Markets
In volatile cryptocurrency markets, can stablecoins live up to the promise implicit in their name?
The cryptocurrency market has long been characterized by extreme volatility, as demonstrated again recently by the significant price fluctuations of Bitcoin. While this volatility has been a persistent feature since the inception of Bitcoin, the recent massive price movements are a stark reminder of the volatility and risks associated with all unsupported cryptocurrencies.
Stablecoins were first introduced in 2014 in response to this inherent instability in the cryptocurrency market. Developed as a trading pair for cryptocurrencies like Bitcoin, the primary goal of stablecoins was to address price fluctuations, which some believed made cryptocurrencies less suitable for day-to-day transactions and less viable as a store of value.
Stablecoins aim to solve this perceived problem by offering the benefits of digital currencies, such as fast, borderless transactions, while maintaining a constant value, usually pegged to a fiat currency such as the U.S. dollar.
By the end of 2023, the stablecoin market had grown to a substantial size, albeit with some significant ups and downs along the way. Today, the total stablecoin market cap stands at around $120 billion, well below its peak of over $180 billion in 2022. This decline can be attributed to a combination of shifting investor sentiment, challenging cryptocurrency market conditions, and attractive returns offered by traditional equity and income markets.
However, despite the decline, stablecoins still represent a significant portion of the overall cryptocurrency base, accounting for approximately 6.5 percent of the total cryptocurrency market cap. Tether (USDT), the largest stablecoin, accounts for over $80 billion of this total, followed by USD Coin (USDC) at approximately $26 billion. While these figures pale in comparison to the market caps of Bitcoin and Ethereum, they are still significant indicators of the importance of stablecoins in the cryptocurrency ecosystem.
Stablecoins aim to offer a more stable digital currency option than traditional cryptocurrencies, employing various mechanisms tailored to each type. The three main types are fiat-backed stablecoins, crypto-backed stablecoins, and algorithmic stablecoins.
While it is often assumed that fiat-backed stablecoins are entirely backed by traditional fiat currencies, they are actually backed by reserves that consist largely of U.S. Treasuries and short-term debt. This introduces specific risks such as interest rate risk, where changes in interest rates can affect the value of these securities, and liquidity risk, which can be problematic if there is a need to quickly convert these securities into cash.
Stablecoins with cryptocurrency collateral leverage other cryptocurrencies as collateral, introducing a different set of risks related to the volatility of cryptocurrency markets. And algorithmic stablecoins use smart contracts to adjust supply based on demand. This can lead to vulnerabilities in the underlying algorithm, while unexpected large-scale economic changes could also destabilize the coin’s value. While each type of stablecoin has its strengths and weaknesses, they all share the common goal of providing a more stable alternative to traditional cryptocurrencies.
Initially, the stablecoin market saw significant growth as investors and traders sought refuge from cryptocurrency volatility. However, this growth was not without its challenges.
The collapse of Terra, an algorithmic stablecoin, sent shockwaves through the cryptocurrency world in May 2022. Despite not being a true stablecoin in the traditional sense, Terra’s failure severely dented confidence in the broader stablecoin market, leading to a period of decline and increased scrutiny.
Terra’s collapse was a reminder that the reality of stablecoins is more complex than their name suggests. While they have proven useful as a means of facilitating cryptocurrency trading and cross-border payments, they face several challenges as a widespread payment method. Issues such as scalability, transaction speed, and costs still need to be addressed for stablecoins to compete with traditional payment systems.
The risk of de-pegging, where the value of a stablecoin diverges from the currency or other asset to which it is linked, has also been a concern, as evidenced by the fluctuations that still occur even in the largest stablecoins. To address this issue, stablecoins such as Terra and FDUSD have implemented specific mechanisms to manage and report their collateral more effectively.
Terra uses a dual-token system, balancing TerraUSD with LUNA to absorb volatility and maintain stability through automatic supply adjustments. FDUSD maintains reserves at a specific threshold, using real-time monitoring and transparent reporting. These strategies aim to mitigate de-pegging risks and improve the stability and reliability of stablecoins.
Photo credit: Binance
Despite this risk of de-pegging, stablecoins offer a number of advantages, particularly in developing economies. In Africa, for example, they have attracted particular interest due to the continent’s unique and challenging financial landscape. With a large unbanked population and currency instability issues in many countries, stablecoins offer the potential to address the need for financial inclusion and can serve as a useful hedge against inflation.
Countries such as Nigeria, Kenya, and South Africa are leading the way in adopting stablecoins in Africa, driven by factors such as the need for remittances, limited access to formal financial services, and the growing popularity of cryptocurrencies.
As the stablecoin market continues to evolve globally, there is growing recognition of the need for clearer regulatory frameworks. Regulatory ambiguity remains a significant obstacle to investor confidence and broader adoption. Debates continue in the United States and other major economies over how to classify and supervise stablecoins. Resolving these challenges will be critical to the long-term viability and growth of the stablecoin market.
In Africa, regulatory responses vary across the continent, with some countries taking a more cautious approach while others are more open to innovation. Kenya is considering regulations to prevent illicit activity, while South Africa is expected to have comprehensive regulations in place for tokenized deposits and cryptocurrencies by 2025. Companies like Binance are actively engaged in discussions with regulators to promote safe and efficient crypto markets.
Looking ahead, stablecoins are likely to continue to play an important role in shaping the digital economy, both globally and in Africa. Recent stablecoin initiatives by major financial service providers such as PayPal and Visa demonstrate growing institutional interest in this form of crypto-pegged stablecoin.
However, the overall payments landscape is also evolving, as evidenced by the development of central bank digital currencies (CBDCs) and tokenized bank deposits, which could offer alternatives to privately issued stablecoins and hinder their path to wider adoption.
That said, as the cryptocurrency market matures and regulatory frameworks continue to evolve, stablecoins could prove to be a valuable bridge between traditional finance and the cryptocurrency world.
However, their long-term success will still depend on their ability to deliver on the promise implicit in their name, which is ultimately to provide the stability that many cryptocurrency investors and users desire.
Did you know: Binance celebrates its seventh anniversary this month, supporting over 210 million users worldwide. Binance’s primary focus remains on users, innovation, and a hardcore work culture. Its robust infrastructure supports 541 digital assets and 2,632 trading pairs, seamlessly handling high user activity. Read our thoughts CEO here: Seven years at the frontier of financial innovation.
Hannes Wessels is the Managing Director of Binance South Africa