This article briefly:
Stablecoins are digital assets that are designed to provide financial stability but may not be as stable as their name implies, thus presenting inherent risks.
Recent disruptions, such as Tether losing its peg to the U.S. dollar and the collapse of TerraUSD, have called into question the stability of these digital assets.
The rise of stablecoins has attracted the attention of regulators around the world, who are working to develop a consistent regulatory framework.
The exponential growth of stablecoins, which are marketed as stable forms of cryptocurrencies, has caused a ripple effect in the financial world, with stablecoins being welcomed by traders and investors for their potential to facilitate faster and cheaper transactions.
However, it is becoming increasingly clear that stablecoins may not be as stable as they claim to be, with potential repercussions for individual investors and broader financial markets.
Stablecoins are not as stable as promised
Unlike other cryptocurrencies, stablecoins are pegged to an asset, usually the U.S. dollar. By linking their value to a less volatile asset, stablecoins seek to offer the best of both worlds: the speed and privacy of cryptocurrency without the price volatility.
Nonetheless, the flaws of this model have begun to emerge, creating huge uncertainty and market disruption for investors.
“We find strong evidence of stablecoin instability, although all stablecoins’ deviations from the $1 mark are gradually corrected at different rates,” concluded Kun Duan, a researcher at Huazhong University of Science and Technology. “Even in the long run, the deviations do not converge due to the non-stationarity of the series of differences between their prices and the $1 mark.”
Stablecoins are primarily used to support speculative trading of other crypto assets, and the two largest stablecoins on the market, Tether and USD Coin, claim to have full asset backing.
However, transparency and oversight of issuers’ ability to meet redemption requests have come under close scrutiny.
Some top stablecoins lose their peg to the dollar
In some cases, regulators have expressed concerns about the liquidity, quality, and valuation of reserve assets held by stablecoin issuers.
For example, Tether, once considered a paragon of stability, faced a loss of investor confidence, which subsequently led to USDT temporarily losing its peg to the U.S. dollar on June 15.
“Markets are nervous today, so it’s easy for attackers to take advantage of the general sentiment,” said Paolo Ardoino, Tether’s chief technology officer. “But at Tether, we are prepared, as always. Let them come, we are ready to redeem any amount.”
Similarly, one of the largest algorithmic stablecoins, TerraUSD, collapsed when it failed to maintain its peg. This led to a massive withdrawal of funds by investors and undermined its stabilization mechanism.
These disruptions were more than just blips; they showcased the vulnerabilities inherent in stablecoin design, particularly those that are not adequately backed by high-quality liquid assets.
Gary Gensler, chairman of the U.S. Securities and Exchange Commission, said: “There are a lot of casinos in the Wild West, and stablecoins are poker chips on the casino tables.”
The risk of a “run” or rapid withdrawal of funds due to illiquid assets could impair the issuer’s ability to redeem in full, a risk similar to that faced by other financial investment products.
However, this problem with stablecoins is amplified due to the opaque and unregulated nature of the crypto ecosystem.
For example, Tether faced a regulatory fine for its stablecoin being “fully backed by U.S. dollars.” It was found to be investing part of its reserves in risky and illiquid assets with minimal capital buffers.
Other large stablecoin issuers have imposed restrictions on redemptions, further undermining investor confidence.
How Stablecoin Instability Affects Investors
For individual investors, the revelations highlight that while stablecoins promise stability, they are far from risk-free.
Investing in stablecoins carries market risk, liquidity risk, and operational risk, including fraud and cyber risk. In the current regulatory environment, investors have little recourse for lost or stolen crypto assets.
The potential impact is not limited to individual investors. As stablecoins become more integrated into the banking sector, they could pose broader financial stability risks. For example, a stablecoin run could lead to a sudden outflow of bank deposits or disruptions in funding markets.
Regulators have begun to recognize these risks, and regulators are developing proposals to address the risks posed by stablecoin activities. However, as these regulatory frameworks develop, investors must proceed with caution.
The lessons from recent events are clear. Similar to other cryptocurrencies, stablecoins do not always guarantee safety. Investors should approach them with caution, considering not only their potential returns but also the significant risks they carry.
At the same time, regulators must redouble their efforts to bring transparency and oversight to this fast-growing corner of financial markets.
