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Everything You Need To Know About Stablecoins In 2023

Explore the comprehensive guide to stablecoins, including their mechanics, risks, and types like fiat-backed and crypto-backed. Delve into trust, transparency, and detailed analysis of Tether. Equip yourself with knowledge for the digital currency epoch.

everything you need to know about stablecoins in 2023

Stablecoins, often referred to as dollar-backed coins, play a vital role in the realm of decentralized finance. By being tethered to traditional currencies or other stable resources, they bridge the gap between the decentralized realm of cryptocurrencies and the regulated domain of fiat money.

However, like most cryptocurrencies that utilize blockchain technology, stablecoins function without the oversight mechanisms that are typically present in traditional finance. As a result, their promise of stability heavily relies on the credibility of their issuers and the transparency of their operations.

In this article, we’ll explore the mechanics of stablecoins, their inherent risks, and the strategies to mitigate those risks. We’ll also touch upon the current events shaping the stablecoin narrative and provide insights into their future trajectory. Whether you’re an investor, a financial enthusiast, or someone keen on understanding the digital currency epoch, this comprehensive guide aims to equip you with the knowledge to navigate the complex world of stablecoins.

What are Stablecoins?

According to Investopedia, “Stablecoins are cryptocurrencies whose value is pegged, or tied, to that of another currency, commodity, or financial instrument.” They aim to provide an alternative to the high volatility of popular cryptocurrencies, making them more suitable for common transactions. The main objective of stablecoins is to serve as a medium of exchange, ensuring that their value remains relatively stable, making them more practical for everyday transactions.

Essentially, stablecoins are cryptocurrencies designed to mirror the value of a real-world currency. This integration brings together the advantages of both realms: the decentralized, borderless nature of cryptocurrencies and the stability of traditional currencies. By maintaining a stable value, these digital assets become more practical for everyday transactions, from buying a cup of coffee to facilitating large-scale business deals.

Trust and Transparency in Stablecoins

In the world of finance, trust and transparency are not mere virtues; they are foundational pillars. However, for stablecoins, these principles are even more critical due to the fact that the value of stablecoins is directly tied to the assets backing them. As a result, trust and transparency from the issuing company become absolutely essential.

Consider this: when one acquires a stablecoin, they are essentially trading a tangible asset, say a US dollar, for a digital representation of that asset. This transaction is underpinned by the belief that the issuer of the stablecoin holds an equivalent reserve of the asset in question.

But how can one be certain?

The answer lies in the transparency of the issuer’s operations, as well as the frequency and credibility of their reports.

Without regular audits and clear communication, even the most prominent stablecoins can become subjects of skepticism and doubt. It’s not just about having the reserves; it’s about frequently verifying their existence and quality.

Types of Stablecoins

Stablecoins, representing approximately 10% of the entire cryptocurrency market, serve as pivotal instruments for trading, transferring, and transitioning between other digital assets. While the foundational principle of stablecoins remains consistent—each issued token is backed by a tangible asset—the nature of this backing varies.

  • Fiat-Backed Stablecoins: Predominantly found in the market, these stablecoins are anchored to real-world currencies, maintaining a one-to-one ratio. For instance, an issuer with a reserve of one million U.S. dollars might circulate an equivalent one million stablecoins, each pegged to a dollar’s value. Notable examples include Tether (USDT) and USD Coin (USDC).
  • Commodity-Backed Stablecoins: Anchored to tangible commodities such as gold, real estate, or precious metals, these stablecoins offer a unique proposition. Tokens like Paxos Gold (PAXG) and Tether Gold (xAUT) enable users to tap into the gold market, bypassing the intricacies of physical ownership.
  • Crypto-Backed Stablecoins: These stablecoins leverage other cryptocurrencies as collateral to maintain their peg, removing the necessity for centralized financial intermediaries. Notably, DAI (DAI) exemplifies this category, where “Individuals receive DAI tokens by depositing cryptocurrency as collateral, and are typically over collateralized,” meaning that the backing cryptocurrency’s value exceeds that of the coin itself.
  • Algorithmic Stablecoins: In contrast, these stablecoins lack tangible collateral support. They employ algorithms to regulate their token supply and circulation, ensuring consistent price stability. However, it’s important to note that stablecoins based on algorithms have shown “inherent architectural weaknesses,” rendering them more susceptible to de-pegging risk.

Of the various stablecoins currently in the market, Tether ($USDT) and USD Coin (USDC) are by far the largest and most commonly used. As a result, their operations and trustworthiness receive the highest levels of scrutiny and attention.

