By Samairra Malhotra
INTRODUCTION
Analogous to the unregulated wildcat banks of the 1800s, the stablecoins can either meet the same fate as their wildcat predecessors or emerge as an innovative tool in the decentralised financial system (DeFi). The Financial Stability Board (FSB) defines stablecoins as crypto assets that aim to maintain a stable value relative to a specified asset or to a pool or basket of assets. The first stablecoin went live on 21st July 2014 when BitUSD was issued on the BitShares blockchain and was crypto-backed. Therefore, they have emerged as a vital tool and intermediary in the cryptocurrency ecosystem, demonstrated by stablecoin market capitalization above $150 billion in July 2024 (Dionysopoulos and Urquhart,24).
In much the same way eurodollars developed to address the risks faced by Cold War-era adversaries of the US, stablecoins emerged to address the banking needs of the systematically under-served by the traditional financial sector exchanges (Massad, 2024). Specifically, to mitigate unbanking limitations, cryptocurrency exchanges like Bitfinex established a third-party entity,the stablecoin provider. The stablecoin provider would be responsible for accepting deposits and converting them into an on-chain representation of said deposit, which could be used on the cryptocurrency exchange as a medium of exchange for other cryptocurrencies. This came to be known as a stablecoin.
TYPES OF STABLECOINS
Stablecoins differ in their underlying design mechanism to maintain price stability.
FIAT - COLLATERALIZED - pegged to fiat currencies, the stablecoin is privately issued for an equivalent amount of fiat currency in the reserve and is exchanged on a peer to peer basis on a blockchain based network like Distributed Ledger Technology (DLT). Tether USD is the largest crypto asset based on market capitalization and daily trading volume. Other examples include Circle’s USDC.
CRYPTO COLLATERALIZED - pegged to cryptocurrencies. These are usually over collateralized to the underlying asset because of the extreme volatility of the cryptomarket. They are maintained by smart contracts which would liquidate the transaction just in case the value of the crypto currency falls below a certain threshold. One example is DAI created by MakerDAO is backed by Ethereum.
ALGORITHMIC - these aim to maintain price stability by automatically expanding and contracting their supply through smart contracts in response to market demand instead of being directly backed by assets. One example was Terra’s UST before its collapse in 2022.
COMMODITY BACKED - backed by physical assets like Gold, Oil etc. These coins are a digital token for a specific quantity of the underlying commodity.The actual commodities are stored in secured facilities while the blockchain records their ownership which can be traded further. Examples include Tether Gold, XAUT, Paxos Gold.
CENTRAL BANK DIGITAL CURRENCY (CBDC)
According to the International Monetary Fund, a central bank digital currency is a digital version of a fiat currency that is issued and regulated by a central bank. It is an account based liability denominated in the national currency at a central bank.
THESIS
This paper is being written with the aim to understand the adoption of stablecoin by advanced economies like USA to enhance innovation in decentralized finance platform, some emerging markets and developing countries (EMDE) for dollarisation of their own devalued fiat currency and the case of India adopting CBDC over stablecoins. It states the market capitalization of some stablecoins in developed economies, its components, risks and regulations.
The research including meta analysis of qualitative and quantitative data as well interviews with financial experts and bank managers indicate that stablecoins can disrupt the financial stability and the monetary policy of India alongwith increasing the divide between the rich and the poor and provided the solution of central bank digital currency to enhance financial inclusion. The research data also highlighted the use of stablecoins by illicit addresses which can escalate problems of funding of terrorism and money laundering for India.
LITERATURE REVIEW
A research paper studied the impact of stablecoins on the cryptocurrency and financial system over a decade to evaluate its growth and purpose. By studying the Mcap, amount of coins minted or burned, on- chain settlement and number of addresses holding stablecoins found out that their market capitalization reached a high of over $180 billion in 2022 and then above $150 billion in 2024 (Dionysopoulos, Urquhart,24). They serve as a stable medium of exchange against the volatile cryptocurrencies and are a good store of value. The rise in their popularity was due to the change in the underlying reserves to yield generating assets like commercial paper,treasuries etc and their use case in DeFi platforms and earning rewards which incentivised the holders (Catalini et al.,2022).
