The Lowdown Hub

What are stablecoins and how do they work?

FT banking and fintech reporter Siddharth Venkataramakrishnan looks at how the digital assets are used, why they are growing in popularity - and why they are in regulators' sights

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Stablecoins have long been a key part of the cryptocurrency economy. But this year has seen them shoot to prominence in the broader world. The nominal value of these coins is stability is held by pegging to other assets, such as dollars, has risen by around $100 billion since the start of the year, setting off alarm bells for regulators.

For years, stablecoins consistent value combined with the lack of friction have made them a favoured method of buying other more volatile digital assets, instead of using Fiat currencies. It is also made them an effective dollar alternative in parts of the world where access can be more limited. But companies are increasingly pitching stablecoins as a payment system for the non-crypto world, arguing that they can provide faster and cheap money transmission around the globe. This is best reflected in the ambitions of Coinbase and Circle's USD coin, and Pax dollar, which is currently working with Meta's digital wallet, Novi, to run a pilot scheme in parts of the US and Guatemala.

Their rise in popularity has drawn growing attention from regulators though on a number of fronts. The first is around the question of financial stability and consumer protection. The oldest and largest cryptocurrency, Tether, has had to settle with both the New York Attorney General's office and the Commodity Futures Trading Commission this year over claims that has misled consumers about the status of its reserves.

Even today, all that is known about roughly half the more than $72 billion worth of underlying assets backing its coins is that they are in commercial paper, a form of short term debt whose issuers' identities, or even their nationalities remains unknown. Ratings agency, Fitch, warned earlier this year the large amounts of commercial paper held by stablecoins such as Tether, could have major consequences for the debt markets. Although experts have pointed out that issues such as bank runs are less of a problem, given that stablecoin operators can effectively choose when to redeem their coins for cash.

The other use of stablecoins has also caught regulators eyes. Meta's Diem project, formerly known as Libra, helped spur the early regulatory movement over fears that a digital dollar by a private company could impact monetary policy making, make capital flight easier, and further consolidate power in the hands of tech titans. Early in November, the US president's working group on financial markets, which includes the heads of key regulators, such as the US Treasury and the Securities Exchange Commission, released a long anticipated report on stablecoins.

It called on Congress to ensure that they were regulated as banks, a move which would offer greater oversight over the nature of their reserves, and the general operations of the US based stablecoins. Pax also received conditional approval for a bank charter from the Office of the Comptroller of the Currency earlier this year, while Circle says that it intends to apply to become a bank as well. The President's Working Group also suggested two legislative amendments more squarely aimed at the second use of stablecoins.

The first was to include digital wallets, which would include Novi, under federal oversight. While the other would be to limit the affiliation of stablecoin issuers with commercial entities, a decision which would potentially impact Meta, but also preemptively affect other companies who sought to create their own digital dollars in the future. There is also the potential challenge of central bank digital currencies, often pitched as a government controlled alternative to private stablecoins with direct access to central bank vaults, and in greater transparency.

The question of whether the two forms of digital money can coexist remains unanswered. Although, international regulators have suggest that it is not impossible. so long as stablecoins are effectively and closely regulated. And while Diem has struggled to make headway with regulators amid the continued fallout over Meta's corporate behaviour, its proposal that a stablecoin could help form the rails for future government digital currencies may yet come to pass.