Original: https://www.ecb.europa.eu/pub/financial-stability/macroprudential-bulletin/html/ecb.mpbu202207_2~836f682ed7.en.html
Written by Mitsu Adachi, Pedro Bento Pereira Da Silva, Alexandra Born, Massimo Cappuccio, Stephanie Czák-Ludwig, Isabella Gschossmann, Georg Paula, Antonella Pellicani, Sarah-Maria Philipps, Mirjam Plooij, Ines Rossteuscher, and Pierfrancesco Zeoli
Stablecoins have attracted attention due to their rapid growth, increasing global use cases, and potential conduits for financial risk contagion. This article analyzes the role of stablecoins in the broader cryptoasset ecosystem and finds that some existing stablecoins are already critical to the liquidity of cryptoasset markets. If a large stablecoin fails, this could have wide-ranging implications for the crypto asset market, as well as a contagion effect if the linkage between crypto assets and the traditional financial system continues to increase. To date, the speed and cost of stablecoin transactions, as well as the terms and conditions of their redemption, have not met the requirements of the actual payment methods in the real economy. Their growth, innovation and increasing use cases, combined with their potential contagion channels for the financial sector, call for the urgent implementation of effective regulatory, supervisory and supervisory frameworks before significant further interconnections with the traditional financial system can occur.
1 Introduction
Stablecoins are currently in the spotlight of policymakers due to their rapid growth, increasing global use cases, and potential conduits for financial risk contagion. Stablecoins are part of a broader ecosystem of cryptoassets and what are often referred to as unsecured cryptoassets. They were developed to address the high price volatility of unsecured cryptoassets such as Bitcoin and Ethereum, and their relatively low price volatility dooms stablecoins to many functions that require this property. However, events in early May suggest that stablecoins may not be all that stable. Their reserve assets (in the case of collateralized stablecoins) give them a direct link to the traditional financial sector, which deserves the attention of policymakers.
A stablecoin is a digital unit of value that relies on a stabilizing instrument to maintain a stable value relative to one or more official currencies or other assets, including encrypted assets. Stability tools include reserve assets held by stablecoins that can be redeemed, as used by so-called collateralized stablecoins, and algorithms that match supply and demand to maintain a stable value, as used by so-called algorithmic stablecoins.
This article discusses the financial stability implications of stablecoins' current role in the cryptoasset ecosystem. First, it analyzes the importance of stablecoins in the broader crypto-asset market, before examining whether they meet the requirements of an actual means of payment in the real economy. The article concludes by emphasizing the current role of stablecoins in financial stability and the importance of their regulation.
2 The role of stablecoins in the encrypted asset ecosystem
The use of stablecoins in the cryptoasset ecosystem has multiplied in recent years. Initially, stablecoins were mainly used as a relatively safe "parking space" for cryptocurrency fluctuations and as a bridge for trading encrypted assets. But with the rise of decentralized finance (DeFi) applications, stablecoins have found new uses.
Stablecoins represent only a small fraction of the overall crypto asset market, but the largest ones already play a key role in the crypto asset ecosystem. Despite their market capitalization increasing from €23 billion in early 2021 to just under €150 billion in the first quarter of 2022, stablecoins still account for less than 10% of the entire cryptoasset market. However, due to their frequent use in crypto asset trading and as liquidity providers in DeFi, they have become an important part of the crypto asset ecosystem. This especially applies to the stablecoins that dominate the market. Tether, USD Coin, and Binance USD are all collateralized stablecoins, accounting for approximately 90% of the entire stablecoin market. Other stablecoins with significant shares include algorithmic stablecoin DAI and TerraUSD, which until its crash on May 9 wiped off almost all of its market cap.
Tether, the largest stablecoin in existence, has become crucial in crypto asset trading. A major activity using stablecoins is crypto asset trading, where they act as a bridge between official currencies and crypto assets. Driven by Tether, trading volumes of stablecoins overtook trading volumes of unsecured cryptoassets during 2021, reaching an average quarterly volume of EUR 2.96 trillion, almost as much as US equities on the New York Stock Exchange (EUR 3.12 trillion). ) is flat. Additionally, Tether is involved in half of all bitcoin and ethereum transactions, a higher percentage than bitcoin and ethereum transactions against official currencies, accounting for about 65% of all transactions.
Tether dominates trading volume in the cryptoasset ecosystem, and stablecoins provide most of the liquidity for decentralized exchanges and lending.
