Stablecoin is a crypto asset (virtual currency) designed to maintain stable value by pegging to an underlying asset such as the US dollar, and is said to be able to provide the flexibility of crypto assets without price volatility. (Editor’s note: Stablecoin in this article is the general definition in the United States, which is different from the legal definition in Japan).

Stablecoins can be backed by fiat currency, as most stablecoins are, or algorithmic (backed by other assets or crypto assets), such as Bitcoin (BTC) and Ethereum (ETH). It is intended to provide users with a haven from volatile crypto asset price fluctuations.

One of the major advantages of stablecoins is operational efficiency and cost effectiveness for cross-border transactions. For example, stablecoin transactions require far fewer intermediaries than traditional bank transfers, making them cheaper and faster to send money overseas.

However, while these use cases are promising, stablecoins have not always been able to deliver on their promised stability. In recent years, there have been several depegs in which stablecoins have fallen below the value of their underlying assets.

There are a variety of factors behind this depegging, including regulatory actions, security breaches, and imbalances in the digital asset pools that support decentralized exchanges.

Investors are selling off stablecoins due to a lack of transparency about the underlying assets held as reserve assets and the appeal of higher yields from traditional assets in a rising interest rate environment.

Reasons for the shift away from stablecoins

Below, we take a closer look at how several events and changes in market conditions led to capital outflows from stablecoins.

Terra: The risks of unregulated stablecoins

In 2022, the algorithmic stablecoin UST crashed on the Terra network, exposing the risks associated with unregulated stablecoins.

The dramatic drop in UST had a knock-on effect on Tether (USDT), the largest stablecoin, briefly dropping below $1. UST was vulnerable to market fluctuations as it depended on market expectations and demand for both the crypto assets Terra (LUNA) and UST.

FTX: Risks due to connections with traditional finance

The collapse of the once highly regarded centralized crypto exchange FTX has raised concerns of contagion in the industry, leading to a decline in the value of USDT on major exchanges. These events have highlighted the interrelationship between traditional finance and crypto assets.

Curve and Uniswap: liquidity pool imbalance

Imbalances in liquidity pools on decentralized finance (DeFi) platforms such as Curve Finance and Uniswap were also an issue. These imbalances, often caused by arbitrage and market fluctuations, have resulted in USDT moving away from its peg to the US dollar, undermining confidence within the DeFi community.

Competition from high-yield, low-risk assets

The situation is further complicated by the inverse relationship between US Treasury yields and stablecoin demand. Rising yields are causing risk-averse investors to move money into government bonds, impacting stablecoin market share.

Furthermore, regulatory ambiguity is also a major hurdle preventing the expansion of stablecoin usage. The lack of a clear regulatory framework in the US has made investors cautious and led to withdrawals from DeFi platforms. There is also concern that if global stablecoins become widespread, purchasing power will shift from fiat currencies to private payment services.

Expected as a bridge between traditional finance and DeFi

Despite these hurdles, rating agency Moody’s believes that stablecoins have the potential to play a notable role in the evolving digital economy as they provide an accessible bridge between traditional finance and DeFi. I think it’s expensive.

In fact, some financial giants are investing in the future of stablecoins. Recently, PayPal introduced its own stablecoin and Visa expanded support for USDC payments within its own business.

Stablecoins face competition from more stable alternatives such as central bank digital currencies (CBDCs) and tokenized bank deposits. However, the demand for the stability and security of digital currencies remains.

In Moody’s view, until such alternatives become widely available, stablecoins are likely to have a significant power in shaping the future of digital money.

｜Translation and editing: Akiko Yamaguchi, Takayuki Masuda
｜Image: Shutterstock
｜Original text: Can Stablecoins Get Past Their Instability?