The rise of stablecoins: What potential do they hold for the future?

Introduction

The landscape of digital finance has seen many rapid developments and exciting innovations. One of the more successful ideas that has grown from the rise of cryptocurrencies and blockchain technology is the concept of stablecoins. These digital assets are designed to maintain a stable value by being pegged to an external source of value. Over the past few years, stablecoins on public blockchains have experienced rapid growth in popularity and use. Unlike the more volatile cryptocurrencies such as Bitcoin and Ethereum, stablecoins offer a more reliable bridge between traditional finance and decentralized markets. And the potential of stablecoins does not stop there.

Many expect that the amount of use cases and the popularity of stablecoins will continue to follow a rising trend, their promising innovation holding the potential to greatly impact the banking system as we know it. In this article, we will explore the ways in which stablecoins can change traditional finance. However, before getting there, we first provide an overview of the basics of stablecons – what are their key characteristics, current use cases, and growth potential for the coming years. Join us on a journey through the fascinating landscape of stablecoins, where stability meets innovation, and the future of finance takes shape.

The basics of stablecoins

What are stablecoins?

At their core, stablecoins are digital currencies designed to maintain a stable value, typically pegged to a reserve asset like the US dollar, a basket of currencies, or even commodities like precious metals. Stablecoins are recorded on distributed ledger technologies, of which blockchains are the most well-known and used. Stablecoins achieve their stability through a combination of smart contract technology, algorithmic mechanisms, or traditional reserves held in custody. 

How are stablecoins different from fiat currency?

While usually pegged to a fiat currency, stablecoins have a few distinct characteristics that distinguish them from fiat currencies, traditional commodities, and other forms of digital currency such as bank deposit accounts [1]. 

Firstly, stablecoins operate on public blockchains, enabling them to be traded 24/7 year-round. This provides them with continuous liquidity and accessibility, not restricted by opening times of banks, exchanges, and other financial institutions. 

Secondly, because stablecoins are constructed on distributed ledger technologies that are programmable, they are what is known as “composable”. Here, composability implies that stablecoins can act as autonomous building blocks capable of integrating with other services, such as smart contracts. This facilitates the creation of a diverse set of financial services and payment solutions. 

Stabecoins’ unique blend of uninterrupted trading and high level of  interoperability sets them apart from conventional digital money systems. 

Different types of stablecoins

Stablecoins do not come in one form. There are different types of stablecoins, each with its own mechanism for maintaining stability. Below, we listed four main categories of stablecoins. It is important to note that due to the rapid developments in the cryptocurrency landscape, these four types do not encompass all the potential future innovations in the realm of stablecoins.

• Fiat-Collateralized Stablecoins: These stablecoins are backed by a reserve of traditional fiat currencies, such as the US dollar, euro, or yen, held in a bank account or other secure custodial arrangement. Each issued stablecoin is typically backed by an equivalent amount of fiat currency, ensuring a 1:1 peg. Examples of fiat-collateralized stablecoins include Tether (USDT), USD Coin (USDC), and TrueUSD (TUSD).
• Crypto-Collateralized Stablecoins: Instead of relying on fiat currency, crypto-collateralized stablecoins use cryptocurrencies, like Ethereum or Bitcoin, as collateral. Users lock up a certain amount of cryptocurrency, which then supports the stablecoin’s value. Crypto-collateralized stablecoins aim to maintain stability through overcollateralization and algorithmic mechanisms. 
• Algorithmic Stablecoins: Algorithmic stablecoins don’t rely on collateral but instead use smart contracts and algorithms to adjust the stablecoin’s supply in response to market demand. When the price of the stablecoin rises above its peg, the supply increases, and vice versa.
• Private or institutional stablecoins: Institutional or private stablecoins are a category of stablecoins that are specifically designed for use within a closed or controlled environment, often by institutions, businesses, or specific user groups. Organizations often create these stablecoins for specific use cases within the issuing institution’s operations. For example, a bank might create a stablecoin for faster cross-border settlements between its branches or as part of a loyalty rewards program for its customers. Institutional stablecoins tend to be more centralized in terms of control and issuance. The entity or consortium behind them typically has the authority to mint, redeem, and manage the stablecoin supply as needed.

Use cases of stablecoins

While stablecoins might have started as just another type of cryptocurrency, they have long since transcended to a whole new category of their own. Their ability to maintain a stable value opens the door to a wide array of applications. In this paragraph, we will highlight some of the most popular use cases of stablecoins. This will give us insight into their functioning and the potential they may hold in changing traditional banking systems. 