Tether ($USDT): A Comprehensive Analysis

Tether, often recognized by its ticker USDT, stands as a dominant stablecoin tethered to the US dollar. Its terms of service accentuate transparency and regulatory compliance, but a deeper dive into its financial operations offers a more nuanced perspective.

USDT: Reserves Appear Healthy

The Attestation Report for Tether in Q2 2023 provides a detailed snapshot of its fiscal health. A striking detail is Tether’s substantial stake in U.S. Treasuries, with holdings amounting to an impressive $55.8 billion in U.S. Treasury bills. When contextualized, if Tether were to be ranked among nations, it would sit 24th globally in terms of U.S. Treasury holdings, nestled between countries like Mexico and Thailand. This positions Tether as a formidable player on the global stage.

George Kaloudis from CoinDesk offers additional insights, highlighting Tether’s strategic shift towards more U.S. Treasuries and fewer private debts. He also points to the $8.9 billion in overnight reverse repurchase agreements and $8.1 billion in money market funds, which further attest to Tether’s robust financial position.USDT: Space For Speculation

While Tether’s Q2 2023 financial report portrays assets that surpass its market capitalization, the classification of $2.4 billion as “Other Investments” raises queries about the nature of these holdings.

Notably, Tether reported a 30% growth in operational profit, amounting to $1 billion between April and June 2023. Although this achievement is impressive, it also invites consideration about the stability and volatility of Tether’s reserves. While these numbers themselves don’t necessarily foretell any negative outcome, the absence of regulation governing their reserves does call for an extra level of caution.

As the cryptocurrency landscape continues to evolve, the trajectory of Tether’s journey will undoubtedly be one to observe closely.

Circle’s USDC: A Comprehensive Overview

Circle’s USDC, also known as USD Coin, is a prominent digital token issued by Circle Internet Financial, LLC. It functions across a variety of blockchains, collectively termed as the “USDC Supported Blockchains.” Designed as a form of stored value or prepaid access, USDC operates under the regulatory umbrella of money transmission laws across several U.S. states and territories.

USDC’s Regulatory Framework

USDC’s Regulatory Framework USDC’s terms, as delineated on Circle’s website, stress its issuance by Circle and its operation on supported blockchains. It’s regulated as stored value in the U.S., specifically for USDC issued by Circle. Recent attestations indicate that 90% of USDC’s liquidity resides with a prominent global bank, bolstering investor confidence in the coin’s tangible asset backing.

USDC: A Transparent Yet Limited Protection

While USDC touts comprehensive regulation, there might be nuances in its regulatory landscape that warrant closer inspection. In this initial phase of adopting blockchain technology, the digital asset markets and exchanges do not adhere to the same controls or offer the same customer protections as other financial products. Furthermore, these markets operate within a constantly evolving regulatory environment. It’s important to note that digital assets such as USDC usually lack legal tender status and aren’t covered by deposit protection insurance.

Headline News: PayPal ($PYPL) Enters The Field

On August 7, 2023, the globally recognized digital payments giant PayPal, has taken a bold step with the launch of its U.S. dollar-pegged stablecoin, PayPal USD. This move wasn’t a standalone initiative; it was a strategic alliance with Paxos Trust Company, a New York-based fintech firm with a strong foundation in blockchain technology.

PayPal’s dive into the stablecoin realm appears to align with a broader trend of increasing interest in digital currencies within the financial sector. However, as with any innovative initiative, it comes with its distinct set of challenges, particularly within a regulatory environment that is still grappling with the complexities of the cryptocurrency space.

While the SEC’s heightened scrutiny of crypto entities is apparent, a clearly defined regulatory framework for stablecoins is still in the process of being developed. This regulatory uncertainty introduces a level of uncertainty to the future trajectory of these digital assets, leading some to question why a powerhouse like PayPal would choose to enter this arena at this particular time.

Central Bank Digital Currency (CBDC)

Central Bank Digital Currencies, commonly referred to as CBDCs, represent a transformative step in the evolution of money. They are digital forms of a country’s official currency, issued and governed by its central bank. Unlike cryptocurrencies, which operate on decentralized platforms, CBDCs are centralized, offering a blend of the traditional banking system’s stability with the efficiency of digital transactions.

