money from purely physical to digital. They will facilitate frictionless value transfer at a global scale, power innovative DeFi applications, and establish a pathway for cryptocurrency integration into traditional finance. Of course, this will only sail smoothly with regulatory hurdles. However, the benefits of stablecoins for users, businesses, and our digitally focused future are undeniably superior.

In conclusion, stablecoins are the pathway to mainstream cryptocurrency usage and crucial infrastructure for the open financial systems of tomorrow. Their dominance is inevitable as both cryptocurrency and traditional institutions increasingly intertwine. If you are still in doubt, this is a reminder that the future of finance is here - it is revolutionized, global, and runs on stablecoins. Want to learn more about stablecoin and their unavoidable impact on the global financial landscape? Head straight to nealthy InvestLab to get answers to all your burning questions.

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