Stablecoins: The Balancing Act between Innovation and Regulation
Download our report
Stablecoins were first introduced in 2014, with the launch of BitUSD. Amidst its relatively young history, the market of stablecoins has expanded rapidly, growing from US$12.2 billion in July 2020 to US$109.3 billion in July 2021. As of the beginning of June 2022, the stablecoin market was equivalent to nearly US$160.0 billion. This exponential behavior of the market capitalization of stablecoins has drawn the attention of regulators, worried about the current and future impact of such cryptocurrencies on the stability of the financial system, especially if they become systemic. This attention has intensified this year due to the crash in the crypto market and the collapse of the algorithmic stablecoin Terra.
While we expect to gain greater regulatory clarity regarding stablecoins in the second half of 2022, this discussion paper presents some of the fundamental factors contributing to stablecoin risks, particularly the instability of stablecoins and the risk to financial stability as digital assets and traditional financial systems become increasingly interconnected.
Stablecoins are asset-linked digital cryptocurrencies that aim to maintain a stable value relative to a specified asset, or a pool or basket of assets. Originally developed to serve as a solution to the high volatility of cryptocurrencies, they are currently mostly used to trade digital assets and as an onramp from fiat currency to digital asset, although use cases and applications are growing in payments, internal transfers and liquidity management, and DeFi support, with additional potential growth areas in tokenized financial markets, supporting next-generation innovations like Web3 and inclusive payment and financial systems.
Stablecoins have the potential to bring tangible benefits to the economy. However, as argued in this discussion paper, contrary to what the name would suggest, stablecoins exhibit high volatility and are too unstable under the current institutional arrangement to fulfill the role for which they were designed, at least in the present. A growing body of academic research has documented in recent years both the high volatility and high correlation of stablecoins with other crypto currencies, particularly Bitcoin. This high correlation is precisely the root of the contagion that was observed last May, following the collapse of Terra stablecoin.
On that note, not all stablecoins are made equal and the precise mechanism used to stabilize stablecoins (i.e. to maintain the peg) is an important source of stablecoins’ instability and can explain variations in exhibited volatility and perceived and actual risks of various stablecoins. Yet, amidst these distinctions, the continued growing correlation between crypto and traditional markets could lead to a global financial stability and payment system crisis should stablecoins become adopted at a larger scale and with deeper ties with the traditional financial markets.
Notice that this does not mean that the future of the stablecoins is doomed, but that the current course is not going to allow this token to exhibit its full potential. Historically, regulation of financial markets has precisely allowed us to manage market failures. While the regulation of a new market is not free of controversy and possibly trade-offs, and in this case over-regulation would stifle innovation and competition, if well-balanced, regulation of stablecoins could help reduce and manage the current risks while enabling further growth, development and adoption of use cases beyond what is currently primarily being reduced to facilitating crypto trading.
Current proposals and recommendations mostly try to accommodate existing regulatory frameworks that aim to reduce risks that are known (similar) to the financial sector. This “same risks, same rules” approach has the advantage of allowing for gradual regulation of the sector, while still allowing for innovative regulation. An example is the proposition from economists Christian Catalini and Nihar Shah, that showed that applying the Basel framework to stablecoins, hedging against credit risk, market risk and operational risk is possible by setting capital requirements from stablecoins issues.
In the end, any regulatory framework should strike a balance between risk reduction and competition, innovation, pragmatism, and technological novelty. To adequately understand and manage those risks, and for regulation to effectively enable the growth and full potential of stablecoins, regulators ought to continue to engage with the private sector and provide an environment conducive to collaboration. And while the answer is certainly not to simply ban or restrict the issuance of stablecoins, a mix of new and old approaches to regulation, if deployed strategically, will likely allow for a gradual yet more rapid path to regulating stablecoins, and harness their full potential.
Download our report
Get in touch with the authors
Our team is made up of dedicated, and experiences executives and consultants, representing the right mix between seasoned entrepreneurship
and professional consulting skills.