An article to understand stablecoins: meaning, classification and supervision

Stablecoins have always been one of the hot topics of long-term discussions in the cryptocurrency market. Stablecoins can improve the efficiency of financial services, including payments, and at the same time, they can also promote financial inclusiveness. For stablecoins, they may also provide a new means of asset trading and value preservation. Stablecoins are beginning to redefine our modern financial structure.

In the extremes of 2020 and the first half of 2021, stablecoins have experienced amazing growth under the boom of the DeFi market. However, stablecoins also bear many risks that may cause harm, and they are not as stable as imagined.

When stablecoins are being used all over the world, do not forget to think about the systemic risks in it. If stablecoins are not interrupted in use, they will have a devastating impact on the cryptocurrency market, and may also have a serious impact on the real financial market, unless financial supervision can enter.

Therefore, the Financial Research Department of Maoqiu Technology believes that there is a major issue to consider here: what kind of financial supervision can make the most effective of stablecoins without compromising the innovation of stablecoins?

What is a stable currency?

In simple terms, a stable currency is a cryptocurrency that is linked to and/or supported by real-world basic assets. These assets can be legal currency, commodities or even another cryptocurrency.

As its name suggests, stablecoins are designed to have (comparable) stable value with traditional currencies or basic commodities. Many stablecoins and their linked products are collateralized at a ratio of 1:1 and can be traded on exchanges around the world.

Stablecoins were born to overcome the price fluctuations of cryptocurrencies such as Bitcoin or Tether. This stems from the lack of a sound mechanism to determine their real-world value. Given the high level of distrust of these cryptocurrencies, investors tend to bet on other safer options such as stablecoins. This choice not only takes advantage of the advantages of cryptocurrency and blockchain, but also does not lose the trust and stability guarantees that the use of legal currency brings.

At present, according to statistics, there are approximately more than 200 types of stablecoins on the market. At the time of the writing of this article by Maoqiu Technology, the total value of stablecoins issued on the public blockchain network has exceeded 110 billion U.S. dollars, and at the beginning of 2021 it was only 28 billion U.S. dollars. This also reflects the high demand for stablecoins from institutions and retailers during periods of instability.

Types of stablecoins

According to the different types of mortgages, Maoqiu Technology divides stablecoins into four main types: legal currency mortgages, cryptocurrency mortgages, commodity mortgages, and algorithmic or non-collateralized.

  • Legal mortgage stablecoin

Fiat-collateralized stablecoins are the simplest and most common type. They are linked to legal currencies such as the U.S. dollar or euro, and are usually backed at a 1:1 ratio, holding a basket of assets denominated in U.S. dollars or euros. This means that for every such stable currency, there is a corresponding legal currency in a bank account. Traders can exchange their stablecoins at any time and redeem USD directly from the exchange. Currently, the most popular stablecoins secured by fiat currencies are Tether (USDT) (market value of US$62 billion) and USD Coin (USDC0 (market value of US$27.3 billion).

  • Commodity mortgage stablecoin

These stablecoins are stablecoins backed by commodity assets such as precious metals, gold, silver, real estate or oil. This theoretically shows to investors that these stablecoins may appreciate as their underlying assets increase in value, thereby increasing the motivation to hold and use these coins. An example of these stablecoins is PAX Gold (PAXG) (market capitalization of $330 million), which relies on gold reserves.

  • Cryptocurrency collateralized stablecoin

The other type is a stable currency collateralized by cryptocurrency. These stablecoins are collateral linked to other cryptocurrencies. Since the value of cryptocurrency itself is not stable, these stablecoins need to use a set of protocols to ensure that the price of the issued stablecoin remains at 1 U.S. dollar. They are usually collateralized by diversified cryptocurrency reserves, which can withstand shocks and maintain price stability.

Another mechanism involves over-collateralization, which means that for stablecoins backed by 1:2 pegged cryptocurrencies, for each stablecoin, cryptocurrencies worth twice the value of the stablecoin will be reserved. Since everything happens on the blockchain, the stablecoins supported by these cryptocurrencies are more transparent, have open source codes, and can be operated in a decentralized manner, which is different from similar products supported by legal currencies.

However, due to the cumbersome setting mechanism of such stablecoins, they are also more complicated and difficult to understand, so they lack popularity. The most popular currency stable monetary support encryption Dai is created by MakerDAO (market value $ 56,800,000), which is pegged to the dollar face value, by the Ethernet Square collateral.

