Tagus Bits n Bobs Issue 7: A Safe Harbour and Fiat Bridge

Deep Dive: Stablecoins – A Safe Harbour & Fiat Bridge

• Stablecoin Dynamics and Demand: Stablecoins aim to maintain a constant value tied to a specific asset, addressing cryptocurrency volatility and enhancing their appeal for payments and savings. They have become a critical and systematic component of the digital asset ecosystem and are increasingly integrated into the global financial infrastructure.

• Stablecoin Market Growth by 2030: The stablecoin market by 2030, is projected to reach $1-3 trillion, driven by increased adoption in both developed and emerging markets, as well as the introduction of new interest-bearing stablecoins.

• Emerging Markets Fuel Stablecoin Activity: Most stablecoins are dollarised, with 99% backed by the U.S. dollar, and see significant demand growth in emerging markets facing high inflation and currency devaluation.

• Stablecoin Regulation: As stablecoins integrate into traditional finance, jurisdictions like the EU, Singapore, Hong Kong, and Dubai are implementing clear regulatory frameworks, while the U.S. lags behind but shows potential for bipartisan cooperation.

According to U.S. Congressman Ritchie Torres, “The proliferation of dollar stablecoins — rendered possible by the ubiquity of smartphones and the cryptography of blockchains — could become the greatest experiment in financial empowerment humanity has ever undertaken” (Torres, 2024).

This paper provides an analysis of stablecoins, including their types, mechanisms, regulatory challenges, and economic implications. By examining the role of stablecoins in financial markets and their potential to disrupt traditional financial systems, this study aims to contribute to the ongoing discourse (Bullmann, Klemm, and Pinna, 2019; Dionysopoulos and Urquhart, 2023) on the future of digital assets in ecosystem.

Stablecoin Adoption: Stablecoins aim to maintain a steady value tied to a specific asset, addressing the price volatility of other cryptocurrencies and enhancing their appeal for payments and savings. Stablecoins have become a vital component of the digital asset ecosystem, offering a stable store of value and a medium of exchange. This has broadened to other uses. Stablecoins are evolving as a preeminent global settlement infrastructure, seamlessly integrating into the traditional financial system. This trend reflects their growing acceptance and utility in various financial transactions, further solidifying their role in the global economy. There is also a deepening of demand from emerging markets where high inflation rates, and FX volatility, are driving stablecoin adoption for payments, currency substitution, and preserving value, with purchases closely tied to inflation rates. Most stablecoins are pegged to the U.S. dollar, constituting 98.9% of the total stablecoin supply. The euro is the second most popular currency, but with only a 0.38% market share. While stablecoins exist for other currencies such as the Singapore dollar, Hong Kong dollar and the Japanese yen, none have more than $100 million pegged to them.

Source: Tagus Capital, (ECB, 2022), Castle Island Ventures

Origins of Stablecoins: The advent of digital assets, spearheaded by Bitcoin with the network initiated when Satoshi Nakamoto mined the first block of the chain, known as the genesis block, on January 3, 2009 (Wallace, 2011), has introduced a new paradigm in financial transactions. However, the volatility inherent in most digital assets has restrained their adoption as a reliable medium of exchange (Adrian and Mancini-Griffoli, 2019). Stablecoins address this issue by maintaining a stable value, typically pegged to a fiat currency, commodity, or a basket of assets. Stablecoins maintain their value through various methods, such as fiat-backed, crypto-backed, and algorithmic mechanisms.

Introduced in 2014 with BitUSD, NuBits, and Tether, stablecoins have proliferated rapidly, with over 150 types of stablecoins have since been issued globally (Dionysopoulos and Urquhart, 2023). The stablecoin market capitalisation has recently reached a new all-time high of $171bn, surpassing the previous peak in March 2022. New money is driving this growth with investors increasingly focusing on stablecoins due to their stability against fiat currencies, low-cost blockchain-based payments, and utility in decentralised finance (DeFi) for lending and borrowing. The IMF (2022) notes the stablecoin market is growing alongside DeFi. The growth is primarily driven by the increasing significance of DeFi and the vital role stablecoins play in DeFi primitives like lending protocols and automated market makers (AMMs).

Source: Category breakdown by daily active addresses (all blockchains). 

