One of the main features of the cryptocurrency market is how unpredictable it is. The value of cryptocurrencies can rise and fall sharply, depending on how investors feel about them or the social media hype around them at the time.

The demand for cryptocurrencies has been driven by the fear of missing out (FOMO), greed (as investors have looked for the next big thing which will be like bitcoin or XRP (XRP increased by 38,000% in a year)), by price dislocations arising due to off-market “whale” (large block) trades or social media-driven hype, or even by manipulative activity. 

Investing is not easy, especially when you have to choose a winner from over 23,000 different cryptos. Traders and investors have to either wait for a long time until their coins (re)gain value, or sell them for fiat money as soon as they start losing value (and sell them faster than others, including those who may have shorted the cryptocurrency in question as they themselves drove the price up). 

Due to the volatility of cryptocurrencies, there was a need for a safer asset that could still be stored in a digital wallet without having to change it back to fiat money – and pay the fees for doing so. This led to the creation of a new type of cryptocurrency that would avoid sudden price changes – the stablecoin.

The name stablecoin suggests the main feature of this coin – price stability. However, some might say that these cryptocurrencies should have been called “pegged coins” because they depend on other assets such as $, £, €, CHF, or even gold or silver.

The rise of stablecoins

As highlighted in a previous article, stablecoins are a type of digital currency that act as a bridge between cryptocurrency and fiat money, tying their value to an asset like the US dollar or gold. This makes them much more stable than traditional cryptocurrencies.

Stablecoins are designed to be suitable for regular use in daily transactions, especially for cross-border payments that can be done very quickly and cheaply. Stablecoins still operate on distributed ledgers (blockchains) that track and confirm payments without needing centralized entities like banks, clearing houses or exchanges like other cryptocurrencies.

And Stablecoins are designed to be less volatile than “unpegged” cryptocurrencies that are about ten times more unstable than major national currencies. The biggest remaining (non-central bank-backed) stablecoin is tether, launched in 2014, which has a daily volume of $20-$40 billion.

Fiat money

Central banks and other regulators keep the prices of government-issued fiat money relatively stable. Stablecoins use reserves, like fiat money (the US dollar is popular as it benefits from the stability provided by the US Federal Reserve and the US high credit rating) and commodities or other physical assets, such as gold. 

There are a variety of different types of stablecoins:

Algorithm-backed stablecoin

These stablecoins are the most complex because they use smart contracts and algorithms to keep their prices stable. Algorithmic stablecoins can be linked to any fiat money, such as the euro, US dollar, or a physical asset, such as gold. The algorithm removes tokens from the market (burns coins) if the price of the asset/fiat money to which it is pegged rises, so there are fewer tokens for the same asset, which should make the price go up.

Likewise, the algorithm makes more coins (mint coins) to stop prices from going above the target value of the asset to which the algorithmic coins are pegged.

There have been a number of instances where algorithmically-pegged stablecoins have become completely unpegged, losing almost all of their value and never recovering.

Currency or commodity-backed stablecoin

These stablecoins are designed to be issued where backed one-to-one by the underlying currency or commodity. Theoretically, if the protocol holds $100, it will issue 100 coins. Stablecoin reserves are turned into money by putting some of the underlying funds into fixed-income assets, ensuring the funds can be redeemed and supported. Some of these assets are short-term corporate debt and debt obligations backed by the government.

Stablecoins use different methods and tools to stay stable, such as holding fiat money, cryptocurrencies, commodities and algorithmic trading. When investors want their money back, makers destroy their coins (burn) and send fiat money back to the investor. Since these stablecoins are usually based on the US dollar (one coin equals $1), the issuer’s account must have enough money to match the coin supply.

Cryptocurrency-backed stablecoin

Stablecoins backed by cryptocurrencies use a mix of cryptocurrencies as their reserve and their value depends on the value of the stablecoin. These stablecoins are made/printed by, and, in a way, supported by a group of cryptocurrencies and usually have more collateral than needed to deal with volatility. 

Fiat-backed stablecoin 

Stablecoins backed by fiat money have drawn the most capital with stablecoins such as tether, USDC and binance USD being the biggest. The makers of stablecoins make their coins (mint) and show that they have enough money to back each coin with enough assets to keep the coin’s value against the fiat money it is tied to (usually US dollars). Of course, to be trusted and for their coin to be reliable, stablecoin issuers must be clear about how much money they have.

Commodity-backed stablecoin 

These stablecoins use commodities such ase gold, platinum, palladium or silver as their reserve, giving them value and stability. Some of these commodity stablecoins are PAX Gold (PAXG) and Silver Token (SLVT).

Stability and caution 

Stablecoins are vital for the cryptocurrency ecosystem because they offer stability and value that other cryptocurrencies lack. They maintain a steady value by using different methods such as algorithms, collateralization and decentralised governance. This makes them suitable for regular transactions, money transfers and storing value.

However, the stability mechanisms are not perfect and may be exposed to risks and changes in the external market. Stablecoins contrast with the volatility of regular cryptocurrencies, linking their value to real-world assets like fiat or commodities. Their stability makes them a useful tool for transactions, but their dependence on various mechanisms such as fiat backing, crypto reserves or algorithmic models, requires caution.

These different stablecoin types provide stability in a volatile crypto environment but are not safe from market changes, so users are advised to be prudent. Stablecoins challenge the volatility of cryptocurrencies, building a connection between digital assets and stability. And they introduce a new asset and the possibility of new kinds of digital payments that could radically change banking as we know it.

The future

Many governments around the globe are investigating launching – or have already launched – central bank-backed cryptocurrencies. Whether the UK follows suit is still to be determined.

In the UK, the movement on stablecoins (and cryptocurrencies in general) has been to bring them within the regulatory perimeter pursuant to the Financial Services and Markets Act 2023. This may mean that some activity in relation to cryptocurrencies is subject to the dual jurisdiction of the PRA and the FCA and to a special wind-down/administration regime (similar to that to which banks are subject), where the cryptocurrency is deemed systemically important in the UK. 

The new regime directly affects issuers, system operators responsible for the managing of on- and off-chain activities including updates, infrastructure, burning and minting tokens, and service providers, such as exchanges and those providing wallet services, custodial services and management of private keys.

There are key differences in the UK’s approach as compared to the EU’s (under the Markets in Crypto Assets Regulation (MiCA)) including that: unlike MiCA, the UK is taking a phased approach to the new regulations; there is no proposal to impose a reserve requirement on asset-referenced tokens_^[1]; non-fungible tokens (NFTs), which are out of scope of MiCA, are intended to be in scope of additional regulatory updates; authorized firms will not receive automatic authority to conduct cryptoasset activities; and UK regulations will require authorization for lending activities.

We are generally supportive of regulations and rules (properly, impartially and consistently interpreted and applied, of course) and in this case, we see material benefits of the UK’s approach (and to MiCA) in reducing the notes of caution listed above.

[1] In theory, at least – the wind-down plans which will be required will, de facto, impose a capital requirement on asset-backed tokens.