Decoding Stablecoins as the US Takes Action on Regulation
Stablecoins are digital currencies designed to maintain a stable value by pegging them to a reserve of assets, such as fiat currencies or commodities. They aim to combine the benefits of cryptocurrencies with the stability of traditional currencies, providing a reliable medium of exchange and a store of value in the volatile digital asset market. Stablecoins represent digital assets that possess an intrinsic value, facilitating their use in transactions. These instruments are structured to uphold a consistent value in relation to a designated reference asset, such as a fiat currency exemplified by the US dollar. In contrast to cryptocurrencies, which are subject to considerable price volatility driven by speculative activities and constrained supply dynamics, stablecoins are designed to offer a degree of price stability.
On July 18, the President of the United States signed the GENIUS Act—Guiding and Establishing National Innovation for US Stablecoins—marking the introduction of the nation’s inaugural federal framework for dollar-pegged cryptocurrencies. The legislation requires complete reserve backing in liquid assets, regular monthly audits, and enhanced protections for consumers. In the context of signing the act into law, Trump articulated that it establishes “a clear and simple regulatory framework to establish and unleash the immense promise of dollar-backed stablecoins”. He further stated that the act “could be perhaps the greatest revolution in financial technology since the birth of the internet itself”. The endorsement of the act by Trump has rekindled interest in stablecoins. However, what precisely are they? What distinguishes them from conventional cryptocurrencies?
What underpins stablecoins? Stablecoins can be classified into distinct categories according to the mechanisms of their collateralization. Each category offers a distinct approach to achieving price stability:
1. Fiat-collateralised stablecoins: These stablecoins are underpinned by reserves of fiat currency maintained in bank accounts or alternative arrangements. The most common examples—such as Tether and USD Coin—are pegged to the US dollar. For each unit of stablecoin issued, it is purported that an equivalent amount in fiat currency is maintained in reserve. These stablecoins are fundamentally dependent on the confidence placed in the issuer and the scrutiny of reserve holdings through auditing. Concerns have been articulated previously about the transparency and sufficiency of these reserves, leading nations to investigate regulatory frameworks, such as the GENIUS Act.
2. Crypto-collateralised stablecoins: These instruments are supported by other cryptocurrencies, which are generally over-collateralised to mitigate the effects of price volatility. For example, a widely known decentralised stablecoin is backed by Ethereum and other crypto assets held in smart contracts on the blockchain. Blockchain functions as a decentralized digital ledger, meticulously documenting transactions with a high degree of security, thereby facilitating the tracking of assets throughout a network.
Smart contracts represent digital agreements recorded on a blockchain, which are executed automatically upon the fulfillment of specified terms and conditions. For example, a stablecoin is liquidated when the value of the cryptocurrency backing it falls below a certain threshold. These remain susceptible to the fundamental volatility of the underlying crypto assets and may encounter challenges during periods of market stress.
3. Algorithmic (non-collateralised) stablecoins: These stablecoins employ mathematical formulas and incentive mechanisms to regulate the supply of the coin and uphold a peg, independent of actual collateral. The supply of tokens is automatically adjusted in response to fluctuations in demand. TerraUSD, which collapsed in 2022, was one such example.
4. Commodity-collateralised stablecoins: Certain stablecoins are underpinned by tangible commodities like gold or silver. These include coins such as PAX Gold, where each coin represents ownership of a specific amount of physical gold held in reserve.
Stablecoins fulfill multiple roles within the retail, institutional, and decentralized finance sectors:
Payments: The reduction in transaction fees and the acceleration of settlement times have led to a growing adoption of stablecoins for cross-border transfers, especially in areas where banking infrastructure is scarce. Stablecoins play a crucial role in decentralized finance platforms, functioning as collateral for loans, facilitating liquidity provision, and enabling decentralized exchanges.
In the context of volatility management, it is common for investors to transition their fluctuating cryptocurrency assets into stablecoins as a strategy to safeguard value amid market declines.
Despite their intended stability, stablecoins carry inherent risks. With the expansion of their market capitalisation, there has been an increase in concerns raised by regulators and policymakers. One of the most significant issues at hand is the extent to which stablecoin issuers maintain adequate, liquid, and readily accessible reserves to fulfill redemption requests. Here is where legislation such as the GENIUS Act becomes relevant. It necessitates complete reserve backing with liquid assets such as US dollars or short-term Treasuries and mandates that issuers provide monthly, public disclosures regarding the composition of reserves. The White House press release states, “In the event of insolvency of a stablecoin issuer, the GENIUS Act prioritises stablecoin holders’ claims over all other creditors, ensuring a final backstop of consumer protection”.
With the increasing adoption of stablecoins, various alternatives are being investigated to mitigate their associated risks and limitations, especially by regulatory bodies and central banking institutions.
Central Bank Digital Currencies (CBDCs) represent the most significant alternative. In contrast to stablecoins, CBDCs are issued by central banks and possess sovereign backing. The objective is to provide secure and programmable digital payment solutions that are devoid of the inherent volatility associated with cryptocurrencies. India has introduced a Central Bank Digital Currency (CBDC) supported by the Reserve Bank of India, referred to as the digital rupee or e-rupee. Tokenised deposits represent digital counterparts to traditional bank deposits, facilitated through blockchain platforms. This innovation enables immediate settlement and seamless integration with smart contracts. E-money and digital wallet balances, although not based on blockchain technology, have achieved significant adoption in the market. These instruments are supported by fiat reserves and are subject to current financial regulations.
