Earlier this month, renowned global payment giant, PayPal announced that it would be launching its own cryptocurrency, PayPalDollar (PYUSD), as a stablecoin to help promote efficient payments.
Since then, more and more analysts as well as crypto exchanges have shared their opinions, with popular exchange, Kraken even listing the coin on its exchange.
News such as this serve to highlight the massive evolution happening to the global financial space where innovative solutions are beginning to both challenge and replace traditional norms.
At the core of this transformation has emerged the concept of stablecoins.
Defined by their resilience against the volatility that often characterizes cryptocurrencies, stablecoins offer a bridge between the dynamic world of digital finance and the stability sought by traditional financial systems and their fiat currencies.
Stablecoins are a type of cryptocurrency designed to maintain a stable price over time.
Their ability to be stable lies in the fact that they are pegged to the value of an underlying asset, like the U.S. dollar or gold, ensuring a consistent value that aligns more closely with traditional financial stability.
As such, they can help people from high-inflation economies to store the value of their savings in an asset pegged to a more stable currency, like the U.S. dollar.
This stability also endows stablecoins with a range of practical applications, making them a fundamental building block in the ongoing evolution of digital currencies.
A Short Story
The year was 2009. In what would turn out to be a revolutionary shift in the world of finance, the enigmatic Satoshi Nakamoto introduced the concept of Bitcoin in a whitepaper.
Although his real identity is still unknown to the world, the digital currency he introduced has gained widespread attention for its decentralized nature and potential to disrupt traditional monetary systems.
Following Bitcoin’s success, Ethereum emerged in 2015, introducing the concept of smart contracts and paving the way for a new wave of blockchain-based applications.
Despite their groundbreaking potential, early cryptocurrencies faced a significant hurdle: extreme price volatility.
The value of cryptocurrencies like Bitcoin could soar to astronomical heights, only to plummet just as rapidly.
For example, CNBC has reported that the cryptocurrency market dropped by nearly $1.4 trillion in 2022 and has been volatile in 2023.
Also, according to Statista, Bitcoin’s annualized volatility rate was 81 percent, while investors could expect on average a 4 percent change on a daily basis.
Ethereum came the closest to Bitcoin’s performance, with 107 percent annualized and 6 percent average daily volatility rates.
This inherent volatility hindered their widespread adoption as a reliable means of exchange or store of value.
Recognizing the need for stability in the cryptocurrency realm, stablecoins entered the scene as a pragmatic solution.
By anchoring their value to established assets like fiat currencies, stablecoins are a dependable digital alternative for transactions and investments.
Moreover, stablecoins present a harmonious fusion of stability and innovation that should resonate with both individuals and businesses alike.
Types of Stablecoins
As stablecoins gain prominence, they manifest in various forms that reflect their underlying mechanisms and assets.
1. Fiat-Backed Stablecoins
Fiat-backed stablecoins derive their stability from real-world assets, most commonly traditional currencies like the US Dollar, Euro, or other major currencies.
These coins are the most common type of stablecoin and are usually backed on a one-to-one basis, meaning that for every stablecoin issued, there is an equivalent amount of the backing asset held in reserve.
One major why this type of stablecoin is quite common is because the backing assets are established currencies, granting users a sense of familiarity and trust.
However, challenges might arise due to the need for centralized custody of the underlying assets and potential regulatory scrutiny.
Examples of fiat-backed stablecoins include Tether (USDT), USD Coin (USDC), and Binance USD (BUSD).
2. Crypto-Backed Stablecoins
These stablecoins take a unique approach by using other cryptocurrencies as collateral. They are backed by a reserve of diverse cryptocurrencies, often with a value that exceeds the stablecoin’s issuance.
This approach maintains stability through diversification. To help maintain their stability, smart contracts are developed to automatically adjust collateral ratios based on market conditions.
This introduces an element of decentralization and automation into the stability mechanism, but it also means that these stablecoins do not use a 1:1 peg. Some examples include MakerDAO’s DAI (DAI) and, Wrapped Bitcoin (WBTC).
3. Algorithmic Stablecoins
Unlike the previous types of stablecoins aforementioned, algorithmic stablecoins are not backed by any asset but instead rely on complex algorithms to maintain their price stability.
They do this by controlling their supply based on demand, adjusting the number of coins in circulation to match changes in demand.
