In part 1 of “Stablecoins: the ‘killer app’ of the financial world?”, we discussed how stablecoins are emerging and impacting global payments, bridging the gap between traditional systems and decentralised innovation. Their ability to function as a stable store of value whilst enabling real-time, low-cost transactions, positions them as a viable challenger to legacy financial infrastructure. As stablecoins continue to disrupt global finance, they may not just be an alternative - they could become the foundation of a faster, more inclusive financial future.
Challenges tempering stablecoins' ‘killer app’ potential
· regulatory uncertainty
The global regulatory landscape for stablecoins is evolving, with a focus on licensing and authorisation regimes. Most regulations follow two models: one permits banks and non-bank financial institutions (NBFIs) to issue stablecoins with specific consent whilst the second requires new crypto-specific licenses, such as being a crypto asset services provider (CASP) or virtual asset services provider (VASP). For instance, in the US, only banks are authorised to issue stablecoins whereas in the EU, banks only need to notify authorities. The UK mandates that banks issue stablecoins via a separate, non-deposit-taking entity. Recent discussions in the US Congress and the Bank for International Settlements (BIS) emphasise stricter regulations, with proposals to implement reserve requirements, liquidity standards and robust governance. Nevertheless, the regulatory landscape surrounding stablecoins in the US is still uncertain, with ongoing jurisdictional disputes between the SEC and CFTC. The SEC classifies stablecoins such as BUSD as securities, whilst the CFTC treats them as commodities. And, recent legal battles, such as the SEC's case against Binance, highlight the lack of clear oversight. Although some states, including Texas and New York, have begun developing their own regulations, federal guidance is still fragmented. As banks express interest in issuing stablecoins, a more cohesive national regulatory framework is necessary to address risks and ensure consumer protection in line with international norms.
Source: Coingecko/TeamBlockchain
· pegging and collateral concerns
The de-pegging of stablecoins and excessive dependence on reserves pose serious risks to the broader cryptocurrency market. A key example is the collapse of TerraUSD (UST) in May 2022. Once the third largest stablecoin with a market capitalisation of $18 billion, TerraUSD de-pegged from the US dollar after a sudden $2.5 billion withdrawal from its DeFi platform, Anchor. This triggered a cascade effect, ultimately causing the failure of its algorithmic system tied to the Luna token. In addition, the Financial Stability Board (FSB) highlighted the need for recovery and resolution strategies for global stablecoins, underscoring the systemic dangers of such events. However, the FSB did not explore extending deposit insurance, deeming it outside its remit (FSB 2020). The TerraUSD collapse revealed the vulnerabilities of algorithmic stablecoins, prompting debates on moving toward reserve-backed models to maintain stability.
· centralisation vs. decentralisation
Stablecoins come in two distinct models - centralised and decentralised - each with its own set of advantages and disadvantages. Centralised stablecoins such as USDC (from Circle) and USDT (issued by Tether) are managed by particular organisations, offering stability and trust due to their adherence to regulations and backing by fiat reserves. These stablecoins tend to be the preferred choice for users seeking dependable assets in volatile markets. Conversely, decentralised stablecoins such as DAI (MakerDAO), FRAX (Frax Finance) and LUSD (Liquity) function without the oversight of a central authority; these coins depend on collateralised assets and algorithms to preserve their stability. Although, whilst offering more transparency and resistance to censorship, they can be prone to volatility, especially during times of market turbulence. And, whilst decentralised stablecoins such as DAI aim to reduce central authority, they are still influenced by centralised entities. DAI is governed by MakerDAO, a centralised organisation and, despite its decentralised nature, decisions by a small group of stakeholders can affect the platform’s future. This brings into play the question: can a stablecoin be truly decentralised if it requires oversight to keep its peg intact? The choice between centralised and decentralised stablecoins depends on your needs and risk appetite.
· competition from CBDCs
Central bank digital currencies (CBDCs) and stablecoins are both vying for a prominent role in the future of digital money, but they could also co-exist in a complex ecosystem. Furthermore, the IMF has raised concerns about how stablecoins might threaten monetary sovereignty as they can weaken local currencies and complicate monetary policy control. Additionally, stablecoins can exacerbate foreign economic shocks, as people may flock to foreign digital currencies in response to global uncertainties. Conversely, CBDCs present a safer, government-supported alternative that could provide stability in financial crises and help reduce the risk of a "digital bank run". Both systems bring innovation to the table, but the challenge will be finding the right balance between decentralisation and central bank oversight. So, how do you foresee the coexistence of CBDCs and stablecoins?
· systemic risks and the future of stablecoins
A stablecoin losing its peg marks a serious imbalance between its market value and the asset it is tied to, which can erode investor and user confidence, sparking a chain reaction that may destabilise the market. In the case of asset-backed stablecoins (e.g. USDC), the issuing entity typically takes corrective steps such as using reserve assets to repurchase and withdraw coins from circulation to restore the peg.
Algorithmic stablecoins, such as DAI, rely on more complex mechanisms involving smart contracts to adjust the supply when the value deviates from the peg. If the price drops, the system can reduce the supply or incentivise users to take actions that help bring the price back to the intended value. However, during periods of market stress, these measures may fall short. In such scenarios, a stablecoin could enter a downward spiral where efforts to restore the peg fail, leading to more selloffs and further destabilisation. And a stablecoin losing its peg causes far-reaching consequences, impacting more than just individual investors; the broader crypto market, especially decentralised finance (DeFi) projects, could face disruptions, liquidity shortfalls and significant effects on trading pairs. Nevertheless, the potential of stablecoins to reshape the global financial system is clear, providing innovative solutions for cross-border transactions, financial inclusion and decentralised finance (DeFi) whilst preserving price stability through their peg. However, their continued success depends on maintaining that stability. A loss of peg in a major stablecoin could lead to market-wide consequences, such as liquidity shortages and disruptions in DeFi projects and exchanges.
Therefore, as different jurisdiction achieve regulatory clarity (as we have seen in Europe with MiCA and guidelines in Singapore and Japan), stablecoins are set to gain further legitimacy and integration into mainstream financial systems. Stablecoins offer transformative benefits - efficiency, inclusion and programmability - making them a contender for the finance sector's ‘killer app.’ However, their long-term success hinges on achieving regulatory clarity, ensuring peg stability and balancing innovation with trust. So, the real question remains: will stablecoins overcome their risks to reshape global finance, or will regulatory and systemic hurdles limit their impact? No doubt, time will decide whether they become a foundation of modern finance, or a promising innovation overshadowed by alternatives such as CBDCs.
This article first appeared in Digital Bytes (24th of December, 2024), a weekly newsletter by Jonny Fry of Team Blockchain.