Stablecoins also reduce intermediation costs (see Lower Fees for Stablecoins than Wire Transfers) and enable transactions on exchanges that do not use fiat currencies, avoiding fees and processing lags (Lyons and Viswanath-Natraj 2020), and also popular in emerging market countries with high inflation and currency debasement (e.g., Turkey and Argentina). Additionally, stablecoins attract digital asset investors due to their relatively low volatility. Research on stablecoins has focused on their volatility and risk management properties. Hoang and Baur (2020) and Grobys et al. (2021) link stablecoin volatility to Bitcoin, while Lyons and Viswanath-Natraj (2020) note stabilising forces on the demand side. Jarno and Kołodziejczyk (2021) find that stablecoin types differ in volatility, with tokenised funds performing best. Stablecoins are also studied as safe haven assets. Wei (2018) and Wang et al. (2020) suggest that stablecoins can reduce portfolio risk during market volatility, with USD-pegged stablecoins being better safe havens than gold-pegged ones. Baur and Hoang (2021) and Xie et al. (2021) confirm their role as safe havens against Bitcoin.

Types of Stablecoins: Stablecoins are cryptocurrencies pegged to underlying assets like the US dollar or precious metals, or stabilised through algorithms. Broadly stablecoins can be categorised into four main types:

• Fiat-Collateralised Stablecoins: The most prevalent type, fiat-collateralised stablecoins, back each issued token with reserves of the corresponding fiat currency, ensuring they are anchored to a real-world asset. Examples include Tether (USDT) and USD Coin (USDC).

• Crypto-Collateralised Stablecoins: These stablecoins are backed by other cryptocurrencies. An example is Dai (DAI) issued by the decentralised organisation MakerDAO.

• Commodity-Collateralised Stablecoins: These stablecoins are backed by commodities such as gold or oil. An example is Digix Gold (DGX).

• Algorithmic Stablecoins: These stablecoins use algorithms to adjust the supply to maintain a stable value, albeit are uncollateralised. Examples include the more recently issued Ethena’s USDe, a synthetic dollar cryptocurrency with a soft USD peg, maintained through automated delta-hedging futures trading operations, and TerraUSD (UST) which collapsed in May 2022 (Briola et al., 2023).

Tether's Stablecoin Dominance to Take a Dent?: Tether (USDT), first issued on October 6, 2014, and currently the leading stablecoin has just breached above the historic $120 billion market cap driven by substantial inflows while Circle’s USD Coin (USDC) has reached over $34 billion, taking the second place. As of October 27, 2024, the stablecoin market has grown to over $171 billion—a 25% year-to-date increase. This growth underscores rising interest in stablecoins as a stable store of value amid digital asset volatility is set to continue over the next five years.

Source: Tagus Capital, DefiLlama.

Even with recent growth, stablecoins make up only 7% of the estimated $2.45 trillion total market cap of crypto-assets. Estimates for the size of the stablecoin market by 2030 vary, but predictions range from a market cap of $1trn to $3trn (Centre for Economics and Business Research and BVNK, 2024; Bernstein, 2023) indicating significant growth potential. This is also likely to be subject to transparent regulation which is beginning to emerge, led by the European Union but still lacking in the U.S. (see Regulation). Overall, growth is likely to be driven by the ongoing adoption of stablecoins in both developed and emerging markets, as well as the introduction of new interest-bearing stablecoins. The potential global demand for USD-pegged stablecoins is evident, with substantial international demand for U.S. dollar cash. According to the St. Louis Fed (2022), nearly $1 trillion in U.S. banknotes—around 45% of all circulating currency—is held overseas, with two-thirds of $100 bills being used abroad. This demand persists despite the challenges individuals overseas face in accessing dollars through local banking systems. Stablecoins offer a viable currency substitute and can facilitate cheaper and faster payments.

Reserves and stability mechanisms: Stablecoins backed by fiat currency, commodities, or other crypto-assets have been less volatile than traditional crypto-assets, but none have maintained perfect peg parity. Despite their stability, safe-haven status, and bridge between fiat and crypto, stablecoins faced significant turmoil in 2022 and early 2023. Notably, the May 2022 crash of Terra's TerraUSD, then the third largest stablecoin, disrupted the crypto market. Additionally, there's no guarantee that stablecoins can be fully redeemed on demand. Thus, current stablecoins do not yet fully serve as a reliable store of value or means of payment (Kosse, 2023).