THE CASE OF TERRA-LUNA CRASH
The market declined due to the collapse of Terra-LUNA ( Briola et al.,2023).This was an algorithm backed design which was supposed to adjust between two tokens UST (stable coin) and LUNA ( a backup token). But this system didn't work well and it couldn't maintain the peg. Due to panic sell off, liquidity dried up quickly leaving investors with fewer options to exit. Terraform Labs, the company behind UST, relied on Bitcoin to stabilize UST but this backfired because of its volatility as the price of Bitcoin also dropped.
COMPONENTS AND REWARDS
It was also found that the dominant design mechanism was USD backed and Tether’s USDT and Coin’s USDC constitute 90% of the issuance. (Klages- Munndt et al.,2020). According to Agata Ferreria, who studied the rewards and risks associated to stablecoins found out that they contribute to faster, cheaper and more efficient payments and enhance financial inclusion. According to the International Monetary Fund,IMF, stable coins can be used for domestic payment services and cross border remittances. They combine the benefits of cryptocurrencies including transparency due to Distributed Ledger Technology and auditability with higher utility due to their purported stability, International transactions, banking and industrial use cases and settlement within minutes as compared to the traditional centralized banking system which is expensive and can take days. They are also programmable making them useful in business logics. (Ferreria,21)
Thus, stable coins are an important innovation in the decentralised finance system.
CASE OF THE LIBRA PROJECT
The announcement of a global stable coin Libra by Meta (Facebook) in 2019 alarmed regulators worldwide. Libra 1.0 would be a stable coin with a global reach due to the strong network leveraging Facebook’s user base. It was backed by a basket of bank deposits and short term reputable government securities but it raised concerns over monetary Sovereignty and policy, supply and capital controls and global financial stability. After intensive public scrutiny of Libra 1.0, in April 2020 the Libra Association announced a revamped version of Libra 2.0 which again met with a lot of criticism. By October 2020 in a major blow to the project several members withdrew from the association and the coin was rebranded Diem which now focuses on the US market with the US dollar as its base currency( Ferreira,21)
RISKS
The International Monetary Fund (IMF), Financial Stability Board (FBS) , Bank of International Settlements (BIS) and numerous Central banks and other regulators are concerned by the scope for rapid adoption of a stable coin rendering it systemic (FSB, 2022, IMF 2021,FSOC 2021, Arner et al., 2020). This would cause a major disruption which would affect the global currency hierarchy, domestic money hierarchies, funding of and loan provision by commercial banks, Financial stability, integrity of payment systems and monetary policy. Meta’s aborted project has merely served to underscore these concerns (Kharif 2022,Diem 2020, Eichengreen and Viswanath - Natraj 2020).
According to the Bank of England's New forms of digital money discussion paper released in June 2021, stable coins pose a risk of Reserve drain and disintermediation. As stable coins become systemic,payments would be made from commercial bank deposits since they are issued for Fiat currency and then they enter the blockchain. Thus, the commercial bank loses both an asset and liability Reserve drain or disintermediation. These banks still need reserves for settlement so they either borrow from Central banks or increase costs on borrowing. On the other hand, stable coin issuers holding fiat reserves can buy more securities and bonds leading to wholesale deposits in few commercial banks. These deposits are treated differently under Basel III which requires more reserve capital thereby increasing costs. These issues can manipulate the market or use platforms to encourage people to use their stable coins exclusively creating monopolies. (Morgan 2022). “Tether Holdings owned $97.6 billion worth of US treasuries in June 2024, a new high. Hence, Tether now owns more US Treasuries than the governments of Germany, the United Arab Emirates (UAE), and Australia. Hence, Tether is now the 18th largest holder of US Treasury bonds.”(Henderson 2024). In 2021, the US president’s Working Group on Financial Markets published a report stating risks associated with stablecoins and the urgent need for regulations. In case of a run on a stablecoin and mass redemptions there would be fire sales of reserve assets such as commercial paper, treasuries etc.
by the issuers to meet the redemption demands. This can lead to decline in prices of the assets. Such situations lead to panic redemptions of other stablecoins worsening the sell- off. This would cause a domino effect affecting the market liquidity in DeFi and mass liquidations of all other crypto assets. Investors who used crypto as collateral for loans face margin calls and forced liquidations adding to market instability.Traditional financial firms with exposure to crypto markets may be forced to liquidate other assets to cover margin calls causing broader market sell offs.
