What are stablecoins, and will their adoption take off?

A STABLECOIN is a type of digital currency whose value is pegged to another asset class. The peg is usually to a currency, such as the US dollar (USD); but can also be to a commodity such as gold, or some other financial asset.

Stablecoins are seen as a bridge between highly volatile cryptocurrencies and fiat currency, which is the government-issued money we use in everyday transactions.

The peg reduces the price volatility of the stablecoin, making it more useful as a medium of exchange.

How do stablecoins work?

To buy a USD-pegged stablecoin such as USD coin (USDC), a user pays US$1 to receive 1 USDC.

In this theoretical exchange, the USDC issuer will hold the US dollar in its reserves. Issuers may put a portion of their reserves in short-term and relatively low-risk assets, such as US Treasury bonds, to earn a return.

Issuers must, however, ensure there is enough liquidity to allow users to exchange their USDC back into USD at any point.

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Without this ability to support an exchange, the stablecoin would lose its peg.

Stablecoins may also be pegged to non-fiat currencies, such as other cryptocurrencies.

Tan Siew Lee, head of OCBC’s group wealth management, said such stablecoins could carry “market risk”.

“The value of stablecoins is primarily determined by the value of the underlying asset, but deviations are possible due to various risks and flaws within the construct used to ensure the stable value,” she said.

Why use stablecoins?

Stablecoins are less volatile than other cryptocurrencies, and may be more suitable as a medium of exchange.

A stablecoin holder may use it to trade other crypto assets or cryptocurrencies, given that few exchanges allow customers to buy or sell crypto assets with fiat money.

Market watchers said other potential use cases are emerging.

For instance, stablecoins could help facilitate trading of tokenised real-world assets and cross-border remittances.

Rene Michau, Standard Chartered’s global head of digital assets, said stablecoins are also more common in countries whose currencies are very volatile.

Regulations to keep stablecoins stable

The Monetary Authority of Singapore (MAS) in August finalised its regulatory framework for single-currency stablecoins issued in Singapore that are pegged to the Singapore dollar, or to any G10 currency.

The G10 currencies are: Australian dollar, Canadian dollar, euro, Japanese yen, New Zealand dollar, Norwegian krone, pound sterling, Swedish krona, Swiss franc and US dollar.

Among MAS’ key requirements: Issuers must submit independent attestations of their reserves every month, and an audited report every year.

They must also hold reserves equivalent to or more than the par value of their stablecoins in circulation. Reserve assets must also be held in cash or cash equivalents, or in three-month Singapore government bonds.

Singapore is not the only country ramping up regulatory oversight of these digital assets.

The Hong Kong Monetary Authority in June announced aims to introduce a regulatory framework by the end of 2024.

Both the United Kingdom and United States are also in the process of amending legislation to keep stablecoins under the governments’ watch.

This comes after a series of stablecoin collapses last year, most notably the Terra/Luna cryptocurrency.

The USDC in March this year also lost its US dollar peg momentarily, after the company revealed nearly 8 per cent of its US$40 billion in reserves was held at the collapsed lender Silicon Valley Bank.

How do financial institutions view stablecoins?

While most market watchers believe there is inherent value in the coins’ use as a payment gateway, many are still wary of its risks.

“Given that stablecoins are still prone to runs, the large part of stablecoins reserves in traditional finance (such as bonds and loans) continue to be vulnerable to redemption risks,” said Heng Koon How, executive director of blockchain and digital assets at UOB.

Evy Theunis, head of digital assets at DBS, said more efforts to improve trust and safety in stablecoins could broaden its adoption.

International standard-setting bodies can also align their stablecoin policies to prevent uneven or disconnected standards for stablecoins and the potential for regulatory arbitrage, said Standard Chartered’s Michau.