Stablecoins maintain their stability through different mechanisms: they can be backed by fiat currency reserves, supported by commodities like gold, or algorithmically adjusted to control supply and demand:

•     Reserve-Based Mechanisms: Fiat-collateralised and commodity-collateralised stablecoins maintain reserves of the underlying assets to ensure stability.

•     Over-Collateralisation: Crypto-collateralised stablecoins often require over-collateralisation to account for the volatility of the backing cryptocurrencies.

•     Algorithmic Mechanisms: Algorithmic stablecoins use smart contracts to adjust the supply in response to price fluctuations, aiming to maintain a stable value.

New entrants: The stablecoin market, currently led by Tether's USDT and Circle's USDC, is set to become more diverse with new entrants. Tether's dominance may face challenges as regulatory clarity emerges in the U.S. Notable new stablecoins include PayPal's PYUSD and Ethena’s yield-bearing synthetic dollar stablecoin USDe, both of which have seen significant growth since their launch. Additionally, FDUSD, a Hong Kong-based stablecoin pegged 1:1 to the U.S. dollar, is gaining traction.

In August 2023, PayPal launched PYUSD, a U.S. dollar-denominated stablecoin for payments. Fully backed by U.S. dollar deposits, short-term U.S. Treasuries, and equivalent cash assets, PYUSD can be redeemed at a 1:1 ratio for U.S. dollars. Operating on Ethereum, PYUSD has over 25,000 active wallets and expanded to Solana in May 2024, with decentralised exchanges like Jupiter and Orca adding it to their pools. PYUSD recently surpassed $1 billion in market cap and now offers "confidential transfers" on Solana, balancing privacy and regulatory visibility. Unlike traditional stablecoins like USDT and USDC, which are backed 1-1 by US dollars or equivalent assets, Ethena’s stablecoin USDe uses a unique backing mechanism combining ETH and derivatives in a cash-and-carry trading framework. This involves staking Ethereum from USDe minters and simultaneous Ethereum futures shorting, introducing a new approach to stablecoin backing. However, this stablecoin, which uses algorithms to adjust supply and maintain value despite being uncollateralised, raises risks, particularly concerning USDe's yield generation. It may also face regulatory issues, especially after the collapse of the Terra algorithmic stablecoin in May 2022 (Briola et al., 2023).

New digital asset custody providers could also emerge, increasing competition. Fintech companies Robinhood and Revolut are planning to issue their own stablecoins as the industry expands and EU regulation like Markets in Crypto-asset (MiCA) provide greater clarity. These potential entries could further alter the stablecoin landscape.

Economic Implications: Stablecoins have significant economic implications that could reshape global finance. They enable faster and cheaper cross-border payments, challenging traditional remittance services by lowering costs for individuals and businesses. Additionally, they promote financial inclusion by providing access to financial services for unbanked and underbanked populations, especially in regions with limited banking infrastructure. However, their widespread adoption could also affect monetary policy, as central banks might struggle to control money supply and interest rates, potentially reducing the effectiveness of traditional monetary tools. As stablecoins evolve, these implications will require adaptation from regulators and financial institutions.

Stablecoins' Growing Role in Global Finance: Stablecoins are poised to play a vital role in the global financial system, potentially reaching between 5%-10% of global economic money in the next decade. Currently, they comprise only 0.2% of the broader money supply (M3), but their growing adoption in payments, banking the unbanked, and cross-border commerce is driving rapid growth.

Notably, stablecoin issuers have become substantial holders of US government debt, with combined holdings currently ranked 18th among major nations, surpassing South Korea and Germany, and just behind Saudi Arabia. As highlighted in previous analysis by Tagus Capital and covered in the Financial Times, this situation has remained largely unchanged since earlier this year, although the absolute holdings have increased from $120 billion to over $140 billion. This $140 billion comprises primarily of Tether (USDT), the largest stablecoin issuer, which holds $110 billion in US Treasury Bills, overnight and term reverse repos, while Circle (USDC) holds short-dated US securities, including US Treasury repos, totalling $30 billion. This significant involvement underscores the growing influence of stablecoin issuers in the US government debt market and the potential implications for market dynamics and financial stability.

