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Cryptocurrency: What are stablecoins and why are governments so worried about them?

12 May 2022 Jonty Sacks, Partner at Jaltech

A stablecoin is a cryptocurrency where the underlying value is backed by a reserved asset, such as the US dollar, gold, or other assets of value.

Stablecoins have become a popular form of cryptocurrency for market participants who use cryptocurrencies for transactional purposes as these digital assets are far less volatile than other forms of cryptocurrencies.

Albeit a much newer asset class than that of Bitcoin or Ether, stablecoins have grown exponentially over the past 3 years with the most dominant being Tether (USDT), a US dollar-backed cryptocurrency with a market cap of over USD 78 billion, followed by USD Coin (USDC) with a market cap of over USD 37 billion.

When compared to traditional banking transactions, stablecoin payments can be settled within minutes, 24 hours a day, 365 days a year, whereas traditional payments require anywhere from 24 – 72 hours for settlement and are only available during business hours. When one compares the cost of transacting, stablecoins transaction fees are a small percentage of traditional banking fees.

Stablecoins do not by any stretch of the imagination have the return and risk profile of the majority of cryptocurrencies in the market, they do however, play a vital role. Here are a few examples of their use case:

Payments

The cryptocurrency market is very volatile, as a consequence, the rapid price movement makes it difficult for market participants to settle a transaction at the intended value. For example, if you were to use Bitcoin to settle a transaction, the recipient of the transaction could receive less or more than what is owed, simply due to the high price volatility of the digital currency.
Stablecoins on the other hand are backed by physical assets which reduce volatility and allow users to manage the risk of price volatility.

Dollar/physical asset exposure:

Stablecoins give the holder exposure to physical assets such as foreign currency, gold, and other commodities. Stablecoins offer a cost-effective way of gaining exposure to physical assets without having to transact through traditional banks or other expensive intermediaries. Lower transaction costs, greater accessibility and increasing liquidity make stablecoins an attractive instrument.

Holding pattern

In times of volatility or uncertainty, investors sell out of their cryptocurrency position and transfer their value to stablecoins. They do this to protect their investment and limit exposure to price volatility. When conditions are favourable for the investor to re-enter the market, stablecoins can then be seamlessly converted back into cryptocurrency,

From a government perspective, stablecoins are not formally recognized. The issuers behind these coins are not beholden to rules and regulations which govern the formal banking sector (although this may soon change). The consequence of which could result in mismanagement of investor capital which would have negative consequences for the holders of stablecoins as well as knock-on effects for the ecosystems in which they are used.

From an investment case perspective, although stablecoins have an excellent use case, investors who are looking for the asymmetric return profile associated with cryptocurrency investing would do well to assess the value proposition of cryptocurrencies outside of stablecoins, as the potential for high growth is limited to the performance of the underlying asset.

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