Stablecoins provide most of the liquidity in DeFi applications such as decentralized exchanges and lending protocols. In May 2022, stablecoins provide about 45% of liquidity on decentralized exchanges (DEX). Roughly half of this is provided by collateralized stablecoins. However, for collateralized stablecoins such as Tether and USD Coin, the liquidity supply for decentralized exchanges or lending is relatively low (less than 8%) compared to their total market capitalization. This suggests that they are still primarily used for other purposes within the cryptoasset ecosystem. In contrast, for algorithmic stablecoins like DAI (over 30%) and TerraUSD (over 75% before the crash), liquidity provision in DeFi represents a significant portion of their total market cap. So, for these particular stablecoins, usage in DeFi is very important.
3 Stablecoins as a means of payment
Stablecoins do not meet the requirements of the actual means of payment in the real economy. Several technical aspects of how stablecoins fall short of what is needed for payments in the real economy are elaborated below, but do not include a detailed comparison with traditional payment systems that offer other benefits such as legal certainty, settlement finality, and operational resilience .
European payment service providers (PSPs) are not very active in the stablecoin market and offer limited stablecoin payment services. One reason for the lack of activity could be regulatory uncertainty ahead of the adoption of Markets in Cryptoassets (MiCA) regulations. Most service providers active in the EU stablecoin market are registered in the EU, only a few are authorized as PSPs, and most are registered as virtual asset service providers (according to the current Anti-Money Laundering/Counter-Terrorist Financing (AML)/CFT) framework). Activities vary widely among EU member states. Stablecoin-related services in the EU mainly consist of acquiring, holding or selling through different means, while currently there is limited availability of services for using stablecoins at merchants. Most stablecoins offered by EU PSPs are still pegged to the U.S. dollar, with only a few offering stablecoins pegged to the euro.
Transaction speeds vary by blockchain, but are slow for stablecoins issued on major blockchains. Transaction speed, as measured by the confirmation time of an average transaction, varies from blockchain to blockchain, and in particular depends on the consensus mechanism used. Other factors such as block times and sizes, transaction fees, and network traffic can also affect transaction speed. The Ethereum blockchain remains the primary blockchain on which many stablecoins operate, although this is changing. The duration between transaction blocks for the largest stablecoins on the Ethereum blockchain, such as Tether, USD Coin, and DAI, is comparable to Ethereum and faster than Bitcoin transactions. However, transaction times are not as near-instantaneous or real-time as needed for use in brick-and-mortar point-of-sale or e-commerce. Additionally, stablecoins on the same blockchain have different transaction speeds between smaller and less liquid stablecoins and stablecoins pegged to real assets like gold, which have longer transaction times.
It is unclear whether blockchain technology will be able to outperform non-blockchain payment technologies. Private stablecoins are considered technologically superior to traditional payment systems because they use blockchain platforms. However, this advantage may be temporary. For example, during testing of a central bank digital currency, the Federal Reserve Bank of Boston showed that non-blockchain payment technologies can perform ten times as many transactions per second as high-performance blockchain technologies. The necessary ordering of valid transactions to prevent double spending in the blockchain creates a bottleneck that limits scalability and may ultimately hinder fast payments.
Blockchain networks vary in scalability, but stablecoins can have different transaction speeds even on the same blockchain.
Stablecoin transaction costs can vary widely and show no clear advantage over traditional payment schemes. The transaction cost of a stablecoin depends on many factors, such as the complexity of the transaction or the congestion of the network, resulting in higher fees. Mizrach's (2022) analysis of stablecoin transaction fees shows that, for the majority of stablecoins, transaction costs are higher than the average cost of an ATM transaction or a European Visa or Mastercard scheme. However, there are differences between stablecoins. While Tether’s median transaction fee is similar to the cost of an ATM transaction, it is three to four times higher when using DAI or USD Coin. In addition, customers often use (fixed) fee payment accounts for most of their payment services. If these payment accounts remain essential to the end user's day-to-day payment usage, and the end user requires an additional account or wallet to hold the stablecoin, then using a stablecoin may represent another layer of expense and be unattractive to the end user.
Stablecoin issuers are turning to new blockchain technologies to address the scalability and efficiency issues of the most commonly used blockchains today. Most stablecoins are minted on blockchains using a proof-of-work (PoW) consensus mechanism that requires network participants (so-called miners) to compete against each other on the network to solve the problems involved in validating new transactions and adding New blocks for complex puzzles. Not only does this make PoW blockchains slower and less scalable, but it is also very energy-intensive. New blockchain networks that follow Proof-of-Stake (PoS) or Proof-of-History (PoH) consensus mechanisms increase speed by requiring fewer network participants (or "validators"), thereby reducing the computation required to verify transactions per block ability. These networks, including Tron, Avalanche, Algorand, and Solana, can perform more transactions per second, are more scalable, and have lower transaction costs than the Ethereum or Bitcoin networks. However, there may be tradeoffs between scalability, security, and decentralization.