Source: Tagus Capital, US Treasury. Note*: Tether and The Circle holdings of US Treasuries/Repo. 

High Stablecoin Adoption in Emerging Markets: In emerging markets, stablecoin adoption for payments, currency substitution, and access to attractive yields is accelerating. High inflation rates in economies such as Argentina and Turkey have driven increased adoption of cryptocurrencies, particularly stablecoins, as users seek to hedge against currency devaluations and preserve value. According to The Centre for Economics and Business Research and BVNK (2024), from 1992 to 2022, currency volatility caused an estimated 9.4% average GDP loss across 17 emerging market countries, totalling $1.2 trillion. Stablecoins have helped mitigate these adverse effects. The correlation between stablecoin purchases using the Turkish Lira, Argentine Peso and Nigeria Naira (Chainalysis, 2024) with inflation rates highlights the role of stablecoins as a store of value during periods of significant local currency volatility and devaluation.

 Source: Chainalysis. 

Lower Fees for Stablecoins than Wire Transfers: Recent scaling upgrades have led to substantial reductions in the cost of crypto transactions, including those involving stablecoins, with some fees dropping by over 99%. On Ethereum, the average gas fee for USDC transactions, a popular U.S. dollar-pegged stablecoin, is currently around $1, compared to $12 in 2021 (a16zcrypto, 2024). Using Base, Coinbase’s L2 network, the cost to send USDC is now less than a cent on average. This contrasts sharply with the average $44 fee for international wire transfers. The fact that stablecoins are also now mentioned in the same context as well-known and established traditional payment services like Visa, PayPal, and Fedwire highlights their increasing utility and importance.

Source: a16zcrypto.

Rating Assessments: Several ratings firms such as traditional agencies such as S&P and Moody's and crypto-native ones like Bluechip provide assessments on the risks associated with stablecoin issuers. S&P Global Ratings, for example, employs the Stablecoin Stability Assessment (SSA) to gauge a stablecoin's ability to maintain its asset peg. The SSA uses a scale of 1 to 5, with 1 being the strongest and 5 the weakest, and is not a formal rating (S&P Global, n.d.). Key assessment factors include, asset quality, overcollateralisation, governance, legal and regulatory framework, redeemability and liquidity, technology and third-party dependencies, and stablecoin's track record.

While USDT remains widely used, supported by numerous DeFi protocols, and popular for cross-border transactions due to its longer history, it differs from USDC in terms of transparency and backing. Rating agencies typically favour USDC for its regulation, audits, and monthly reserve assurances, despite challenges such as the Silicon Valley Bank crisis. In contrast, USDT has faced investigations and fines for misleading users about its reserves. Furthermore, Tether has been criticised for its lack of transparency, providing only quarterly reports with limited detail, while USDC undergoes monthly detailed audits by independent firms and offers clear reserve reporting. USDC's commitment to transparency and compliance makes it a favoured choice compared to Tether, which has ongoing regulatory concerns and reports of anti-money laundering laws in the US and potential U.S. Treasury sanctions (OneSafe, 2024).

Source: Tagus Capital, S&P Global. 

Regulatory Challenges: The rise of stablecoins has brought several regulatory concerns to the forefront of financial discussions. One major issue is reserve transparency; the clarity and auditing of the reserves backing stablecoins are essential for maintaining trust among users, as highlighted by Moin, Kher, and Adhami (2020). However, several key stablecoins now self-report reserves transparently, backing them 1:1 to the U.S. dollar, which addresses some of these concerns. Regulatory oversight is welcomed but in certain jurisdictions the ulterior motive might be aiming to centralise control and potentially create a window for Central Bank Digital Currencies (CBDCs). Lastly, consumer protection remains a significant challenge, with the need to ensure that stablecoin users are safeguarded against fraud and market manipulation. Together, these concerns underscore the importance of establishing a balanced regulatory framework for stablecoins that fosters a secure and trustworthy financial environment.

