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Cryptocurrencies firstly received public attention after the release of the Bitcoin white paper in 2008. Since then, the value of bitcoin has surged, but bitcoin hasn’t fulfilled its original purpose – its usage as a medium of exchange. Various reasons stand behind this, such as the long settlement time, lack of merchant acceptance, complex tax treatment, but mostly the price volatility. For instance, since January 2020, the annualized volatility of Bitcoin stands around 70%, 6-times the volatility of commodities like Gold or Oil, more than twice the volatility of the S&P 500, and 10 times the volatility of the EURUSD exchange rate.
In 2014, the company Tether Ltd. addressed this shortcoming by launching the first stablecoin – Tether (USDT). Stablecoins represent a specific category of cryptocurrencies aiming to keep their value stable against a benchmark asset, usually a fiat currency like the US dollar. As of January 2022, the market capitalization of stablecoins stands at around 170 bn USD, according to CoinMarketCap. Tether maintained a disproportionate share of the market with a market cap of 78 bn USD. The other main stablecoins include USD Coin (USDC) and Binance USD (BUSD), with a market cap of 50 bn USD and 15 bn USD, respectively. The rapid rise of new crypto-assets did not escape academic attention. Catalini et al. (2021) studied the potential role of stablecoins in the financial system. In a related study, Barthelemy et al. (2021) focused on the source of their stability and investigated the reserve composition of major stablecoins.These two research papers are the primary sources for today’s post.
So far, the major stablecoins successfully maintained their peg while exhibiting volatility comparable to the fiat currencies. Over the recent period, they were even less volatile than the EURUSD exchange rate. By overcoming the extreme volatility of other crypto-assets, stablecoins serve more and more as liquidity vehicles – “a safe asset” for the digital world. Gensler (2021) underlines that nearly three-quarters of trading on all crypto trading platforms occurred between a stablecoin and some other token. In addition, Griffin and Shams (2020) identified strong links between the supply of Tether and Bitcoin price movements. Specifically, flows of Tether are correlated with predictable trading patterns in Bitcoin and participated in inflating its price in 2017. Conversely, negative returns on Bitcoin predict flows in Tether, indicating its safe-haven properties during times of stress in cryptocurrency markets.
Stablecoin issuers use different mechanisms to ensure the stability of their tokens against the reference asset. Generally, they back the value of stablecoins by reserves held in the benchmark fiat currency. The riskier approach involves backing the stablecoins with cryptocurrencies while relying on over-collateralization. Lastly, the algorithmic stablecoins rely on an algorithm that aims to achieve their price stability by regulating the supply of coins. In the “reserve assets” approach, when demand for stablecoins rises (falls), an issuer increases (reduces) the supply of coins and expands (reduces) its reserve assets. To remain credible, issuers must hold the reserves in the most liquid asset like the cash equivalent. Until recently, the reserve composition of stablecoins was not public. However, since July 2021, Tether has started to disclose some information regarding its reserve composition. The independent accountant report has shown that Tether tokens were mainly backed by Commercial Paper (CP) and Certicates of Deposits (CD) denominated in USD. As of June 2021, Tether Holdings Limited held around 31 bn USD of CP/CDs. Alexander (2021) remarks that Tether tokens are largely unbacked, while peg to the USD is maintained by arbitrage traders associated with Tether Ltd. He explains: “No ordinary trader would have felt comfortable arbitrage scalping USDT after the NYAG report was released.” Nevertheless, the company declares that all Tether tokens are backed one-to-one with USD in its reserve assets.
Stablecoins have the potential to drastically increase competition and innovation in financial services by reducing our reliance on traditional intermediaries. But they also introduce new challenges, as regulators rely on intermediaries to ensure financial stability, market integrity, and consumer protection. Because they operate at the interface between traditional banking and cryptocurrencies, stablecoins also represent an ideal setting for understanding the key trade-offs cryptocurrencies involve, and insights from robust stablecoin design and regulation are highly relevant for related innovations in decentralized finance (DeFi), non-fungible tokens (NFTs), and Web3 protocols. We describe the key stablecoin design choices from reserve composition to stability mechanism, legal claim against the issuer, non-interference with macroeconomic stability, and interoperability with public sector payment rails and central bank digital currencies (CBDCs). Last, we cover the key benefits of stablecoins in the context of real-time, low-cost programmable payments, financial inclusion, and decentralized finance.
Authors: Jean Barthelemy, Paul Gardin and Benoît Nguyen
The market capitalization of stablecoins — crypto-assets aiming at maintaining their value stable, and generally pegged to a fiat currency — has skyrocketed over the past year. This paper documents one implication for the real economy. Issuers of the two main stablecoins back the value of their tokens on short-term debt denominated in US dollar, such as commercial papers that are key for the funding of banks and firms. We show that changes in the stablecoin market capitalization are correlated with the issuance of commercial papers and their interest rates, and run placebo tests to confirm these findings.
Author: Carol Alexander
Title: The Tether-Binance Axis and the Great Crypto Crash of 2022
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