  • Algorithm or non-collateralized stablecoin

The fourth category is the so-called algorithmic stablecoins, also known as non-collateralized stablecoins. This is a very different design because it is not backed by any collateral. It operates in the same way as legal tender, that is, it is managed by a country’s central bank and other sovereign institutions. Given that these stablecoins have obvious difficulties in maintaining value stability, their role is limited.

Algorithmic stablecoins use manipulation of the total supply to maintain the peg. The basic mechanism is to create a new currency, set a peg, and then monitor the exchange price. This can be done through algorithms, in a decentralized manner, with open source code that everyone can see and audit. This so-called relinking is a speculative investment asset, and the probability of gain and loss are both greater than zero.

The second type of algorithmic stable currency is coupon type currency. Unlike rebalancing coins, holders will not see changes in the number of their tokens unless they do specific operations. However, the disadvantage is that coupon-based coins seem to be more unstable. The more well-known stablecoins of this type include Ampleforth ( AMPL ), Based, Empty Set Dollar (ESD) and Dynamic Set Dollar (DSD).

How does stablecoin work?

Some central stablecoins, such as Tether, require a custodian to supervise the currency and then reserve a certain amount of collateral. Tether holds U.S. dollars in a bank account. The amount held must be equal to the amount they issued to maintain the order of the system. In this way, price fluctuations should be prevented.

However, there are other stable decentralized cryptocurrencies, such as the cryptocurrency-backed stablecoin Dai, which can achieve this goal without a central authority figure. They use smart contracts on the Ethereum blockchain to manage collateral and maintain order. Stablecoins will automatically adjust the number of tokens in circulation to maintain price stability. This means that the value of stablecoins should (in theory) not fluctuate as frequently as ordinary crypto assets.

Why use stablecoins?

There are many reasons for the use of stablecoins in the cryptocurrency market. The main one is that cryptocurrency owners may convert profits into stablecoins in the short term, with the goal of investing in other cryptocurrencies when opportunities arise, rather than converting profits into fiat currencies and transferring them to bank accounts.

Stablecoins are also invested in cryptocurrency exchanges or decentralized finance (DEFI) applications to return interest and income. Especially investing in cryptocurrency exchanges provides a safe and attractive alternative to the traditional savings methods provided by traditional finance.

Stablecoins can enable more people to enjoy the benefits of blockchain without the risk of large market fluctuations. For example, in the case of the collapse of the local legal currency, people can easily exchange their savings with stable currencies backed by US dollars or euros or even gold, thereby preventing their savings from further depreciation.

The use of stablecoins

With the increase in the number of stablecoins, the use cases for using stablecoins are also increasing.

  • Convert between unstable cryptocurrency and stable currency

The most common use of stablecoins is to quickly switch between unstable cryptocurrencies and stablecoins during transactions to protect the value of assets held. They provide traders with a “safe harbor” that can reduce the risk of traders’ crypto assets, but they do not need to leave the cryptocurrency ecosystem.

  • Allow the use of smart contracts

Stable coins allow the use of smart financial contracts that can be executed for a long time. These are self-enforcing contracts that exist on the blockchain network and do not require the participation of any third party or central agency. These automated transactions are traceable, transparent and irreversible, making them ideal tools for wage/loan payments, rent payments and subscriptions.

  • Mainstream business

Since these stablecoins are considered to have relatively low price volatility compared with other cryptocurrencies such as Bitcoin and Ethereum , the idea of ​​the Financial Research Department of Maoqiu Technology is that stablecoins may be more widely accepted in mainstream business . Therefore, consumers, businesses and merchants will be more willing to use stablecoins as a true unit of exchange.

  • payment method

Stablecoins allow payers to get as close as possible to the benefits of cash. Stablecoins can be transferred freely just like cash; anyone on the blockchain network can receive and send stablecoins. The structure of the currency is a bearer note, which gives the holder the right to redeem the currency for U.S. dollars at any time. This is particularly important in the field of decentralized finance (DeFi), where stablecoins have played an important role in enabling the ecosystem to be realized. The mainstream applications of stablecoins are also gradually increasing in cross-border payments, and they are used to promote cross-border trade and remittances.

