The past few years have witnessed an array of technological developments and innovations, especially in Fintech; and while the world focused on Bitcoins and other cryptos, a new entrant ‘Stablecoin’ slowly crept its way into the limelight. With the primary motive of shielding its users from the high volatility associated with cryptos, and promises of boosting cross-border payments and remittance, ‘Stablecoins’ emerged in 2018, and now have become the focal point of discussion of several international bodies including the Financial Standards Board (FSB), G20, Financial Action Task Force (FATF) and International Organization of Securities Commission (IOSCO).
Additionally, the widespread notion that the desperate need of cross-border payments and remittances during the ongoing COVID-crisis may prove to be a defining moment for stablecoins, has drawn all the more attention towards the need of establishing regulations and legal framework pertaining to Stablecoins.
In this article, we shall have an insight as to what Stablecoins, (Global Stable Coinss) are, its modality, its current status of acceptance by the international bodies, and how the ongoing COVID crisis, may act as a catalyst for its rise.
Suggestive of its name, ‘Stablecoins’ are crypto-assets that aim to maintain a stable value relative to a specific asset, or a pool or basket of assets. It attempts to address the high volatility of the traditional crypto-assets (think Bitcoins), by tying the stablecoin’s value to one or more other assets, like sovereign currencies. As has been acknowledged by the FSB, Stablecoins have the potential to bring efficiencies to payments and promote financial inclusion.
Hence, the following can be enlisted as the defining elements of GSCs
- Existence of a stabilization mechanism; and
- Potential reach and adoption across multiple jurisdictions
Types of Stablecoins
Depending upon the mechanism which lends this stability, Stablecoins are broadly classified as Collateralized and Non-Collateralized (Algorithm) based Stablecoins. The same have been discussed hereunder-
As the name suggests, ‘Collateralized Stablecoins’ are asset-backed stablecoins that purport to maintain its value by referencing real or financial assets, or even other crypto-assets. The mechanism by which the stablecoin’s value is maintained in relation to the referenced asset may vary and includes the use of creation and redemption structures, arbitrage, and direct rights to receive underlying reserve assets. Collateralized Stablecoins may further be classified into two types, depending upon the asset to which it is referenced- it may either be centralised Stablecoins backed by fiat; or decentralised, backed by other crypto.
The fiat-backed stablecoins are usually backed in the ratio of 1:1 which signifies that 1 unit of stablecoin is equivalent to 1 fiat currency. Currently, the majority of stablecoins are pegged against the US Dollar because it is regarded as the world’s leading fiat currency. In view of the fact that it involves a centralised form of currency, it makes stability more likely. Another similar category with a slight tweak is a commodity backed stablecoin, which although not backed by fiat, references its value on the basis of a commodity, say gold, diamond, or any other form of asset. Considering that they fall under the centralised structure, they also require auditing from time to time.
On the other hand, the crypto-backed stablecoins peg its value to other cryptocurrencies. For instance, DAI, wherein the users can lock-up a certain amount of Ethers (a popularly traded cryptocurrency) for borrowing DAI. This attribute counts on decentralised which enhances transparency. However, one may think that since the value of such stablecoins eventually depends on another crypto which is volatile, how does it serve the purpose? The concerns are indeed real and as such, there persists a certain level of uncertainty is Stablecoins of this kind.
Non-collateralized or Algorithmic stablecoins purport to maintain a stable value via protocols that provide for the increase or decrease of the supply of the stablecoins in response to changes in demand. Similar to a central bank printing banknotes to maintain valuations of the fiat currency, the stability in case of algorithmic stablecoins are achieved by implementation of ‘smart contracts’ that can make decision for increase/ decrease of supply based on demand.
Stablecoin, like Bitcoin, is a part of the wide umbrella of the cryptocurrency; however, what makes its stand out of the crowd, as a more trusted face is that it does not carry the baggage of the high volatility or potential risks of terror financing.
As much as the fact that Bitcoins attracted its own exclusive share of the world’s attention, it would not be surprising to see a 10-20% fall in its value, in one single trading day. Hence, even though it renders decentralization, transparency coupled with adequate privacy, what it majorly lacked was stability. Thus, an asset-backed digital currency seems to be good idea.
On a similar note, due to its hybrid, complex nature, it has also been difficult to categorize Bitcoins as a particular kind- money, or goods, or securities. In the Indian context specifically, despite a comprehensive order by the Hon’ble Supreme Court, the nature of Bitcoins still remained unascertained. However, despite the fact that Satoshi Nakamoto’s vision for Bitcoin was for it to be used as electronic cash, in reality it is rarely used as a medium of exchange on a day-to-day basis and has as such has failed to be classified as money, atleast as the tradition Four-test rule.