The largest stablecoins limit the possibility of redemption by users. Users should be able to redeem their stablecoins at any time at face value in reference to the official currency. As with traditional PSPs, users should also be able to easily access information about redemption terms. However, stablecoin issuers limit the possibility of redemption by users, and there is insufficient public disclosure of their redemption terms. For example, the largest stablecoin issuers only offer one redemption per week or on weekdays. In addition, the right to redeem official denomination currency at face value is not always guaranteed, meaning that redemptions depend on reserve valuations or must be in kind. Holders of stablecoins also face redemption restrictions or high minimum thresholds in some cases. This makes them non-convertible for most regular retail users. Additionally, consumer protection measures, such as transparency requirements, chargebacks, protection against excessive fees, and fraudulent compensation, do not currently apply to stablecoins.
4 Potential risks of stablecoins to financial stability
Stablecoins may pose risks to financial stability through different contagion channels. These channels include: (i) financial sector exposures; (ii) wealth effects (i.e. the extent to which changes in the value of cryptoassets are likely to affect the extent to which developments in crypto-assets may affect investor confidence in crypto-asset markets and possibly the wider financial system); (iv) the extent to which crypto-assets may be used in payments and settlements.
Issuers of collateralized stablecoins need to ensure robust reserve asset management to instill confidence, ensure the stability of the peg, and avoid token runs that could infect the financial sector. Like a money market fund (MMF), a stablecoin’s reserve assets need to be liquid to allow users to redeem their stablecoins for fiat currencies. Adequate management of reserve assets underpins user confidence in stablecoins. A loss of confidence could trigger large-scale redemption requests—especially where redemption possibilities are limited—leading to the liquidation of reserve assets, with negative contagion effects on the financial system. Notably, the largest stablecoins have reached sizes comparable to large premium money market funds in Europe.
While there has been more transparency about the composition of reserve assets than last year, details remain scant. Reserve asset disclosures have become more transparent since early 2021 and have shifted to more liquid assets. However, despite the 20% reduction by the end of 2021, Tether still holds a large investment in commercial paper, as well as positions in MMF and digital tokens. The lack of detailed information on the geographic origin or exact size of Tether’s commercial paper holdings—because they are not separate from certificates of deposit—has hampered a clear understanding of the liquidity of these reserves and contagion effects in short-term funding markets. In addition, due to the lack of disclosure and reporting standards, it is difficult to compare the reserve asset composition of stablecoins.
Recent developments have shown that stablecoins are by no means stable, such as TerraUSD’s debacle and Tether’s temporary depeg. Amid a general downturn in the cryptoasset market, TerraUSD de-pegged from the U.S. dollar on May 9 and fell below 10 cents after May 16. At the same time, its market value fell from about 18 billion euros to less than 2 billion euros. Tether’s price came under pressure amid the ensuing crypto market pressure, with the largest stablecoin temporarily depegged on May 12. Since then, Tether has seen outflows of more than 8 billion euros, equivalent to almost 10% of its market capitalization. This suggests that stablecoins cannot guarantee their peg, and if depegged, there is a risk of contagion within the cryptoasset ecosystem. The market seems to have differentiated between stablecoins. In the case of Tether, deficiencies in its redemption possibilities and a loss of confidence that may be related to the opaque composition of its reserves may have played a role in the observed decoupling and continued outflows. Two other major collateralized stablecoins, USD Coin and Binance USD, saw small inflows.
If there is a run or failure on the stablecoin, the holders of the stablecoin may face losses. Currently, holdings of Tether, USD Coin, and DAI are concentrated among large investors, those holding more than 1 million tokens. They account for over 80-90% of the supply of these stablecoins on the Ethereum blockchain, while retail investors (defined as having a balance of less than 10,000 of each of these stablecoins) account for 3% or less. Data gaps fail to identify these large investors. Anecdotal evidence suggests that they may be professional institutional investors, such as professional crypto funds or hedge funds, in which case spillovers to the financial system would be limited. In the specific case of TerraUSD, holders suffered huge losses.
The growing interest of banks, PSPs, and large tech companies in issuing or using stablecoins could increase linkages to the traditional financial system. In the US, a consortium of FDIC-insured banks recently announced their plans to issue a stablecoin. In the EU, banks and financial institutions may also be interested in issuing stablecoins or providing related services once the MiCA regulations come into force. Additionally, stablecoin adoption could accelerate if large tech companies start offering their own stablecoins or integrating existing ones into their wallets.