Digital payments

One of the most widespread use cases of stablecoins is their role in digital payments. Stablecoins provide a stable medium of exchange for online transactions, enabling fast and cost-effective cross-border payments without the volatility associated with cryptocurrencies like Bitcoin. These transactions are peer-to-peer, eliminating the need for intermediaries. 

For cross-border transactions specifically, stablecoins offer a much faster and cheaper way of transferring money.

Trading and speculation

Traders often use stablecoins as a safe haven to park their assets during periods of high cryptocurrency volatility. They also facilitate quicker trading between different cryptocurrencies on exchanges.

DeFi applications

Stablecoins are a fundamental component of decentralized finance (DeFi) platforms, serving as a stable unit of account and collateral for lending, borrowing, yield farming, and liquidity provision.

Tokenization of assets

Stablecoins can represent real-world assets like real estate, stocks, or commodities on a blockchain, making it easier to trade and fractionalize these assets. Tokenization of assets opens up the way to more liquidity, especially of previously illiquid assets, such as real estate.

The future potential of stablecoins

What are the benefits of stablecoins?

Stablecoins offer a myriad of benefits that have solidified their position in the world of digital finance. Foremost among these advantages is their ability to provide a more reliable store of value and medium of exchange compared to the often volatile cryptocurrencies. Their 24/7 availability and borderless nature facilitate swift and cost-effective cross-border transactions, making them a promising solution for remittances and international trade. Within the realm of decentralized finance (DeFi), stablecoins underpin various innovative applications, enabling lending, borrowing, and yield farming with reduced exposure to price swings. Moreover, stablecoins promote financial inclusion by granting access to financial services in regions with limited banking infrastructure. Their transparency and traceability make them valuable for charitable donations and disaster relief efforts, ensuring funds reach their intended destinations. Additionally, businesses can harness the stability of stablecoins for hedging and efficient cross-border payroll.

A world of greater financial inclusion

Because of their characteristics, stablecoins can pave the way to a world with greater financial inclusion. As mentioned above, due to their decentralized nature, stablecoins can offer finance tools in areas that are unbanked or underbanked in traditional finance infrastructure. Greater financial inclusion is crucial if we want a world in which everyone can join the economic system in a fair way.

Potential impact of stablecoins on traditional banking

If stablecoins indeed continue to grow in use cases and popularity, they have the potential to impact traditional banking systems in several ways. 

Firstly, stablecoins can streamline cross-border payments and settlements, reducing the need for correspondent banks and intermediaries. 

Secondly, stablecoins can cause disruptions to money flows of banks. An example of a scenario in which this can happen, is when a run on stablecoins occurs. Stablecoin issuers often hold a portion of the reserves backing their stablecoin in traditional bank deposits. When there’s a run on the stablecoin, people exchange it for fiat currency or other assets, which prompts the stablecoin issuer to redeem the stablecoins for the corresponding bank deposits. This sudden demand for withdrawals can lead to a significant outflow of funds from the banks holding these deposits.

Impacts depend on integration

Ultimately, the impacts stablecoins will have on traditional banking, and the element that will influence the usage and popularity of stablecoins in the future, is the extent to which we integrate them into traditional systems. 

For stablecoins to have a significant impact on traditional banking, they need to integrate into the existing financial infrastructure. This means that stablecoins should be readily accepted and usable by traditional banks and financial institutions. They should be compatible with established payment systems, compliance standards, and regulatory frameworks. 

Integration also implies interoperability. Stablecoins should be able to interact with traditional banking systems, allowing for easy transfers, settlements, and conversions between stablecoins and fiat currencies. If users can move funds between stablecoins and traditional bank accounts without friction, it enhances the appeal and convenience of stablecoins.

Regulatory compliance is critical in this integration. Stablecoins must adhere to financial regulations to gain trust from both users and traditional financial institutions. Governments and regulators need to be comfortable with the stability and transparency of stablecoins, which often involves robust anti-money laundering (AML) and know-your-customer (KYC) procedures. Currently, regulation is an important area of work for stablecoins.

Conclusion

In conclusion, stablecoins have the potential to change the traditional banking system, especially in making financial infrastructure more widely available, lowering costs and waiting times for cross-border transactions, and in further stimulating the development of new decentralized applications, such as DeFi services and Web 3. 

However, the extent of their impact will ultimately depend on their integration into traditional financial infrastructure. To truly revolutionize traditional banking, stablecoins must blend into existing systems, ensuring compatibility, regulatory compliance, and interoperability.

All in all, the future of stablecoins remains promising, and we are looking forward to seeing how this concept might help in creating a better world.

Sources / further reading

[1] Liao, G. Y., & Caramichael, J. (2022). Stablecoins: Growth potential and impact on banking. Retrieved from https://www.federalreserve.gov/econres/ifdp/files/ifdp1334.pdf