Stablecoins in Cryptoeconomics: From Initial Coin Issuance to Central Bank Legal Digital Currency

Oct 23, 2021 By Aynsley Moore

What is a stablecoin?

1. Main features of stablecoins

Stablecoins are cryptocurrencies that maintain a stable value relative to the target price (usually USD). Theyusually combine liquid collateral (such as gold and USD) or algorithmic stability mechanisms with supply management, incentivizing the market to trade the currency at a price of no more than 1 U.S. dollar.

There are three main characteristics that distinguish virtual currency from the traditional financial industry. First, virtual currency uses blockchain, which makes peer-to-peer transactions easier. Second, it is not issued by a central bank or a licensed financial institution. Third, it is priced in new account units rather than legal tender units. And these are also the features of stablecoins.

In addition, the mechanism of stablecoins can minimize exchange rate fluctuations, which is not possessedbyother cryptocurrencies, making stablecoins a “price-stable cryptocurrency.” At the same time, stablecoins have the main characteristics of cryptocurrencies such as programmability, efficiency, and fungibility.

2. Different types of stablecoins

There are three main types of stablecoins on the market, each of which uses a different model to stabilize its value.

The first type backed by legal currency assets depends on legal currency as collateral, so it cannot be completely decentralized, which can also be called an off-chain collateralized stablecoin.

The second is the on-chain collateralized stablecoin, which is usually collateralized by digital assets of one or a basket of cryptocurrencies. This type is completely decentralized because the decentralized system cannot use mortgage assets outside the blockchain. In principle, the on-chain collateralized stablecoin helps to increase the transparency of issuance and transactions.

The third one is non-collateralized stablecoins, which use algorithmic tools to maintain stability. As Robert Sams explained in a seminal paper, Bitcoin-like cryptocurrencies “manage the money supply through simple and definite money supply rules.” For this reason, any change in the demand for such stablecoins may affect the price, which will result in significant price fluctuations and limit the utility of stablecoins as a medium of exchange.

In addition to the three main categories mentioned above, there are another two types of stablecoins: hybrid stablecoins and alternative stablecoins. Hybrid stablecoins combine off-chain and on-chain stability mechanisms, such as the financial reserve. An example of an alternate stable currency is “Terra”, a cryptocurrency whose price is pegged to the basket of currencies.

3. The role of stablecoins in cryptoeconomics

In theory, stablecoins should facilitate the basic purpose of cryptocurrency serving currency, which is to act as a store of value, a medium of exchange, and a unit of account at the same time.

Although stablecoins function as a store of value and a medium of exchange, the continuous increase in the value of stablecoins and the astonishing growth and decline of other alternative currencies motivate people to hold these assets for speculative purposes. In the context of such volatility, people have an incentive to maintain their expectations of the value of cryptocurrencies instead of choosing to circulate them.

As a supplement to the medium of exchange, stablecoins can also be used as accounting units. In the short term, the stable currency account can be linked to the national account as a digital account unit, while in the long run, it can become an independent account unit.

Concerns about liquidity have led venture capitalists to invest in stablecoin, which may help them because it doesn’t have to keep multiple utility token wallets. Venture capitalists can put most of their money in stablecoins and then exchange them for the desired tokens.

As a supplement to traditional banking services, stablecoins play an important role in strengthening the payment system. In fact, the European Banking Authority (EBA) classifies it into the category of “payment/exchange/currency tokens”, distinguishing it from “investment tokens” and “utility tokens” because it notices that the International Organization for Standards lacks a common classification method.

Finally, the value of stablecoins can be further realized where stability is needed. For smart contracts, stablecoins are a better choice than cryptocurrencies with greater volatility. One of the most important and profitable areas will be smart insurance, which has attracted the interest of large companies such as AXA.

Key considerations about the stablecoin economy

1. Collateral and issues related to each type of stable currency

The label of “stable currency” indicates that it is a stable cryptocurrency. So far, some “stability” experiments on stablecoins have failed. On the contrary, due to increased speculation opportunities, the volatility of stablecoins may further intensify.

To answer the question of whether stablecoins can improve stability, we should start by analyzing the vulnerability of each type of stablecoins. The term “stable currency” covers a series of cryptocurrencies, and their features are not exactly the same, including the most important one-the use of collateral. After the 2008 financial crisis, in order to resolve systemic risks and reduce conduction risks, regulators required the addition of high-quality collateral to enhance financial stability.

In principle, stablecoins backed by off-chain legal assets are the most reliable, because they use real high-quality assets as a guarantee. However, a structural contradiction to stability outside the chain is the existence of centralized power to issue tokens, which is not easy to resolve, and stablecoins are no exception.

If the legal asset-backed stablecoin plummets, users will face risks from specific counterparties and third parties. In this case, the risk from the counterparty involves the goodwill of the central manager of the trust capital, while the third-party risk depends on external participants.

For stablecoins backed by digital assets, the guaranteeing digital assets may have major problems. Digital asset-backed stablecoins are usually secured by other cryptocurrencies or the basket of cryptocurrencies. Under this situation, the main risk is brought about by the fluctuation of the collateral.

Non-collateralized stablecoins (based on algorithms) can be fragile because they depend on the platform’s growing expectations, which may not be particularly reliable.