There are three types of CBDCs:

  1. Direct CBDCs: These are digital currencies where the central bank deals directly with the public. It implies that the central bank has the sole responsibility for all aspects, from issuance to management and regulation.
  2. Indirect CBDCs: Here, the central bank involves intermediaries, often commercial banks, to handle the customer-facing side of operations. While the central bank issues the currency, the distribution and management are done by these intermediaries.
  3. Hybrids: As the name suggests, hybrid CBDCs combine elements of both direct and indirect types. The central bank might issue the currency and also involve intermediaries in some aspects of distribution or management.

The implications of CBDCs are vast. On the positive side, they can enhance payment efficiency, reduce transaction costs, and provide financial inclusion to those without traditional banking access. However, concerns arise regarding privacy, potential misuse, and the impact on traditional banking systems.

Yet, the true challenge lies in striking a balance. While CBDCs offer numerous advantages, it’s crucial to ensure they don’t destabilize the existing financial ecosystem or infringe upon individual rights. The world of CBDCs is a delicate one, requiring careful navigation to harness its benefits while mitigating potential risks.

USPC Stablecoin: Backed 2:1 By Cash & Real Estate

Set to launch later in 2023, USPC is our new stablecoin owned and managed by the security token USP. Like other stablecoins such as USDT and USDC, USPC will be pegged 1:1 to the U.S. dollar, ensuring its value remains consistent with the fiat currency. What truly sets USPC apart, however, is its distinctive reserve strategy.

USPC Stablecoin

As a stablecoin owned by a company who owns and manages a real estate portfolio, USPC will maintain a 2:1 backing by cash and real estate. Compared to USDT and USDC, which rely solely on collateral in the form of cash or cash equivalents, USPC distinguishes itself by being fully backed with cash – and overcollateralized by the properties in USP’s portfolio.

USP Security Token

United States Property, Inc. (USP) is a security token that signifies fractional ownership in a corporation overseeing a tokenized real estate portfolio and the USPC stablecoin. Analogous to stocks, bonds, and REITs, these tokens serve as digital shares of the corporation existing on the blockchain.

USP & USPC Synergy

The profits from the USPC stablecoin, combined with the portfolio’s monthly rental income, are retained in the assets backing the stablecoin as compounding returns. This strategic fusion is designed to provide unparalleled stability and trust to ensure there are always more than enough assets in reserves.

Inherent Risks of Stablecoins

The decentralized finance (DeFi) space, while promising, is full of uncertainties. One of the most debated topics within this realm is the inherent risks associated with stablecoins. Despite being pegged to traditional currencies and offering value stability, these digital assets present their distinct array of challenges that investors must fully comprehend.

Proof of Reserves (Trust and Transparency)

Stablecoins, by design, promise a 1:1 peg with traditional currencies, such as the US dollar. The truth is, many stablecoin issuers who claim to hold equivalent reserves, aren’t mandated to undergo rigorous third-party audits. Tether, for instance, has been at the center of controversies regarding its reserves. While it’s one of the largest stablecoins with a significant market capitalization, its history is marred with questions about its reserve backing. Without proper audits and transparency, the very foundation of stablecoins – trust – is at risk.

Quality of Reserves

Beyond the mere existence of reserves, the quality of these reserves is paramount. Not all reserves are created equal. While cash remains king, short-term cash equivalents like treasury bonds, bank deposits, and money market funds are also considered robust. A diversified and high-quality reserve ensures that the stablecoin can weather market fluctuations and maintain its peg.

Regulatory Uncertainty

The realm of cryptocurrencies, especially within the DeFi sector, is notably characterized by a considerable absence of regulatory structure. This lack of clear oversight gives rise to inherent risks within the ecosystem, including potential transparency issues and the lack of accountability in cases of fraud or manipulation.

As the stablecoin domain evolves and matures, the call for a well-defined regulatory framework becomes increasingly pronounced. Until such a framework is established, the responsibility falls on investors to navigate this space with caution and due diligence.

USDC Bank Run: What Happens If Holders Doubt The Reserves

Just as a traditional bank maintains deposits and extends loans, a stablecoin issuer, in many ways, operates similarly. They hold deposits, and in return, issue digital tokens, each pegged to a traditional currency, like the US dollar. The trust in these tokens is built on the presumption that for every token in circulation, there’s an equivalent amount in reserve.

Circle, the company behind USDC, faced a crisis of confidence in early 2023. With about $3 billion deposited in Silicon Valley Bank (SBV), concerns arose when SBV’s financials showed a mismatch between its assets and liabilities.