The risks of stablecoins

Although stablecoins may improve the efficiency of financial services, they may also pose risks to financial stability, especially if they are adopted on a large scale. Some stablecoins are actually more risky than they seem. Stablecoins may take risks in terms of asset transfer, collateral and accountability. Maoqiu Technology believes that the risks that stablecoins may bring to the financial system in terms of systemic risks should not be ignored, thereby weakening the power of sovereign currencies.

  • Not all stablecoins are stable

Although their names and their value implies that they are fairly stable, not all stablecoins are truly 100% price stable. Their value depends on their underlying assets. Stable coins will only be truly stable if they are 100% backed by cash.

The reason is that issuers of legal currency-collateralized stablecoins need to manage the supply of their currency through issuance and redemption to ensure that the value of their currency is roughly one-to-one with the legal currency. The same is true for commodity-backed stablecoins and cryptocurrency-backed stablecoins.

This commitment can only work if stablecoin issuers manage their reserves appropriately. Since the price of cryptocurrencies fluctuates drastically, stablecoins backed by cryptocurrencies are more susceptible to price instability than other collateralized stablecoins.

  • Risk of asset contagion

The rapid growth of stablecoin issuance, over time, may have an impact on the operation of the short-term credit market. Certain stablecoins are economically equivalent to money market funds. In some cases, their actions may lead to a decrease in value and cause significant losses in the broader cryptocurrency market.

There is a potential risk of asset contagion related to the liquidation of stablecoin reserve holdings. These risks are mainly based on the scale, liquidity and risk of their asset holdings, as well as the transparency and governance of operators.

Stablecoins that are fully backed by safe and highly liquid assets pose less risk.

One of the most well-known and widely traded stablecoins is Tether. Each Tether token is pegged to the US dollar 1:1. But the true value of these tokens depends on the market value of their reserves. Tether has disclosed that as of March 31, it only held 26.2% of cash, trust deposits, reverse repurchase notes and government securities reserves, and 49.6% of commercial paper (CP).

  • Collateral consequences

It is also worth noting that there are further collateral consequences, especially since the recent increase in cryptocurrency prices is largely driven by debt. One thing to note is that it is questionable whether stablecoins can be liquidated quickly to meet demand. In the larger cryptocurrency ecosystem, the consequences of this inability to cope with the sudden wave of withdrawals can be severe.

  • Lack of accountability

The disadvantage of fiat-collateralized stablecoins is that they are not transparent and cannot be audited by everyone. They operate like non-bank financial intermediaries, providing services similar to traditional commercial banks, but outside the scope of normal banking supervision.

Therefore, they may evade responsibility. In the case of fiat-backed stablecoins, traders need to blindly trust exchanges or operators to trade these currencies, or try to find and check out their financial disclosers themselves to ensure that the stablecoins are fully backed by fiat currencies, even if they do not Publish audit results.

  • Financial stability and systemic risk

Stable coins may also pose risks to financial stability. Some of the tokens linked to fiat currencies are not backed by actual fiat currencies, but are backed by risky asset portfolios. This not only puts stablecoin holders at risk, but may also threaten the entire financial stability. If a run on the stablecoin causes the price of the asset and other cryptocurrencies to collapse.

There is also the problem of systemic risk. Widely used stablecoins like Facebook’s Libra (now called Diem ) may be used in one or more jurisdictions and across regions (the so-called “global stablecoin” or GSC) and become systematic important.

Why do stablecoins need to be regulated?

The above risk issues highlight the large gaps in the regulation of stablecoins, leading to ineffective investor protection and the rise of fraudulent activities. There is currently no legal framework for regulating stablecoins, so there are no requirements for how reserves must be invested, nor are there requirements for auditing or reporting. When new products related to stablecoins entered the market, this lack of clarity in regulation also caused market chaos.

Activities related to “global stablecoins” and the risks they may bring may span banking, payment, and securities/investment regulatory systems, whether in jurisdictions or across borders. In particular, if stablecoins will become an important part of the payment and financial fields, a regulatory framework is even more needed. Therefore, Maoqiu Technology believes that it will be very important to ensure that appropriate regulatory methods are adopted across industries and borders in various jurisdictions. important.

