Hi all,

You may have heard that crypto regulation is making progress around the world. In the EU, for example, the European parliament passed the MiCA regulation a few months ago.

Regulation takes time though. The MiCA provisions will be applicable in separate steps and enforced by EU member-states. The first step, starting on 30 June, will mostly affect issuers of stablecoins.

So what’s up?

Stablecoins can become really important for many blockchain-based applications. That's why it's useful to understand them. We'll explain:

• What is a stablecoin?

• Which different types exist?

• Why are they important?

Let’s get started! 🤓

At first glance, you might say that stablecoins are a solution in search of a problem. Why would you need a cryptocurrency pegged to the US dollar or the euro when those currencies are already widely accepted?

According to Jeremy Allaire, stablecoins are actually a critical element in a 'new internet financial system'. He may be slightly biased, given that he's the CEO of Circle, a well-known issuer of stablecoins which may soon be listed on the stock exchange.

In any case, there are many parallels to innovative solutions which only became possible when the internet entered our daily lives.

Stablecoin basics are simple to understand. As the name would suggest, they mirror the value of an external reference. That is usually another currency, but it could also be a commodity like gold or something else entirely.

How can you ensure that stablecoins maintain a stable value? That brings us to the first question.

What is a stablecoin?

The most important stablecoins are pegged to the US dollar. Ideally, one unit of Tether or USDC – which are by far the largest examples – is always worth exactly one dollar.

Stablecoins are therefore a lot more stable than "normal" cryptocurrencies. That makes them a lot more useful as a medium of exchange.

Imagine you run an online shop. You have to pay most invoices in US dollar, but you want to accept crypto payments. Would you like to accept Bitcoin, Ether or Solana and constantly adjust your prices according to the current value of these cryptocurrencies? Or would you like to receive a US dollar-pegged stablecoin instead?

The latter alternative is much easier to administrate. Keep in mind, however, that stablecoins are not all the same.

Which different types of stablecoins exist?

There are three different types. You can differentiate them by how they maintain their value.

Fiat-backed stablecoins

A fiat-backed stablecoin has a reserve in a traditional or fiat currency such as the US dollar or the euro. The value is assured by this collateral.

For a US dollar-pegged stablecoin, for example, it makes sense to be based on financial instruments which can easily be turned into cash. Treasury bills are a perfect example. They are issued as debt by the US government and considered as very low-risk investments.

When a stablecoin is completely backed by such instruments, it shouldn't lose its peg. While there's no absolute guarantee that treasury bills will always maintain their value, such a development would have significant implications on the global financial system beyond cryptocurrencies.

Crypto-backed stablecoins

As the name suggests, they are backed by other cryptocurrencies. Due to the volatility of the underlying assets, crypto-backed stablecoins are overcollateralized.

That means that the value of cryptocurrency held in reserve is higher than the value of the stablecoin. Even if the market drops significantly, the peg can be maintained. There are popular examples, most notably DAI which has been steady for years, even though the underlying cryptocurrencies have experienced significant swings in value.

Algorithmic stablecoins

An algorithmic stablecoin is supposed to maintain its value through a specific formula (the algorithm). In theory, that's similar to a central bank which doesn't have to rely on reserve assets to keep the currency value stable. However, central banks also decide monetary policy in public, based on well-understood parameters.

For algorithmic stablecoins, there's no fallback option. In a crisis, the value may therefore plummet. The most prominent example: TerraUSD. In May 2022, the entire ecosystem around this stablecoin became almost worthless within the space of a few days. Billions of dollars in value disappeared virtually overnight.

Summary

When you're using stablecoins for payments or investments, you should select those which are most likely to maintain their value. It's important to understand that these cryptocurrencies are not issued by central banks. There is no government guarantee on the value.

However, private issuers of large fiat-backed stablecoins aim to create digital currencies which are fully backed by assets. When reserves are transparent and regularly audited, the respective stablecoins should be considered just as safe as the value of traditional money market funds.

Why are stablecoins important?

Stablecoins are crucial types of cryptocurrencies – simply because they are stable.

Traditional cryptocurrencies, e.g. Bitcoin, Ether or Solana, have key advantages. You don't have to trust intermediary institutions to send a payment anywhere in the world.

Transaction costs for cryptocurrencies are the same, irrespective of the locations of sender and receiver. That's different from traditional bank transfers abroad. Moreover, thanks to advances in blockchain technology, transactions can merely cost fractions of a cent.

As mentioned above, the conversion rates of Bitcoin or Ether into "regular" currencies fluctuate wildly. That makes them relatively useless for everyday transactions.

Stablecoins combine advantages of cryptocurrencies (i.e. instant payments at low costs without the need for third parties) with advantages of fiat currencies (i.e. stable value to create a useful medium of exchange).

Outlook

The two largest stablecoins alone currently have a market capitalisation of more than $140 billion (Tether around $110 billion, USDC around $33 billion). Both have also experienced significant growth in recent months.

With stablecoin regulation advancing, the market for these types of digital assets looks set for even more growth. That was underlined by fintech giant PayPal launching its own stablecoin in 2023. In the EU, euro-denominated stablecoins may also become a more important part of the crypto ecosystem.

That’s the end for today! 😢