The cryptocurrency market has long been characterised by extreme volatility, as evidenced again recently by Bitcoin’s significant price fluctuations. While this volatility has been a persistent feature since Bitcoin’s inception, the recent massive price movements are a stark reminder of the volatility and risks associated with all unbacked cryptocurrencies.
Stablecoins were first introduced in 2014 in response to this inherent instability in the crypto market. Developed as a trading pair for cryptocurrencies like Bitcoin, the primary aim of stablecoins was to address price fluctuations, which some felt made crypto less suited to everyday transactions and less viable as a store of value.
Stablecoins aim to solve this perceived problem by offering the benefits of digital currencies – such as fast, borderless transactions – while maintaining a consistent value, typically pegged against a fiat currency like the US dollar.
By the end of 2023, the stablecoin market had grown to a substantial size, albeit with quite significant ebbs and flows along the way. Today, the total market capitalisation of stablecoins stands at about $120 billion, well down from its peak of over $180 billion in 2022. This decline can be attributed to a combination of shifting investor sentiment, challenging crypto market conditions, and the attractive returns on offer by traditional equity and income markets.
However, despite the decline, stablecoins still represent a significant portion of the overall cryptocurrency base, accounting for about 6.5 percent of the total crypto-asset market capitalisation. Tether (USDT), the largest stablecoin, accounts for over $80 billion of this total, followed by USD Coin (USDC) at around $26 billion. While these figures pale in comparison to the market capitalisation of the likes of Bitcoin and Ethereum, they are still significant indicators of the importance of stablecoins in the crypto ecosystem.
Stablecoins aim to offer a more stable digital currency option compared to traditional cryptocurrencies by employing various mechanisms tailored to each type. The three primary types are fiat-collateralised stablecoins, crypto-collateralised stablecoins and algorithmic stablecoins.
While it’s often assumed that fiat-collaterised stablecoins are entirely backed by traditional fiat currencies, they are actually backed by reserves that consist largely of US treasuries and short-term debt. This introduces specific risks such as interest rate risk, where changes in interest rates can affect the value of these securities, and liquidity risk, which can be problematic if there’s a need to quickly convert these securities into cash.
Crypto-collateralised stablecoins leverage other cryptocurrencies as collateral, introducing a different set of risks linked to the volatility of the crypto markets. And algorithmic stablecoins use smart contracts to adjust supply based on demand. This can lead to vulnerabilities in the underlying algorithm, while unexpected large-scale economic shifts could also destabilise the coin’s value. While each type of stablecoin has its strengths and weaknesses, all share the common goal of providing a more stable alternative to traditional cryptocurrencies.
Initially, the stablecoin market saw significant growth as investors and traders sought refuge from crypto volatility. However, this growth was not without its challenges.
The collapse of Terra, an algorithmic stablecoin, in May 2022, sent shockwaves through the crypto world. Despite not being a true stablecoin in the traditional sense, Terra’s failure severely dented confidence in the broader stablecoin market, leading to a period of decline and increased scrutiny.
Terra’s collapse was a reminder that the reality of stablecoins is more complex than their name might suggest. While they have proven useful as a means of facilitating crypto trading and cross-border payments, they face several challenges as a widespread payment method. Issues such as scalability, transaction speeds, and costs, still need to be addressed for stablecoins to compete with traditional payment systems.
The risk of de-pegging, where a stablecoin’s value deviates from the currency or other asset to which it is linked, has also been a concern as demonstrated by the fluctuations that still take place in even the largest stablecoins. To address this, stablecoins like Terra and FDUSD have implemented specific mechanisms to manage and report their collateral more effectively.
Terra uses a dual-token system, balancing TerraUSD with LUNA to absorb volatility and maintain stability through automated supply adjustments. FDUSD maintains reserves at a specific threshold, using real-time monitoring and transparent reporting. These strategies aim to mitigate de-pegging risks and enhance stablecoin stability and reliability.
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Despite this de-pegging risk, stablecoins offer numerous advantages, particularly in developing economies. In Africa, for instance, they have garnered particular interest due to the continent’s unique and challenging financial landscape. With a large unbanked population and issues of currency instability in many countries, stablecoins offer the potential to address the need for financial inclusion and can serve as a useful hedge against inflation.
Countries like Nigeria, Kenya, and South Africa are leading the way in stablecoin adoption in Africa, driven by factors such as remittance needs, limited access to formal financial services, and the growing popularity of cryptocurrencies.
As the stablecoin market continues to evolve globally, there is a growing recognition of the need for clearer regulatory frameworks. Regulatory ambiguity remains a significant hurdle to investor confidence and wider adoption. In the US and other major economies, debates continue over how to classify and oversee stablecoins. Resolving these challenges will be crucial for the long-term viability and growth of the stablecoin market.
In Africa, regulatory responses vary across the continent, with some countries taking a more cautious approach while others are more open to innovation. Kenya is considering regulations to prevent illicit activities, while South Africa is expected to have comprehensive regulations in place for tokenized deposits and crypto assets by 2025. Companies like Binance are actively engaged in discussions with regulators to promote safe and efficient crypto markets.
Looking to the future, stablecoins are likely to continue to play an important role in shaping the digital economy, both globally and in Africa. Recent stablecoin initiatives by major financial services providers like PayPal and Visa demonstrate growing institutional interest in this form of pegged cryptocurrency stablecoins.
However, the overall payments landscape is also evolving, as evidenced by the development of Central Bank Digital Currencies (CBDCs) and tokenised bank deposits, which could offer alternatives to privately issued stablecoins and hinder their journey towards more widespread adoption.
That said, as the crypto market matures and regulatory frameworks continue to evolve, stablecoins may well come into their own as a viable bridge between traditional finance and the world of cryptocurrencies.
However, their long-term success will still depend on their ability to deliver on the promise implied by their name, which is ultimately to provide the stability that many crypto investors and users desire.
Did you know: Binance is celebrating their seventh anniversary this month supporting over 210 million users globally. Binance’s core focus remains on users, innovation, and a hardcore work culture. Their robust infrastructure supports 541 digital assets and 2632 trading pairs, handling high user activity smoothly. Read thoughts from our CEO here: Seven Years at The Frontier of Financial Innovation.
Hannes Wessels is the General Manager of Binance South Africa