The key role that some stablecoins play in the broader cryptoasset ecosystem is a concern for financial stability insofar as future unsecured cryptoassets may pose risks to financial stability. The nature and size of the cryptoasset market is rapidly evolving, and if current trends continue, unsecured cryptoassets will pose a risk to financial stability. As the analysis in Section 2 shows, stablecoins are closely related to unsecured cryptoassets. For example, if Tether fails, a lot of trading liquidity in the crypto asset ecosystem will dry up. This could disrupt trading and price discovery in the crypto asset market. In turn, if at some point in the future the cryptoasset market poses a risk to financial stability, it could have contagion effects on the financial system.
5 Regulatory Stablecoins
Given the potential risks and cross-border nature of stablecoins, a nuanced and robust global regulatory approach is critical. Important steps have been taken in this direction. The Financial Stability Board (FSB) has published high-level recommendations for 2020 on global stablecoin regulation, management and oversight. However, the FSB's recommendations only provide high-level guidance. They are less granular in terms of the specific requirements needed to ensure stablecoin stability (for example, capital and liquidity requirements for credible management of reserve assets or public disclosure) and a level global playing field.
International standards need to cover all relevant entities and functions in a stablecoin agreement. Stablecoin engagements are complex and consist of a series of functions and activities performed by multiple entities across multiple sectors and jurisdictions. It is therefore important that all relevant entities and functions are adequately covered in stablecoin arrangements. Global organizations such as the FSB can provide granular guidance to close gaps in areas where relevant standards or standard-setting bodies do not exist. Furthermore, the standard should ensure consistency of requirements regardless of the stablecoin’s originator, function and sectoral origin of its activities (for example, if it is issued by a bank or other entity), under the “same business, same risk, same rules "the rules.
Existing international industry standards may have gaps in adequately mitigating the inherent risks of stablecoins. International sector standards were designed at a time when stablecoins did not exist. Consequently, the regulatory treatment of exposure to stablecoins and the prudential requirements to apply when assuming any stablecoin function/activity have not been established for different financial sectors.
Given the rapid growth of the stablecoin market, stablecoins need to be urgently brought under regulation. A good example is the MiCA regulation proposed by the European Union, which needs to be urgently implemented. The European Union is leading international efforts to establish a new, harmonized regulatory framework for stablecoins, building on the EU Electronic Money Directive and taking into account its limitations. The MiCA regulation is a custom framework for the issuance and provision of services related to stablecoins and other cryptoassets. Under the regulation, both stablecoin issuers and crypto asset service providers are subject to the same minimum requirements, regardless of their applicable licensing regime. For example, electronic money institutions are one of two types of issuers allowed to issue stablecoins alongside credit institutions. Their requirements overlap with additional requirements to address bank-like risks arising from stablecoin issuance, such as those associated with reserve assets. In response to potential systemic risks, stricter requirements will be imposed on “essential stablecoins” that could pose a greater threat to financial stability, monetary policy transmission, and monetary sovereignty. Recent events surrounding TerraUSD have highlighted the need to differentiate between different types of stablecoins based on the risks they pose. The idea that stability can be created in an algorithmic stablecoin with no collateral or quasi-collateral, consisting of unsecured crypto assets with no intrinsic value, seems like wishful thinking. Algorithmic stablecoins should be considered unsecured cryptoassets based on the real risk of their collateral, or the lack of it.
Six conclusions
Financial stability risks posed by stablecoins remain limited in the euro area for now, but could change in the future if growth trends continue at the current pace. Stablecoins have rapidly developed into an important part of the cryptoasset ecosystem, and in the event of failure, some stablecoins pose a risk to the liquidity of the cryptoasset market. The speed and cost of stablecoin transactions, as well as their redemption terms and conditions, fall short of the real economy's actual means of payment.
Effective regulation of stablecoins is critical to responsible innovation and financial stability. Proper regulation, management and oversight need to be implemented before stablecoins become a risk to financial stability and the smooth functioning of payment systems. Existing stablecoins urgently need to be included in the regulatory scope, and new stablecoins need to establish a regulatory framework. To address their specific risks, algorithmic stablecoins should be considered unsecured crypto assets. In the case of stablecoins being used for payment purposes, the regulatory regime needs to further clarify other areas such as data privacy, consumer protection, market integrity, AML/CFT and tax rules. At the international level, it is important to ensure a level playing field globally through a consistent, granular and robust regulatory approach. This includes both the regulation of stablecoins themselves and the traditional financial sector exposures to which stablecoins are linked.
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