Thus, amidst this backdrop, Stablecoins were introduced in the later half of 2018 to create stability amongst cryptocurrencies, to be used as a regular means of payment, as effortlessly as fiat, and to eventually bridge the gap between fiat and cryptos.
Stablecoins vs. Bitcoins
Having discussed the nature of Stablecoins it may be interesting to note what the essential differences between Stablecoins and Bitcoins are; the same is discussed hereunder-
|Basis||Stablecoins||Bitcoins/ Traditional Cryptocurrency|
|Correction of under/ over valuation||Yes.
The very mechanism of stablecoin works upon stabilisation of value in case of under/ over valuation.
Traditional cryptocurrencies do not fulfil this criteria; and as such witness high volatility and fluctuations
|Issuance- centralised/ decentralised||Issuance in case of fiat-backed/ asset-backed Stablecoins is centralised;
Whereas, in case of algorithm based/ crypto-backed Stablecoins is decentralised
|The very nature and purport is based on decentralised issuance|
|Mode of payment||Widely accepted||Not widely accepted|
|Store of Value||Since it is asset/ fiat backed, it proves to have great potential to become a store of value||Since it has no asset backing, whatsoever, cannot be identified as having store of value|
|Uses||Widely used for payment and remittances||Use is essentially restricted to trading|
|Regulatory acceptance||Seemingly high||Most economic regulations are bitcoin averse.|
Table 1: Differences between Stablecoins and Traditional Cryptocurrency
Potential Risks & Vulnerabilities
Although Stablecoins promise stability or facilitate a faster payment/ remittance mechanism, it is only one side of the coin- what lies on the other side is the potential risks and vulnerabilities associated with it. It is important to note that a common observation across international bodies like FSB, IOSCO, and G20 has been that while Stablecoins/ GSCs have the potential to contribute to developing new global payment arrangements, an expansion or splurge (a most expected one) may indeed pose a systemic risks to the financial system and significant risks to the real economy, including substitution of domestic currencies.
In this light, the FSB identified several potential risks that are associated with GSCs- the same have been discussed hereunder-
- Risk of fluctuation in user’s wealth
It must be noted that the gaps in case of other cryptocurrencies through which Stablecoins found its way was lack of stability or high fluctuations. However, can it be said that the functioning of Stablecoins are completely free of fluctuations? Well, nothing can be said with such certainty. It has been observed that if a GSC were used as a common store of value, even a moderate variation in its value might cause significant fluctuations in users’ wealth. Such wealth effects may be sizeable enough to affect spending decisions and economic activity; as such, it is necessary to make such measures which mitigates the risk of such fluctuations of users’ wealth.
- Disruption in financial system
It is to be noted that at its present volume of operations, Stablecoins do not pose a significant risk to the financial systems, rather it is efficiating wider financial inclusion. However, having said so, it cannot be excused that if widely used for payments, any operational disruption in the GSC arrangement might have significant impacts on economic activity and financial system functioning. If users relied upon a stablecoin to make regular payments, significant operational disruptions could quickly affect real economic activity, e.g. by blocking remittances and other payments. Large-scale flows of funds into or out of the GSC could test the ability of the supporting infrastructure to handle high transaction volumes and the financing conditions of the wider financial system, and at the present juncture, there might not be supporting infrastructure to handle high volume transactions.
- Exposure of financial institutions
Exposures of financial institutions might increase in scale and change in nature – particularly if financial institutions played multiple roles within a GSC arrangement (for example as resellers, wallet providers, managers or custodians/trustees of reserve assets). This may be a source of market, credit and operational risks to those institutions. This may be a source of market, credit and operational risks to those institutions. Moreover, closer linkages to financial institutions might also expose a GSC to adverse confidence effects, such as when a financial institution that acts as reseller/market maker of the GSC arrangement comes under financial distress. The reverse may also be true – the potential failure of a GSC might expose the financial institutions involved in the GSC arrangement to adverse confidence effects.
- Macro-financial risk
Additionally, macro-financial risks may arise particularly if, over time, households and businesses in some economies come to hold substantial portions of their wealth in GSCs, rather than in local currencies. During periods of stress, households in some countries might come to regard GSCs as a safe store of value over existing fiat currencies and exacerbate destabilising capital flows. Volatile capital flows can have a destabilising effect on exchange rates and on domestic bank funding and intermediation, which is not desirable for any economy.
