Everything You Need to Know About Stablecoin Payments

Stablecoin payments offer a reliable alternative to traditional cryptocurrencies, pegged to the value of a fiat currency or a commodity. They're designed to minimize price volatility, making them a more attractive option for everyday transactions.

One of the key benefits of stablecoin payments is their low risk of price fluctuations. This is because they're backed by a reserve of assets, such as US dollars or gold, which maintains their value.

Stablecoins can be used for a wide range of transactions, including online purchases, remittances, and even microtransactions. They're also being explored for use in cross-border payments and as a store of value.

Types of Stablecoins can be broadly categorized into four main types: Fiat-backed, Reserve-backed, Commodity-backed, and Algorithmic stablecoins.

Fiat-backed stablecoins, like Tether and TrueUSD, are pegged to the value of a fiat currency, such as the US dollar. Their stability relies on the trust in the custodian of the backing asset.

Reserve-backed stablecoins, on the other hand, are stabilized by other assets, but in practice, few meet the assumptions required for stability.

Commodity-backed stablecoins, such as those backed by gold or other precious metals, have a fixed value tied to the commodity and can be redeemed for the backing asset.

Here's a breakdown of the main characteristics of each type of stablecoin:

Each type of stablecoin has its own strengths and weaknesses, and understanding these differences is essential for making informed decisions about stablecoin payments.

Reserve-backed stablecoins are digital assets that are stabilized by other assets. They work by having a mechanism for redeeming the asset(s) backing them, making it unlikely to drop below the value of the underlying physical asset due to arbitrage.

However, few reserve-backed stablecoins meet these assumptions in practice. They are subject to the same volatility and risk associated with the backing asset.

If a reserve-backed stablecoin is backed in a decentralized manner, it's relatively safe from predation. But if there's a central vault, it may be robbed or suffer loss of confidence.

In some cases, reserve-backed stablecoins can be redeemed from the issuer, making them a reliable option for users. However, the trust in the custodian of the backing asset is crucial for the stability of the stablecoin's price.

Here are some key characteristics of reserve-backed stablecoins:

Cryptocurrency-backed stablecoins are issued with cryptocurrencies as collateral, similar to fiat-backed stablecoins, but with a significant difference. The collateralization happens on the blockchain, using smart contracts in a more decentralized fashion.

This design allows users to take out a loan against a smart contract via locking up collateral, making it more worthwhile to pay off their debt should the stablecoin ever decrease in value.

A user who takes out a loan may be liquidated by the smart contract should their collateral decrease too close to the value of their withdrawal.

The value of the stablecoin is collateralized by another cryptocurrency or a cryptocurrency portfolio, and the peg is executed on-chain via smart contracts.

The supply of the stablecoins is regulated on-chain, using smart contracts, and price stability is achieved by introducing supplementary instruments and incentives, not just the collateral.

Here are the significant features of crypto-backed stablecoins:

This type of stablecoin has a more complex technical implementation than fiat-collateralized stablecoins, which introduces a greater risk of exploits due to bugs in the smart contract code.

Some stablecoins, like USDT, have raised concerns about their creation and backing. Research attributed the creation of unbacked USDT to the rise in Bitcoin's price in 2017.

Tether, the issuer of USDT, has been accused of failing to produce audits for reserves used to collateralize the quantity of minted USDT stablecoin. This lack of transparency has led to speculation about the backing of USDT.

Research has indicated little to no evidence that Tether's minting events influence Bitcoin values unless they are publicized to the public.

Tether, the world's largest market capitalization stablecoin, has been accused of failing to produce audits for the reserves used to collateralize the quantity of minted USDT stablecoin.

This lack of transparency has led to speculation about the true backing of USDT. Tether has since issued assurance reports, but some doubts remain.

Tether's failure to provide regular audits has raised concerns about the stability of the USDT stablecoin.

De-Pegging is a major concern for stablecoin investors. Many projects can advance a product and call it a stablecoin, but that doesn't necessarily mean it's stable.

TerraUSD and other stablecoins have been crashed to zero in the past. This shows that even with a stablecoin name, there's no guarantee of stability.

The issue lies in the fact that digital assets can be built to many different standards. This lack of standardization can lead to instability in the market.

Projects like TerraUSD have historically needed more stability than they've been able to provide. This is a clear example of the risks associated with de-pegging.

Some researchers have linked the creation of unbacked USDT to the rise in Bitcoin's price in 2017. This suggests that the value of USDT may be influenced by external market forces rather than its own stability mechanisms.

Griffin and Shams' research found little to no evidence that Tether USD minting events influenced Bitcoin values unless they were publicized to the public by Whale Alert.

Defunct stablecoins have made headlines in recent years, serving as a cautionary tale for investors and users alike. The Basis stablecoin project, which had received over $100 million in venture capital funding, shut down in December 2018 due to concerns about US regulation.

One notable example of a stablecoin crash is Terra's UST, which fell from $1 to 26 cents in May 2022. This event led to the failure of Terraform Labs and resulted in a significant loss of nearly $40B invested in the Terra and Luna coins.

Facebook's Libra, now known as Diem, was also abandoned by the company and later purchased by Silvergate Capital. This shows that even established players in the tech industry can face challenges in the stablecoin space.