A chapter of the October 2021 global financial stability report explores the growing systemic risk of crypto assets including stable coins. Benoit Coeure, Chair of the Committee on Payments and Market Infrastructures (CPMI) and member of the Executive board of the ECB in his July 2019 speech to the G7 highlighted several serious risks stemming from global stablecoin concerning anti-money laundering (AML), combating the financing of terrorism (CFT), consumer data protection, cyber resilience, fair competition , tax compliance, issues related to monetary policy transmission, financial stability and public trust in global payment systems. He also acknowledged the many benefits of faster and cheaper payments and cross border remittances. He suggested meeting the highest regulatory standards, prudent supervision and globally consistent regulatory approaches. “These developments (stablecoins) can undermine the effectiveness of monetary policy, circumvent capital controls, strain fiscal resources and threaten financial stability. Inconsistency in thresholds to identify a systemically important stablecoin (e.g., an advanced economy versus a small open emerging economy) remains a unique cross-border regulatory and supervisory challenge.”
(G 20 report)
REGULATIONS
In the July 2019 G7 meeting, ministers agreed that projects such as Libra may affect monetary sovereignty and the functioning of the International Monetary system. World leaders were more concerned that projects like Libra could disrupt the status quo of financial systems and the established economic order than they were perceptive of the potential benefits and opportunities that stable coin innovation presents. In October the financial stability board (FSB) delivered a report to the G20 acknowledging that stable coins can indeed pose systemic risk due to the large user base. Similarly the financial action task force (FATF) issued a statement reiterating that global stable coins should not fall outside of AML controls and should be subject to the FATF standards. (Ferreira, 2021). Among the more comprehensive regulatory developments is Markets in crypto assets (Mica) in the EU which aims to address potential risks to financial stability and orderly monetary policy. For stable coins of significant potential, Mica provides additional rules including stronger capital investor and supervisory requirements, covering governance, conflicts of interest, reserve assets, custody, investment and the white paper as well as provisions on the authorisation and operating conditions of service providers. Requirements include potential safeguards, organisational requirements and rules on the safekeeping of funds. Plus more specific requirements applicable to certain services, the offering and trading of any stable coins that do not fall within mica definitions and do not fulfil regulatory requirements will not be permitted within the EU.
Before the end of the tenure of the 116th U.S Congress, a draft of the stable coin tethering and Bank licence enforcement (STABLE ACT) was introduced proposing significant increases in the regulatory oversight of stable coins requiring all stable coin issuers to have a banking charter, be licensed by multiple federal agencies and follow banking regulations (Ferreira, 2021).
STABLECOINS IN THE EMERGING MARKETS
Emerging Markets and Developing economies (EMDE) such as Turkey or Argentina suffer hyperinflation which could lead their citizens to turn their savings into US dollars.(Ante, Fiedler et al.,23). In 2024 USDT-TRY is by far the largest trading pair by volume on Binance with more than 22 billion dollars (Aubert,24).According to the Chainalysis Team, Argentina's stable coin market is among the leaders in the Latin America region. Argentina share of stable coin transaction volume is 61.8% which is well above the Global average of 44.7%.
CENTRAL BANK DIGITAL CURRENCY (CBDC)
According to Mohit Chawdhary, 2024, An INR-backed stablecoin holds significant appeal due to its synergies with the India Stack, a collection of open APIs and digital public goods centered on identity, data, and payments. The India Stack provides an open infrastructure that Indian entities can utilize to deliver digital products and services in a transparent and efficient manner.
The core components of the India Stack, including DigiLocker, Aadhar, the Unified Payments Interface (UPI), and the Data Empowerment and Protection Architecture (DEPA), form a robust foundation for the development of a transparent and open INR-stablecoin ecosystem. For example, the government could require that INR-based stablecoins be issued exclusively to verified VDA wallets using DigiLocker and Aadhar, thereby addressing concerns surrounding anonymity.