2. The financial relationship between stablecoins and other cryptocurrencies

Blockchain has systematic characteristics. Therefore, the market value of cryptocurrencies is always consistent. In this context, stablecoins that are linked to fiat currencies and may benefit from the existence of collateral may break the interconnection between cryptocurrencies, especially the dependence on Bitcoin.

In addition to the financial impact, the interconnection between cryptocurrencies (including stablecoins) and Bitcoins also has an impact on transparency. The role of Tether in the Bitcoin bubble in 2017 is a good example.

When a stable currency was decided to launch, the issuer and the cryptocurrency exchange may have a significant conflict of interest, because the exchange may gain advantages and profits from the conversion of fiat currency and cryptocurrency. It also explains why cryptocurrency exchanges are increasingly launching stablecoins on their own platforms.

This situation has raised questions about the opportunity for cryptocurrency exchanges to “own” a stablecoin and list it, which has forced regulators to act accordingly. These actions should be conducive toreducing conflicts of interest, while strengthening the basic function of exchange and protecting the collateral of stablecoins, helping to maintain market integrity and strengthen investor protection in the context of cryptoeconomics.

3. Eligibility for stablecoins under European and American securities laws

Cryptocurrency and ICO (Initial Coin Offering) have attracted the attention of securities regulators in the United States and Europe. Regardless of their names and roles in the market, they may still become deposits, electronic money, securities or commodities, which will trigger new regulatory uncertainties.

In the United States, the regulatory uncertainty inthe classification of ICOs and cryptocurrencies between 2017 and 2018 may reappear with stablecoins. Consistent with the situation with ICOs, the U.S. Securities and Exchange Commission (SEC) may treat stablecoins as “securities” rather than “cryptocurrencies.” Therefore, the SEC may try to extend the securities law framework to this type of cryptoassets.

With stablecoins, different stability mechanisms and various types of collateral are unlikely to result in the classification of stablecoins as different “marketable securities.” After detailed analysis, stablecoins secured by fiat currencies or commodities and those by cryptocurrencies may both meet the criteria for becoming securities.

Another way that stablecoins may be applicable to the Securities Law is to define them as one of the “demandbills.” In most cases, the purchaser deposits fiat currency into an issuing unit, which provides stablecoins with the equivalent amount. When the holders want to liquidate positions, they will return the stablecoins to the issuer, and the issuer will provide the equivalent legal currency.

Another set of related laws is the U. S. Commodity Exchange Act (CEA). The U.S. Commodity Futures Trading Commission (CFTC) can also play a role in stabilizing exchange rates. Stablecoins may be classified as “commodities” or “swaps.” Similar to “securities”, the definition of “commodity” is also broad and covers a wide range of products: physical commodities, all services, rights or benefits. In addition, stablecoins can be described as “swaps”. In this case, the CFTC may choose to describe stablecoins as “options to purchase fiat currency, or options based on the value of fiat currency.”

With the large-scale implementation of stablecoins, the interpretation of CFTC and CEA will undoubtedly play a vital role. The function of CFTC and CEA in stablecoin supervision may be more important than that of the SEC, which may be as important as the role of the SEC and the Securities Law in the ICOs.

The consideration of stablecoins in European commodity law and securities law may lead to the same conclusion. At the end of 2017, the European Securities Markets Authority (ESMA) issued a warning that companies involved in ICOs need to meet relevant regulatory requirements.In the documents mentioned in the warning, two general concepts are considered: “transferable securities” and “financial products”, the definitions of which are provided in the document. It means that stablecoins may be recognized as financial products under European law-which will lead to the application of consumer protection regulations to stablecoin owners. At the same time, member states can provide specific types of laws to apply to specific obligations under different legal systems.

In addition, EBA and ESMA call for the establishment of a common regulatory framework for cryptocurrencies. Although ESMA did not mention stablecoins in its documents, EBA, after noticing the lack of a unified classification used by theInternational Standard Organization, classified it into the category of payment/exchange/currency token, which is different from “investment tokens” and “utility tokens”.

4. Impact of stablecoins on the central bank--taking the central bank digital currency as an example

In addition to causing concerns from securities regulators, cryptocurrencies have also attracted the attention of central bank officials. The rapid spread and development of stablecoins will further intensify its competition with the official currency issued by the central bank. These acts of private issuance have undoubtedly triggered heated public discussions, and governments and central banks of various countries are eager to find countermeasures.

Central Bank Digital Currency (CBDC) is one of them, which means the issuance of an official and public “stable” cryptocurrency, fully backed by central bank reserves. In fact, the role of CBDC in the economy is not significantly different from that of stablecoins. Since CDBC and stablecoins have similarities, it is unlikely that cryptocurrencies coexist, especially stablecoins and CBDCs. CBDC will bridge the existing gap between the real and the digital economy, as well as between the legal and digital currency. It is also the main purpose of the creation of stablecoins.

Although the central bank’s electronic money has significant advantages, a central bank may lack incentives to conduct issuance. Because of the high reputation risk of the anonymity mechanism behind the cryptocurrency and the relatively new blockchain technology, unpredictable operational risks are also worrying.

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