Regulatory review of stablecoins by countries or institutions

A series of regulatory agencies, from the G7, the Federal Stability Board (FSB) to the Bank for International Settlements, have begun to issue guidelines. Most of them emphasized risks and challenges, including issues such as financial stability, consumer and investor protection, anti-money laundering, combating terrorist financing, data protection, market integrity, and monetary sovereignty, as well as competition, monetary policy, cyber security, operational flexibility, and Regulatory uncertainty and other issues.

  • G7 Summit

At the 2021 G7 Summit held in Cornwall (UK) recently, the delegations jointly concluded that they will maintain common standards through international cooperation and the standards of the Financial Standards Committee. Their conclusion is that no global stablecoin project should start operation until the relevant legal, regulatory and supervisory requirements are fully met through proper design and compliance with applicable standards.

  • Basel Committee on Banking Supervision

The Basel Committee on Banking Supervision also recently issued a consultation document on prudent handling of stable currency risks. Although the document pointed out that the current risk exposure of banks is limited, the continued growth and innovation of encrypted assets and related services, coupled with the high interest of some banks, may increase global finance without specific prudential handling. Stability issues and risks in the banking system.

  • Bank for International Settlements (BIS)

The Basel Committee of the Bank for International Settlements “hypothesized” in a recent announcement that the cryptocurrency category will be divided into products such as stablecoins and tokenized assets, and these products will be eligible for the treatment of the Basel Framework Agreement, which is Bank supervision provides standards. The proposed roadmap implies more regulation, such as stablecoins that should be subject to stricter capital reserve policies.

  • Recommendations of the Financial Stability Board

The Financial Stability Board (FSB) has agreed on 10 high-level recommendations to address the regulatory, supervisory, and supervisory challenges posed by the “global stablecoin” arrangement. These suggestions respond to the G20’s call to study the regulatory issues caused by the “global stable currency” arrangement, and make recommendations on multilateral countermeasures as appropriate, taking into account the views of emerging markets and developing economies.

The Financial Stability Board believes that the emergence of global stablecoins (GSCs) may challenge the comprehensiveness and effectiveness of existing regulations and supervision. Therefore, they put forward some principles for regulating stablecoins, including restrictions on reserves, restrictions on risks, and transparency requirements. This should promote the coordination and effective supervision, supervision and supervision of global supply chain arrangements, which should address the financial stability risks brought by the global supply chain at the domestic and international levels. These recommendations require supervision, supervision and supervision commensurate with the risk. Therefore, they support responsible innovation and provide sufficient flexibility for jurisdictions.

According to the Financial Stability Commission’s document, the final recommendations for stablecoins and feedback to the public consultation will be announced in October 2021, and the international standard setting work is scheduled to be completed in December this year.

Regulatory methods of countries or agencies

Although various international regulatory and supervisory agencies are actively working, it is still uncertain which supervision method will be chosen. How they will regulate is still uncertain. Either propose a special system for stablecoins, or directly prohibit them, or incorporate asset classes into their existing regulatory framework.

There are some regulatory methods that have begun to shape the way stablecoins are managed and more rigorously define their uses. The most advanced is the European Union, the European Commission put forward their MICA proposal, although the timetable and details of the changes in the plan are still unclear or there is a possibility of change. Of course, regulatory activities in countries such as the United States and the United Kingdom are also accelerating.

  • EU Crypto Asset Market Regulation (MICA)

Europe is currently evaluating the large number of comments received during its consultation on the proposed Crypto Asset Market Regulation (MICA) issued in September last year. MICA pays special attention to the rules governing stablecoins, especially those that are likely to become widely accepted and systematic stablecoins and crypto-asset providers such as exchanges. The purpose is to provide a comprehensive and transparent regulatory framework, establish a unified set of rules that can provide investors with protection, have transparency and governance standards, and ensure the vigorous development of the digital asset ecosystem.

Therefore, the regulation divides stablecoins into categories such as electronic currency tokens (stable currencies whose value is linked to a single legal currency) and important asset reference tokens. These tokens are designed to maintain a stable value by referring to the value of legal currency. These major asset reference tokens will be subject to strict regulatory standards in terms of transparency, operation and governance.

Unlike other cryptocurrencies, stablecoins need to be authorized by regulatory agencies before they can be traded within the EU. Authorization requirements also apply to stablecoins that are already in circulation. In addition to existing credit institutions, everyone else who wants to engage in stablecoin activities must also obtain prior permission from their national regulatory agency.