Additionally, integrating programmable INR-backed stablecoins with UPI could unlock a wide range of applications. Such stablecoins could facilitate automated international transfers to and from countries like France, which already support UPI payments. This would ensure complete traceability while addressing issues related to money laundering.
Furthermore, INR-backed stablecoins could serve as an alternative payment method for accessing public and private services on open networks like the Open Network for Digital Commerce (ONDC). This approach could enable a significant portion of India’s unbanked population to access digital services by simply using a wallet to store and transfer INR-backed stablecoins, bypassing the need for a bank account, which often involves cumbersome documentation.
The decentralized and open nature of INR-backed stablecoins would also empower start-ups and fintech companies to harness their programmability for developing innovative financial solutions. In contrast, the scope for such innovation with the eINR (Indian CBDC) may be limited, as it is issued and controlled by the Reserve Bank of India and commercial banks, which tend to adopt a more cautious stance toward financial innovation.
The introduction of a Central Bank Digital Currency (CBDC) in India provides several advantages, including:
Reduced Currency Management Costs: The Indian CBDC can alleviate the challenges of handling, printing, and managing cash. It will lower the reliance on physical cash, reduce transaction costs, and result in higher seigniorage.
Mitigation of Payment Risks: By reducing settlement risks, offering efficient and trusted payment options, and facilitating quicker and more cost-effective cross-border transactions, the CBDC minimizes payment-related risks.
Boost to the Digital Economy: The implementation of a CBDC, especially in collaboration with Fintech companies, will significantly accelerate the growth of India's digital economy.
Enhanced Financial Inclusion: The CBDC initiative will help integrate more unbanked individuals into the formal financial system, expanding financial inclusion.
Combating Illicit Financial Activities: The Indian CBDC can strengthen anti-money laundering (AML) and countering the financing of terrorism (CFT) measures, serving as a secure medium for cross-border transactions.
[20/01/25, 12:26:41 PM] mom: An INR-backed stablecoin holds significant appeal due to its synergies with the India Stack, a collection of open APIs and digital public goods centered on identity, data, and payments. The India Stack provides an open infrastructure that Indian entities can utilize to deliver digital products and services in a transparent and efficient manner.
The core components of the India Stack, including DigiLocker, Aadhar, the Unified Payments Interface (UPI), and the Data Empowerment and Protection Architecture (DEPA), form a robust foundation for the development of a transparent and open INR-stablecoin ecosystem. For example, the government could require that INR-based stablecoins be issued exclusively to verified VDA wallets using DigiLocker and Aadhar, thereby addressing concerns surrounding anonymity.
Additionally, integrating programmable INR-backed stablecoins with UPI could unlock a wide range of applications. Such stablecoins could facilitate automated international transfers to and from countries like France, which already support UPI payments. This would ensure complete traceability while addressing issues related to money laundering.
Furthermore, INR-backed stablecoins could serve as an alternative payment method for accessing public and private services on open networks like the Open Network for Digital Commerce (ONDC). This approach could enable a significant portion of India’s unbanked population to access digital services by simply using a wallet to store and transfer INR-backed stablecoins, bypassing the need for a bank account, which often involves cumbersome documentation.
The decentralized and open nature of INR-backed stablecoins would also empower start-ups and fintech companies to harness their programmability for developing innovative financial solutions. In contrast, the scope for such innovation with the eINR (Indian CBDC) may be limited, as it is issued and controlled by the Reserve Bank of India and commercial banks, which tend to adopt a more cautious stance toward financial innovation.(Ozili, 2023).
META-ANALYSIS
The research was conducted using mixed methods of analysing available data and the report issued by Reserve Bank of India(RBI) and G 20 and an interview conducted with Mahesh Swaminathan, Senior Consultant- India Lead for Payments and Commerce Market Intelligence (PCMI).
The G20 report stated, “These developments can undermine the effectiveness of monetary policy, circumvent capital controls, strain fiscal resources and threaten financial stability. Inconsistency in thresholds to identify a systemically important stablecoin (e.g., an advanced economy versus a small open emerging economy) remains a unique cross-border regulatory and supervisory challenge.”