The Terra stablecoin crash resulted in the arrest of its founder, Do Kwon, on an Interpol notice in Montenegro. This highlights the serious consequences of stablecoin failures and the importance of regulatory oversight.

Here are some examples of defunct stablecoins:

The regulatory environment for stablecoin payments is a complex and rapidly evolving landscape. Nellie Liang, Under Secretary of the Treasury for Domestic Finance, has emphasized the need for Congressional regulation due to the rapid growth of the stablecoin market.

In May 2024, US legislation aims to provide increased regulatory clarity for digital assets, but the Financial Innovation and Technology for the 21st Century Act currently excludes certain stablecoins from regulation by the SEC, except for fraud and certain activities by registered firms.

The McHenry Stablecoin Bill seeks to regulate aspects like the legal authority for issuing stablecoins, regulatory oversight of issuers, and the classification of stablecoins. This bill has passed the House committee with bipartisan support and is expected to be enacted into law.

The McHenry bill proposes the following key aspects of the regulatory environment:

The regulatory environment for stablecoins is still taking shape, and there are some limitations to be aware of. Nellie Liang, Under Secretary of the Treasury for Domestic Finance, has reported to the Senate banking committee that urgent Congressional regulation is needed.

The Financial Innovation and Technology for the 21st Century Act, currently in its May 2024 draft, aims to provide increased regulatory clarity for many digital assets. However, it excludes certain stablecoins from regulation by the SEC.

Certain stablecoins are exempt from SEC regulation, except for cases of fraud and specific activities by registered firms. This means that some stablecoins may not be subject to the same level of oversight as others.

The Payment Clarity Act is a significant development in the regulatory environment of cryptocurrencies. It seeks to regulate aspects like the legal authority for issuing stablecoins and regulatory oversight of issuers.

The Act aims to bring divergent parties to an agreement on stablecoin matters. Recent developments in the cryptocurrency space have led to increased adoption, yet despite the benefits of growth and utility, the space has also attracted thorough scrutiny from lawmakers.

The McHenry bill, a key part of the Act, passed the House committee with bipartisan support. This is a notable achievement, as other efforts have failed to garner sufficient support to make significant headway into becoming law.

Nonbanks would have the authority to issue stablecoins under the Senate version of the McHenry bill, provided the nominal value is below $10 billion. This means that issuers with amounts exceeding that limit must be authorized as a depository institution to earn the right to become a national payment stablecoin issuer.

The McHenry Bill is a significant piece of legislation that aims to regulate the stablecoin industry in the US. It's currently being considered by Congress and has already passed the House committee with bipartisan support.

The bill sets out requirements for entities with the legal authority to issue payment stablecoins, which would prevent unpermitted issuers from violating the law. This includes a provision that only stablecoins issued on public blockchains would be considered payment stablecoins, promoting transparency through public ledgers.

The McHenry Bill also proposes bank-like regulation for federal-qualified nonbank payment stablecoin issuers, including risk management, liquidity, and capital requirements. This could increase the influence of centralized financial institutions on stablecoins, a concern at the heart of decentralized finance.

Here are some key points about the McHenry Bill:

The bill also includes an extraterritorial clause, which means companies outside the US would be subject to its provisions, as seen with Tether, a company domiciled in the British Virgin Islands. This would require Tether to comply with the legislation to issue its USDt stablecoin to US residents.

The stablecoin industry has grown rapidly, with over $100 billion in total market capitalization. This growth is largely driven by the increasing adoption of stablecoins in traditional finance and the rising popularity of decentralized finance (DeFi) applications.

Tether (USDT) is the largest stablecoin by market capitalization, with over $60 billion in circulation. It's widely used for cross-border payments and as a store of value.

Stablecoins have also become a popular choice for investors looking to reduce their exposure to cryptocurrency price volatility. By pegging their value to a fiat currency, stablecoins offer a more stable store of value compared to traditional cryptocurrencies.

Ripple's RLUSD industry relevance lies in its ability to provide a stable store of value, pegged to the US dollar, which is not subject to the same volatility as other cryptocurrencies.

Ripple's RLUSD is designed to be used in cross-border payments, reducing the need for correspondent banking and increasing the speed and efficiency of international transactions.

Ripple's partnership with banks and financial institutions has helped to increase the adoption of RLUSD, making it a more widely accepted stablecoin.

By using a stablecoin like RLUSD, businesses can reduce their exposure to exchange rate fluctuations and increase the speed of their international transactions.

Ripple's technology, including its distributed ledger technology, is also being used to develop other stablecoins that can be used for a variety of purposes.

Circle's Policy Principles aim to promote a stable and secure stablecoin ecosystem.

The company emphasizes the importance of compliance with anti-money laundering (AML) and know-your-customer (KYC) regulations.

Circle's principles also prioritize transparency, encouraging open communication with regulatory bodies and the public.

To achieve this, Circle has implemented a robust system for tracking and reporting suspicious transactions.

The company's commitment to transparency is reflected in its decision to publicly disclose its reserve breakdown.

Circle's policy principles are designed to foster trust and cooperation within the stablecoin industry.

This approach has earned Circle recognition from regulatory bodies, including the New York State Department of Financial Services (NYDFS).