In addition to the risks discussed above, the functioning of GSCs is also characterised by few vulnerabilities viz.
- Traditional financial risks
Traditional financial risks include market, liquidity and credit risk. Large-scale GSC redemptions might result in “fire sales” of reserve assets that could reduce the “stable” value of the GSC relative to the reserve assets absent secondary guarantees. The ability of GSC arrangements to sell reserve assets in large volume at (or close to) prevailing market prices would depend on the duration, quality, liquidity and concentration of the GSC’s reserve assets. Hence the choice and management of the GSC reserve assets, particularly the degree to which they could be liquidated at or close to prevailing market prices, is of key importance in this regard.
- Potential fragilities
A second type of vulnerability concerns potential fragilities in the governance, operation and design of the GSC arrangement’s infrastructure. This vulnerability could crystallise, for example, due to an operational incident at a custodian or a compromised ledger resulting from a design defect, a cyber incident, or a failure of validator nodes. A lack of network capacity to validate – and subsequent delays in processing – large volumes of transactions might amplify users’ loss of confidence, and trigger further redemption requests.
Analysing Applicable standards
In view of the fact that the GSCs enable forex transactions and purport to be used as a widely used mode of payment on a cross-border level, it is important to have standard rules that may be applicable internationally. In this light, the nature of tenet of GSCs suggest that the following international standards that could apply to GSC arrangements are:
(i) Basel Committee on Banking Supervision (BCBS)
Banks having a role in a GSC arrangement could be subject to cyber, fraud, and other operational risks as well as legal, third-party and implementation risks. The BCBS Principles for the Sound Management of Operational Risk should help address those risks by calling a strong control environment, appropriate internal controls and business resilience and continuity plans.
(ii) Financial Action Task Force
The FATF clarified that both global “stablecoins” and their service providers would be subject to the FATF standards either as virtual assets and VASPs or as traditional financial assets and their service providers, and that stablecoins should “never be outside of the scope of anti-money laundering controls. Accordingly, the FATF has made clear that countries should effectively implement the FATF standards as part of their domestic regulatory and supervisory regimes for virtual assets, including stablecoins.
(iii) Committee on Payments and Market Infrastructures (CPMI) and International Organization of Securities Commissions (IOSCO)
In its preliminary analysis, the CPMI-IOSCO established that the Principles for Financial Market Infrastructure apply to systemically important stablecoin arrangements that perform systemically important payment system functions or other financial market infrastructure (FMI) functions that are systemically important. To the extent that systemically important stablecoin arrangements perform.
IOSCO concludes that GSCs may, depending on their structure, present features that are typical of regulated securities or other regulated financial instruments or services. It then engages in a lifecycle analysis of a hypothetical stablecoin used for domestic and cross-border payments.
Expected changes in legal frameworks- India and abroad
The G7, in its Report dated October, 2019 stated that “no global stablecoin project should begin operation until the legal, regulatory and oversight challenges and risks outlined above are adequately addressed, through appropriate designs and by adhering to regulation that is clear and proportionate to the risks. That said, depending on the unique design and details of each stablecoin arrangement, approval may be contingent on additional regulatory requirements and adherence to core public policy goals.”
Hence, based on the principles, as discussed in the preceding section, it is expected that following regulatory changes, in the Indian context, may be introduced by the Reserve Bank of India:
- Acceptance as a mode of payment;
- Considering that Stablecoins are widely accepted as mode of payment, and also are a store of value, may be included in the definition of money;
- Necessary changes be made in the Payments and Settlement Systems Act, 2007;
- Synchronization of the Foreign Exchange Management Act, 1999
- Appropriate amends in the Prevention of Money Laundering Act, 2002
- Introduction of a new legal framework specifically dealing with Stablecoins, in harmony with other corresponding changes as may be introduced.
It is important to note that the probable reason why the fate of Bitcoins has been nothing less than a roller-coaster in India was a relative lack of preparedness to accept such innovation in the financial realm. Having said so, it must be appreciated that a vigilant stance for acceptance of Stablecoins and early steps taken in this regard may in fact turn out to be India’s much awaited leap in the crypto-world.
Additionally, as per the recommendations put forward by G7, all economies must make consider and ensure the following, so as to provide a conducive environment for the optimal functioning of Stablecoins-
- Legal certainty- A well founded, clear and transparent legal basis in all relevant jurisdictions is a prerequisite for any stablecoin arrangement
- Sound governance- Sound and efficient governance promotes the safety and efficiency of payments and related services. The governance structure of the arrangement must also be clearly defined and conveyed to all ecosystem participants.