This situation mirrored a classic “Bank Run“, with depositors, including Circle, rushing to withdraw. For USDC, this resulted in a massive sell-off, as token holders feared potential insolvency. The episode highlights the critical need for transparency and the risks present even in the regulated world of fiat.

Judging Strength or Trustworthiness of a Stablecoin

Trust and transparency are the cornerstones of a stablecoin’s ability to maintain its peg. However, without proper regulation, confirming these attributes becomes a challenge. To navigate this conundrum and minimize risks, potential users should evaluate several key factors before adopting a stablecoin.

Regulatory Adherence

The cryptocurrency landscape is still evolving in terms of regulation. Some regions have already started developing specific guidelines for stablecoins, aiming to enhance transparency, combat fraud, and ensure financial stability. As evidenced by the experiences of USDT and USDC, the onus of adhering to these regulations, or at least the existing ones, primarily lies with the issuer.

Attestation: A Reliable Report or Just Smoke & Mirrors?

Attestation is the process where an independent entity verifies a stablecoin issuer’s claims about its reserves. Renowned audit firms usually conduct these reports, providing investors with a glimpse into the issuer’s financial health.

While these attestations can boost a stablecoin’s credibility, it’s essential to ensure that the report comes from a reputable and recognized source. A deeper dive into the auditing firm’s background and its relationship with the issuer might be necessary to gauge the report’s authenticity. This cautionary stance is emphasized by the Public Company Accounting Oversight Board (PCAOB), which warns investors to “exercise extreme caution” when relying on proof of reserve reports (PoR Reports) that are frequently prepared by third-party firms on behalf of various crypto companies.

Quality of Reserves

As previously highlighted, a stablecoin’s strength is intrinsically tied to the quality of its reserves. Ideal reserves are liquid and stable assets, like cash or short-term government securities. Such reserves ensure that issuers can promptly fulfill redemption requests.

Conversion Mechanisms

The ability to efficiently convert stablecoins back to traditional currency is vital. Trustworthy issuers facilitate a smooth conversion process, allowing users to transition seamlessly between the digital token and fiat currency.

Remedies for Users

In scenarios where an issuer faces financial challenges or engages in unethical practices, stablecoin holders should have avenues for recourse. These might include legal actions or claims against the issuer’s reserves. However, the effectiveness of these remedies often hinges on the current regulatory landscape and the terms set by the issuer.

Current Events

In the pursuit of regulatory clarity, the blockchain space is never short of excitement. Turning to the legislative front, the U.S. Congress made notable strides in July 2023, as evidenced by the Senators’ Stablecoin Bill. This development marks a departure from previous initiatives and has the potential to mold the regulatory landscape for stablecoins in the United States.

This proposition followed the recent remarks from Jerome Powell, the Chair of the U.S. Federal Reserve, who characterized stablecoins as a form of currency. This viewpoint stands in stark contrasts with the SEC’s stance that, “stablecoins backed by securities might be treated as securities under U.S. law.” However, as noted in the recent SEC v. Ripple ruling by Judge Torres, “a standalone commodity, which is not itself inherently an investment contract, does not indicate the tokens themselves are securities.”

Global Stablecoin Adoption

Internationally, some countries treat stablecoins as a form of money, while others categorize them as securities or prepaid payment instruments. Switzerland’s Financial Market Supervisory Authority (FINMA) equates stablecoins with other blockchain tokens. In contrast, Japan’s Financial Services Agency (FSA) perceives them as prepaid payment instruments rather than traditional cryptocurrencies. These distinctions, though nuanced, profoundly impact the regulation and utilization of stablecoins within these nations.

End Note: Are Stablecoins Safe?

While stablecoins can indeed offer a buffer against the notorious volatility of other cryptocurrencies, they warrant due caution and consideration. It’s crucial to stay informed, understand the mechanisms that underpin your chosen stablecoin, and be aware of the potential risks. Diversifying holdings, using reputable wallets, and regularly auditing the issuing entities are some ways to mitigate these risks.

However, a stablecoin’s safety fundamentally hinges on the trust users place in the centralized entity that issues it. In the realm of finance, trust is a delicate asset, evident from the fall of even ‘too big to fail’ giants in history. Given stablecoins’ connections to short-term treasury bonds, banks, and various financial institutions, the web of trust broadens.

Thus, trust extends beyond a single entity to encompass multiple institutions, corporations, and even governments. The question then isn’t just about the safety of stablecoins. It’s also about the fundamental essence of trust in fiat currency and the overall system.

And that should speak volumes.

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