If demand increases, the algorithm mints new coins, and if demand decreases, coins are burned to reduce supply.
While innovative, this approach is often influenced by external factors and market sentiment. Examples of algorithmic stablecoins include Empty Set Dollar (ESD) and Frax (FRAX)
Use Cases and Benefits
As can already be seen, stablecoins extend their impact across a spectrum of practical applications, revolutionizing the way transactions are conducted, assets are exchanged, and financial systems are structured. Here are some benefits they bring:
1. Cross-Border Transactions
Cross-border transactions have long been plagued by high fees, lengthy processing times, and currency conversion hassles.
In Nigeria, these issues are particularly pronounced due to the country’s high inflation rate and the instability of the Nigerian naira.
This is shown in a recent report which reveals that the average cost of sending remittances to Nigeria is 8.9%, a value that is higher than the global average of 6.8%.
Although remittances to Nigeria currently account for around 38% of total remittance inflows to Sub-Saharan Africa, a World Bank report also mentions that the average cost of sending $200 across international borders to Africa is at 8%.
This is quite alarming if you consider that the Sustainable Development Goal target is 3% by 2030. Stablecoins, however, introduce a groundbreaking solution by enabling seamless and near-instant cross-border transfers at a fraction of the cost associated with traditional methods.
These efficiency gains and cost savings are possible because of the decentralized nature of the technology backing these stablecoins.
2. Digital Payments and Everyday Transactions
Digital payments and everyday transactions are an important aspect of any economy, and stablecoins offer a promising solution to some of the challenges faced by traditional payment methods.
Truth be told, there is virtually no society where everyday transactions are swift, secure, and devoid of intermediaries. However, with stablecoins, this can be turned into a reality as these coins offer a reliable medium of exchange that transcends the constraints of traditional currency forms.
From purchasing goods and services to facilitating peer-to-peer transactions, they redefine the way value is exchanged digitally.
They provide faster settlement times, lower transaction fees, and increased accessibility, especially for individuals without access to traditional banking services.
Stablecoins also offer a more secure and transparent payment system, as transactions are recorded on a blockchain ledger that is immutable and tamper-proof.
Whether it’s micropayments, online purchases, or remittances, stablecoins offer a frictionless and cost-effective alternative to traditional payment avenues.
3. Challenges and Risks
While stablecoins hold the promise of revolutionizing various aspects of the financial landscape, they also bring forth a set of challenges and potential risks that demand careful consideration.
4. Regulatory Considerations
The intersection of stablecoins with existing regulatory frameworks poses a significant challenge.
As stablecoins gain prominence, regulators around the world grapple with defining their legal status, potential classification as securities, and implications for consumer protection.
The Bank for International Settlements has identified regulatory and supervisory issues, particularly around market integrity, anti-money laundering, and combating the financing of terrorism.
In Nigeria, the Securities and Exchange Commission (SEC) has also issued warnings to investors about the risks associated with cryptocurrencies and has proposed a regulatory framework for digital assets.
This lack of regulation can create risks for investors and users, including market manipulation, fraud, and money laundering.
5. Centralization vs. Decentralization
A delicate balance between centralization and decentralization lies at the heart of stablecoins. Some stablecoins operate with centralized control, relying on trusted entities to manage reserves and maintain stability.
Others champion decentralization, using smart contracts and algorithms to regulate value without human intervention.
As such, there is an ongoing debate over whether the concentration of power in the hands of a few large players would end up resurrecting the problem of centralization and undermining the principles of decentralization.
As stablecoins continue to gain traction, there is no denying that they will challenge the established norms of traditional financial systems. This disruption could impact central banks’ monetary policies, currency circulation, and the broader stability of financial markets.
Hence, it is imperative that we approach stablecoin adoption with a comprehensive understanding of the potential consequences.
Addressing these concerns proactively is essential to ensuring that stablecoins can fulfill their transformative potential while upholding the principles of transparency, regulatory compliance, and sustainable financial innovation.
The future of stablecoins is dynamic and promising, with the potential for continued innovation and growth in the financial industry.
These digital currencies are poised to play a vital role in facilitating financial activities, particularly in cross-border payments and financial inclusion.
As the world becomes increasingly digital and decentralized, they would no doubt grow in popularity and adoption, offering a bridge between traditional and digital finance.