- Financial Integrity- If not effectively regulated and supervised, cryptoassets, including stablecoins, can pose significant risks to financial integrity and may create new opportunities for money laundering, terrorist financing and other illicit financing activities..
- Safety, efficiency and integrity of payment systems- The smooth functioning of payment systems is vital to the financial system and the wider economy. Individuals and firms need accessible and cost-effective means of payment. The system facilitates commercial activities and fosters economic growth, thereby benefiting society as a whole.
- Cyber and other operational risk considerations- Public authorities will require that operational and cyber risks from stablecoins be mitigated through the use of appropriate systems, policies, procedures and controls
- Market integrity- A stablecoin arrangement must ensure fair and transparent pricing in both primary and secondary markets.
- Data Protection- Authorities will apply appropriate data privacy and protection rules to stablecoin operators, including how data will be used by the participants in the ecosystem and shared between the participants and/or with third parties.
- Consumer/investor protection- As with any nascent technology, additional work may be required to ensure that consumers and investors are informed of all material risks as well as their individual obligations.
Rise of GSCs amidst the Crisis
As mentioned earlier in the article, stablecoins were introduced to the crypto ecosystem in 2018 itself- then why is it that it during such time of global instability, where almost all sectors are seeing a downward map, that GSCs are expected to be a rise? While the World Health Organisation officially declared the spread of COVID-19 a pandemic, stock markets, globally, witnessed some of its worst days in over a decade, all sectors took a hit, but stablecoins shined.
It was noted that while prices of Bitcoin dropped aggressively, the two leading dollar-backed Stablecoins, Tether and USD Coin saw a substantial rise; even smaller coins such as Binance USD and Paxos Standard witnessed an increase in market capital. Other asset-backed stablecoins, like the gold-backed stablecoins are also witnessing a resurge. In what may be called an ‘opportunity in tragedy’ many investors are flocking towards gold-backed stablecoins instead of actual gold.
The reason behind such results, as most widely believed is the ease of access and liquidity it provides. Holding up to its purport, GSCs are enabling faster and hassle-free payments and remittances across the globe which would have otherwise taken hours or days to be processed via traditional payment system. Further, with the current scenario posing a significant level of ‘risk-off’ in every asset class, masses are more inclined towards holding more and more liquid cash, and GSCs seem to be the most easiest and their best way to hold on to USD.
It may not be an exaggeration to say that while this outbreak has been an unprecedented hit in the stock markets and big players like Bitcoins and Ether have seen big bouts of volatility, it is during this time that GSCs have held on to the word ‘stable’ as the industry’s top 5 stablecoins have barely shifted in value over a much larger timeframe.
It further goes without saying that once the economy recovers or atleast takes its first steps towards recovery, and added risk of volatility, like that in Bitcoins, it the last thing an investor would be in favour of- welcome stablecoins. Further, while it is now presumed with reasonable clarity that the so-called ‘first generation’ of cryptos have failed to classify as a medium of exchange or store of value, Stablecoins comes as a fitting answer to these gaps left behind. Infact its very nature implies that Stablecoins, especially the asset-backed ones could prove to be massive store of value.
How stable is the future?
Although GSCs have proven their potential and metal during these testing times, one cannot simply ignore or overlook the looming risks as have been discussed above, the most significant one being the risk of substitution of domestic currencies. While its performance globally has been phenomenal, India has seen a rather slow pace, courtesy regulatory uncertainties, inadequate infrastructure and lack of awareness. As a simple, stable, and secure means of transacting in a digital environment, stablecoins could be the answer to helping India take the leap into cryptocurrencies and solve some of the key challenges facing the country’s economic infrastructure.
Hence, while International Bodies like FATF, G20 are under the process of framing regulations to avert the risks while reaping optimum benefits, it may be the apt time for India to hit the iron while its hot, and provide a foundational layer for crypto assets that will generate immense value for the digital assets ecosystem while also helping to address real economic challenges.
 Consultative Document dated 15th April, 2020- https://www.fsb.org/wp-content/uploads/P140420-1.pdf
 Smart Contracts are self-executing contracts with the terms of arrangement between buyer and seller being directly written into lines of the Code. The Code and agreements contained therein exists across a distributed, decentralised blockchain network- See here
 Founder of Bitcoin
 The term Bitcoins, for this section, also includes other cryptocurrencies working on the same model as bitcoins
 Derived from the Report by Financial Standard Board dated 14th April, 2020