As stablecoins increasingly integrate into the traditional financial landscape, clear and transparent regulation is necessary. Stablecoin oversight is gaining political traction, outpacing broader crypto regulation. The EU has led with Markets in Crypto-assets (MiCA) regulation and other jurisdictions like Singapore, Hong Kong, and Dubai are implementing with pilot programmes The EU's MiCA framework is considered as the ‘north star’ in providing a foundation for stablecoin regulation. The EU has already implemented widespread regulation for stablecoins. The EU's MICA regulations, which categorise stablecoins into "regulated" and "unauthorised" groups and impose registration and capital requirements, was introduced on June 30, 2024, with some provisions phased in by December 2024. This regulatory clarity is driving additional stablecoin growth globally, but critically the U.S. lags behind, potentially losing its influence over the dollar's role in digital asset markets.

In the U.S. there is still a distinct absence of a clear regulatory framework for stablecoins but there are indications of potential area for bipartisan cooperation in Congress. While U.S. lawmakers have struggled to pass comprehensive legislation on cryptocurrencies, stablecoin regulation may be more feasible due to their similarities with existing financial products like money market funds. U.S. Senators have already introduced a bipartisan stablecoin bill to establish a regulatory framework and is awaiting further progress. The new stablecoin bill introduced by U.S. Senators Cynthia Lummis and Kirsten Gillibrand seeks to limit institutions without a banking license to a maximum issuance of $10 billion, potentially reducing Tether's market share and encouraging traditional banks to enter the stablecoin market. The approval of the stablecoin bill could accelerate institutional blockchain innovation and create opportunities for banks as stablecoin issuers, but it may also reduce Tether's dominance in the global stablecoin market. USDT is issued by a non-US entity and is not a permitted payment stablecoin under the proposed bill, which means that U.S. entities can't hold or transact in it. However, USDT transaction activity is located mainly outside the U.S. in emerging markets and is driven by retail investors and remittances.

Overall, with clear demand for stablecoins, compliant issuers are well-positioned to capitalise on this demand, potentially gaining market share, as authorities crack down on non-compliant operators in the impending regulatory environment. However, algorithmic stablecoins face higher regulatory and operational risks, including a potential U.S. ban, which could limit their adoption.

CBDCs vs Stablecoins: Central Bank Digital Currencies (CBDCs) present a challenge to stablecoin expansion. Issued by central banks and acting as direct liabilities of those institutions, CBDCs offer the potential for improving cross-border transactions, financial inclusion, and payment efficiency. Backed by national currencies, they promise a stable value, although this depends on the effectiveness of their stabilisation mechanisms. According to the World Economic Forum (2021) over 70% of central banks are currently exploring the design and issuance of CBDCs to address these opportunities as cash usage declines.

However, several concerns remain, particularly around its centralised system, data protection and online privacy. CBDCs raise potential risks of mass surveillance, as well as the misuse and abuse of personal data by central banks or other authorities. This could undermine trust in the digital currencies. Meanwhile, stablecoins offer an immediate and largely untapped opportunity, providing a ready-made solution for faster, more efficient payments and financial inclusion without the complexities of launching a CBDC. Their decentralised nature enhances privacy, reducing the risk of mass surveillance and giving users greater control over their financial data compared to centralised systems. Stablecoins are gradually being integrated into the global financial system, leveraging existing fiat systems, while clear regulatory frameworks help manage risks. As CBDCs face longer development timelines and concerns over data privacy and potential misuse, stablecoins present a ripe opportunity for adoption and growth today.

Conclusion: Stablecoins represent a significant innovation in the cryptocurrency ecosystem, offering a stable store of value and a reliable medium of exchange. Their growing adoption, particularly in emerging markets facing high inflation and currency devaluation, highlights their potential to disrupt traditional financial systems. The projected market growth to $1-3 trillion by 2030 underscores their increasing integration into the global financial infrastructure.

However, the regulatory landscape remains a critical challenge. While jurisdictions like the EU, Singapore, Hong Kong, and Dubai are implementing clear frameworks, the U.S. lags behind. The introduction of new stablecoins and the growing acceptance of existing ones, such as Tether (USDT) and USD Coin (USDC), indicate a dynamic and evolving market. The economic implications of stablecoins are profound, including faster and cheaper cross-border payments, enhanced financial inclusion, and potential impacts on monetary policy.

As stablecoins become more prevalent, it is essential to develop robust frameworks that balance innovation with financial stability and consumer protection. The future of stablecoins is promising, but navigating the regulatory and operational challenges will be crucial for their sustained growth and integration into the mainstream global financial system.

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