MICA regulations stipulate that stablecoin projects are legally obliged to publish white papers and submit them to their national financial regulatory agencies. The regulator has the power to prohibit issuers from releasing their planned stablecoins. Most importantly, the regulations prohibit the payment of interest to electronic currency tokens. Through the interest ban, EU legislators can be said to curb cryptocurrency profits from investing in stablecoins, thereby protecting the interests of the European banking industry.

  • Bank of England

Although compared with the European Union, the UK’s regulatory activities surrounding stablecoins are far behind, but the UK’s regulatory agencies are now accelerating the steps to regulate stablecoins. Earlier this year, the UK Treasury Department issued a general consultation and evidence collection on encrypted assets and stablecoins.

However, the UK proposal is narrower than the EU MICA proposal, reflecting the intention of adopting a “phased and proportionate approach”. In particular, the United Kingdom suggested initially only regulating “stable tokens as a means of payment”.

The recently launched Bank of England discussion paper initiated a dialogue on digital currencies, stating that stablecoins are usually backed by fiat currencies or other assets, but are issued by private companies. If they become widespread and may affect financial stability, they need to be processed by banks at present The payment method is regulated.

  • US Biden Administration

As Biden’s new administration’s activities in the United States around stablecoin regulation are also accelerating, people are increasingly optimistic that US regulators and legislators will “witness substantive progress” in 2021 to better understand this technology. And clarify the regulatory framework.

  • Stability Act

Last December, 2020, just before the end of the US Congress, a draft of the “Stablecoin and Banking License Enforcement Act” (the Stability Act) was proposed. The law will approve the use of stablecoins and cryptocurrencies as legal alternatives to other real-time payment systems. However, the bill proposes to substantially increase the supervision of stablecoins. It will restrict who can issue stablecoins, require stablecoins to be issued by banks, and set certain standards. However, it is questionable whether this form of bill will actually be approved by the US Congress.

  • U.S. Federal Reserve

The U.S. Federal Reserve has now also noticed the rise in the use of stablecoins. They announced that they would release a report later this year to begin the regulation of cryptocurrencies, especially the “major public consultation” on the regulation of stablecoins, expounding the risks and benefits associated with stablecoins and potential digital dollars.

Federal Reserve Chairman Jerome Powell said that the U.S. regulation of these digital currencies is at a “critical point” and advocates the application of stablecoins to new rules similar to those applicable to bank deposits and money market mutual funds. In this regard, the U.S. has a Very strong regulatory framework. The issuance of stablecoins should be conditional on compliance with risk restrictions to ensure that the tokens are actually worth the price.

  • President’s Working Group on Financial Markets

The President’s Financial Markets Working Group is the highest financial regulatory agency in the United States. It met in July to discuss how stablecoins should respond. This marked the first publicly announced meeting of this panel of regulators since Joe Biden took office earlier this year. The topics discussed included the rapid growth of stablecoins, the potential use of stablecoins as a means of payment, and potential risks to end users, financial systems, and national security. Of course, this discussion is obviously only just beginning.

The meeting promised that the group will issue recommendations on the regulation of stablecoins in the next few months. From this discussion, it is unclear what kind of regulatory framework we might see and which framework is most meaningful for stablecoins.

Future regulation

Stablecoins pose special challenges to regulators, requiring narrow-minded cooperation between regulators and the stablecoin industry, as well as global regulatory cooperation.

Stablecoins do not represent a unified category, but represent various cryptocurrency tools, which may be very different in terms of law, technology, function, and economy. In order to effectively limit risks and not interfere with innovation, the stablecoin industry must work with regulators to propose a framework to reassure them, while protecting this nascent industry from over-regulation.

The Venture Capital Department of Maoqiu Technology believes that another major regulatory challenge related to global stablecoins is the international coordination and supervision of different economies, jurisdictions, legal systems, and different levels of economic development and needs. Regulators around the world do not yet have a unified regulatory method for stablecoins. The call for a unified legal and regulatory framework also includes areas such as managing data use and sharing, competition policy, consumer protection, digital identity and other important policy issues.

These all help stablecoins to be more stable.

 

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/an-article-to-understand-stablecoins-meaning-classification-and-supervision/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

Like (0)
Donate Buy me a coffee Buy me a coffee
Previous 2021-09-10 08:53
Next 2021-09-10 08:55

Related articles