Stablecoins Are Not Stable: How It Affects You

The exponential rise of stablecoins, which are marketed as a stable form of cryptocurrency, has sent a wave of excitement through the financial world. Touted for their potential to enable faster and cheaper transactions, stablecoins have gained popularity among traders and investors.

However, it is becoming increasingly clear that stablecoins may not be as stable as they claim to be. This could potentially have implications for individual investors and the wider financial market.

Stablecoins not as stable as promised

Unlike other cryptocurrencies, stablecoins are pegged, or “pegged”, to an asset, often the US dollar. By pegging their value to a less volatile asset, stablecoins aim to offer the best of both worlds: the speed and privacy of cryptocurrencies without the price volatility.

Nevertheless, cracks are beginning to appear in this model, leading to significant investor uncertainty and market distortions.

“We find strong evidence of stablecoin instability, although these deviations from the $1 mark are gradually being corrected at different rates for all stablecoins. [At times,] the anomalies do not converge even in the long run due to non-stationarity of the differentiated series between the price and the $1 mark,” concluded Kun Duan, a researcher at Huazhong University of Science and Technology.

Stablecoins have largely been used to enable speculative trading in other crypto assets. Tether and USD Coin, the two largest stablecoins in the market, claim to be fully backed by assets.

However, the transparency and oversight of issuers’ ability to meet redemption requests has come under scrutiny.

Some Top Stablecoins Lose US Dollar Peg

In some cases, regulators have raised concerns about the liquidity, quality and valuation of the reserves held by stablecoin issuers.

For example, Tether, once considered a paragon of stability, has faced a loss of investor confidence. As a result, USDT temporarily lost its peg to the US dollar on June 15.

“Markets are tense these days, so it’s easy for attackers to take advantage of this general sentiment. But at Tether, we are ready as always. Let them come. We are ready to redeem any amount,” said Paolo Ardoino, CTO at Tether.

Similarly, TerraUSD, one of the largest algorithmic stablecoins, collapsed when it failed to maintain its peg. This led to significant investor withdrawals and disruption to the stabilization mechanism.

These disruptions are not just blips. They demonstrate an inherent vulnerability in stablecoin design. Especially those that are not fully backed by high quality liquid assets.

“We have a lot of casinos here in the Wild West, and the poker chip is these stablecoins at the casino gaming tables,” said Gary Gensler, chairman of the US Securities and Exchange Commission.

The risk of “runs” or rapid withdrawal of funds may jeopardize the ability of issuers to repay the full amount due to asset illiquidity. This risk is comparable to that of other financial investment products.

However, it is magnified for stablecoins due to the opaque and unregulated nature of the crypto ecosystem.

For example, Tether has faced regulatory fines over claims that its stablecoin is “fully backed by US dollars.” It turned out to invest part of its reserves in risky and illiquid assets with only a small capital buffer.

Other major stablecoin issuers have imposed restrictions on redemptions, further eroding investor confidence.

How Stablecoins Instability Affects Investors

For the individual investor, these revelations highlight that while stablecoins promise stability, they are far from risk-free.

Investing in stablecoins involves market, liquidity and operational risks, including fraud and cyber risks. Under current regulations, investors have little recourse for lost or stolen crypto assets.

The potential impact extends beyond individual investors. As stablecoins become more integrated into the banking sector, they may pose greater financial stability risks. For example, a run on a stablecoin could lead to a sudden outflow of deposits from banks or disruptions to funding markets.

Regulatory agencies are beginning to recognize these risks. Regulators are developing proposals to address the risks arising from stablecoin activity. However, as these regulatory frameworks evolve, investors should proceed with caution.

The lesson from recent events is clear. Stablecoins, similar to other cryptocurrencies, do not always guarantee a safe bet. Investors should approach them with caution, considering not only their potential rewards, but also the significant risks they entail.

Meanwhile, regulators must redouble their efforts to bring transparency and oversight to this fast-growing corner of the financial market.