According to the RBI Report on stablecoins, it issued a stern warning on 30 December 24 regarding the widespread use of crypto assets, including stablecoins, highlighting their potential adverse impact on the macroeconomic and financial stability of the country.
The RBI's warning, made in its latest Financial Stability Report (FSR), outlines the risks posed by excessive crypto adoption, which could undermine various facets of economic management.The RBI pointed out that excessive use of crypto assets could reduce the effectiveness of monetary policy. It stressed that these assets, by bypassing conventional financial channels, could worsen fiscal risks and circumvent capital flow management measures.
Moreover, the shift of resources into cryptocurrencies could divert funds from financing the real economy, posing a threat to national economic stability. The report also pointed to the broader risk to global financial stability.
Even though the size of crypto-asset markets remains small, their continued growth and increasing linkages with the traditional financial system could pose systemic risks. Stablecoins also present potential run risks, citing the International Monetary Fund - Financial Stability Board (IMF-FSB) synthesis paper on policies for crypto assets.
Through 2021, Bitcoin reigned supreme as the cryptocurrency of choice among cybercriminals, likely due to its high liquidity. But that’s changed over the last two years, with stablecoins now accounting for the majority of all illicit transaction volume. This change also comes alongside recent growth in stablecoins’ share of all crypto activity overall, including legitimate activity. However, stablecoin dominance isn’t the case for all forms of cryptocurrency-based crime.
Source - CoinGecko The total fiat-pegged stablecoin market cap has since grown 35.4% from $119.1 billion to $161.2 billion as of August 2024.
According to the Central Board of Workers Education (CBWE), only 38% of households in India are digitally literate. This implies that the benefits of Stablecoins will be available to only a few, further increasing the divide between the rich and poor and also affecting the government monetary schemes for the underprivileged in India.
Source - Chainalysis
Through 2021, Bitcoin reigned supreme as the cryptocurrency of choice among cybercriminals, likely due to its high liquidity. But that’s changed over the last two years, with stablecoins now accounting for the majority of all illicit transaction volume. This change also comes alongside recent growth in stablecoins’ share of all crypto activity overall, including legitimate activity. However, stablecoin dominance isn’t the case for all forms of cryptocurrency-based crime.
According to a senior consultant - India head at Payments and Commerce Market Intelligence (PCMI), in a country of 1.4 billion, use of stablecoins could undermine the sovereign control over currency and the effectiveness of monetary policy. In India, 70 to 90% of all transactions by volume are done using cash so trust in digital financial systems which is not backed by the government is very low.
CONCLUSION
Stablecoins represent a significant innovation within the realm of decentralized finance, offering developed economies a versatile tool for enhancing financial efficiencies and fostering innovation. Their ability to facilitate faster, cheaper transactions and serve as a stable medium of exchange amidst volatile crypto markets has positioned them as pivotal instruments in the modern financial ecosystem. In advanced economies like the United States, the integration of stablecoins into the financial infrastructure supports innovation and expands opportunities within the digital economy.
The potential for stablecoins to disrupt financial stability and undermine monetary policy is considerable. Their widespread adoption could bypass traditional banking systems, thereby reducing the effectiveness of central bank policies and complicating macroeconomic management.
Moreover, the uneven digital literacy across India, where only 38% of households are digitally literate, suggests that the benefits of stablecoins would be unevenly distributed. This could exacerbate existing economic disparities, deepening the divide between the wealthy and the underprivileged. Additionally, the anonymity and borderless nature of stablecoins make them attractive for illicit activities, including money laundering and terrorism financing, posing significant risks to national and international security frameworks.
In contrast, the adoption of a Central Bank Digital Currency (CBDC), like the proposed digital rupee, offers a controlled, regulated alternative that could enhance financial inclusion without compromising monetary sovereignty. A CBDC could leverage India’s robust digital infrastructure while maintaining oversight by the Reserve Bank of India, ensuring alignment with national economic objectives and mitigating risks associated with financial crime.
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