Will stablecoin revitalise cryptocurrencies?

Lokeshwarri SK | Updated on October 23, 2019

Linked to a collateral asset, it is more stable than earlier cryptos. But the risk of it being used for nefarious activities remains

That human ingenuity knows no bounds is effectively reflected in the manner in which the cryptocurrency ecosystem is evolving. Even as the supporters of bitcoin and other cryptocurrencies dwindled and regulators patted themselves on the back for handling the challenge reasonably well, the next version of digital currencies is already gaining ground.

The new-generation cryptocurrency — stablecoin — is being viewed by geekdom as the answer to the issues plaguing the first version. There was a lot of excitement, about five years ago, when digital currencies began gaining traction. They were then viewed as an alternative to existing fiat currencies; an innovative payment system, devised, maintained and utilised by the public.

But unfortunately, it is now proven beyond doubt that the first generation cryptocurrencies are unsuitable to serve as a medium of exchange or store of value due to erratic price movement caused by absence of intrinsic value. Also, excessive misuse of this payment system for nefarious activities has made it easy for central banks including the RBI to clamp down on them.

The stablecoin tries to address part of the issue in the earlier cryptocurrencies — price volatility and lack of fundamental worth. But stablecoins, especially those with global footprint, are also vulnerable to misuse, unless the regulation is made watertight.

The innovation in cryptocurrencies is unlikely to stop with stablecoins, and soon, a more refined version could be launched. Indian regulators should try to keep pace with the developments in this space, instead of turning away, as they are doing now.

What are stablecoins?

Stablecoins are digital currencies that are transacted on distributed ledgers called blockchains. They have to be stored in wallets by users and can be traded on special exchanges, similar to bitcoin and other existing digital currencies. But the similarity ends there.

In order to prevent price volatility, stablecoins need to be linked to an underlying asset, so that the nominal value of the holding is protected. The underlying asset could be fiat currency, commodity or even other cryptocurrencies.

Many stablecoins such as Tether, USD Coin, True USD, Stably, Paxos Standard and Gemini Dollar have the US dollar as their underlying asset. There are others with cryptocurrencies as collaterals such as Bitshares, MakeDAO, Sweetbridge, Havven and Augmint. Metal-backed stablecoins include Digix Global and Hello Gold.

Since the linking to the collateral has to be done at the creation stage, the stablecoin units are made through stablecoin mints that issues new units, collect funds from users and manage redemptions.

Most stablecoins available currently are benchmarked to the US dollar and the value tries to hug the $1 mark closely. The buyers of most these coins are promised 1:1 payment in the underlying asset.

Will it do the trick?

It was the excessive volatility in the price of bitcoin and other cryptocurrencies that was largely responsible for the loss of credibility. Value of one bitcoin was $990 in January 2017 and it was $16,340 by December 2017, only to fall to $3,900 by December 2018. Such sharp movements made it unsuitable as a medium of exchange as it would be next to impossible to budget for expenses or project revenue based on a currency that can move over 15 times in a year. Such sharp movement was largely due to lack of underlying asset to anchor the price.

Stablecoins try to address this issue well by linking the crypto-assets with underlying assets. While the intention is good, the implementation is the key. The crux of the problem is that stablecoins are issued by private players and not by global central banks. Many stablecoin issuers have agreed to independent audit of reserves at regular intervals. But if the company defaults and is unable to exchange the stablecoins with the promised underlying asset, there is no recourse.

Some stablecoins, especially those pegged to the US dollar, intend to closely hug the $1 mark. This will remove the attractiveness of cryptocurrencies as a hedge against inflation, since they will also lose their value if the dollar is further debased due to inflation or central bank policies. Maintaining the value of the cryptocurrency at $1 level requires real-time management of the supply of the coins, which is a very complicated process.

The most important regulatory risk arises in the case of global stablecoins that are intended for cross-border transactions. Since these are unregulated by any government or central bank, the risk of money laundering and other criminal activities through these currencies arises once again.

Why regulators are worried

It is therefore not surprising that regulators are not too pleased with the latest version of cryptocurrencies. In the July 2019 meeting, the G7 finance ministers and central bank governors had stated that stablecoins which are intended for global cross-border transactions raise ‘serious regulatory and systemic concerns’.

The IMF has also been flagging the concerns existing in this version of crypto assets. With intense opposition from SEC and other global central banks to the cryptocurrency Libra, Facebook is trying to launch a revamped Libra, as a stablecoin, linked just to the US dollar.

Going forward, stablecoins could become more acceptable if they agree to central bank oversight with respect to the rules for maintaining the reserves and end-use. The design of stablecoin is certainly an improvement on the first generation crypto assets, but governments can be comfortable with them only if they are assured that misuse by miscreants is impossible.

The IMF has suggested that digital currencies issued by global central banks with the backing of the government’s forex reserves could be the way forward.

The Reserve Bank of India put an end to crypto currency trading and transaction in India by asking banks and other financial institutions not to facilitate transactions involving these assets in 2018. Further, the draft ‘Banning of Cryptocurrency and Regulation of Official Digital Currency Bill, 2019’, proposes a prison sentence for persons who “mine, generate, hold, sell, transfer, dispose, issue or deal in cryptocurrencies.”

Looking at the manner in which the cryptocurrencies are progressing, with stablecoins replacing bitcoin et al, and probably a more refined version of crypto-assets to be introduced next, the RBI and the Indian government should avoid taking such an obstinate and short-sighted stance towards cryptocurrencies as this could result in India losing the race in moving towards a cashless economy.

Published on October 23, 2019

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