182$ Billion in Stablecoin Market Capitalization: Why?

Recently, stablecoins have been in the spotlight. What has been drawing particular attention is that the stablecoin market cap has steadily increased despite the crypto market as a whole following a downward trend since peaking last November.

According to data from TheBlock, the total stablecoin market value is $182 billion. This marks an about 25-fold increase over 2 years ago. Even compared to just last year, the market cap grew about six times.

Why is it growing? Stablecoin as risk hedging tool and DeFi channel amid bear market

The background to this incredible growth of the stablecoin market is the crypto market downtrend that started last November. Stablecoins were used as a so-called temporary safe haven when cryptocurrencies such as Bitcoin fell by more than 50% due to increased macroeconomic uncertainty due to the US Federal Reserve (Fed)’s rate hike and Russia’s invasion of Ukraine. Investors took a break from converting cryptocurrencies to cash, instead changing them into stablecoins.

James Malcolm, head of foreign exchange and crypto research at UBS, told Bloomberg: “Rather than moving money off crypto-trading exchanges by converting back into fiat currencies — a cumbersome and potentially costly process — it’s easier for investors to simply wait out the volatility in stablecoins”.

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Another background to the growth of the stablecoin market is DeFi (decentralized finance). DeFi is a financial service that aims to provide deposits, loans, and derivative transactions through a smart contract system without institutional intervention. When a DeFi service is used for the first time, stablecoins are used to link it to fiat currencies.

Stablecoins can be either deposited on a DeFi service for interest or exchanged for the protocol’s tokens to yield return on investment. According to DeFirate.com, depositing stablecoins in cryptocurrency services offers a remarkably high annual interest rate (APR) of 2-9%, considering that the average interest rate on bank savings accounts is a mere 0.06%.

The risky process of value linking

However, stablecoins also carry risks and challenges.

In the case of fiat currency-linked stablecoins, the risk varies depending on whether the operating institution maintains a fiat currency reserve. For example, stablecoin project Tether (USDT) is controversial because its reserve is not 100% cash and includes risky assets. The no. 2 by market cap, Circle (USDC), also sparked controversy with its recent reserve statement report, which changed the account’s status from “correctly stated” to “fairly stated”.

Another risk is that the value of a stablecoin can change when the underlying asset depreciates. Stablecoins that link their value to highly volatile cryptocurrencies are much more vulnerable to price instability. If the price of the cryptocurrency used to maintain its value plummets, this can break the stablecoin’s peg to the crypto value.

A recent example is Terra USD (UST). This algorithmic stablecoin is intended to link to the value of the USD by burning LUNA each time it is issued, but a recent surge in demand for UST has made it difficult to maintain its value through LUNA alone. In response, Terra has been hastily experimenting with adding Bitcoin to its reserve assets.

Erika Rasure, assistant professor of business and financial services at Maryville University told CNN that “because there are so many different issuers of stablecoins and they each have their own policies and offer different degrees of transparency, you have to do your own research before buying from any of them, adding that “it’s important that [issuers] have the cash assets on hand to keep [their] promise. It’s a transparency issue”.

Fiat currency influence – Regulatory volatility risk

Another risk to fiat-linked stablecoins is that they are affected by all the regulations to which fiat currencies are subject. Especially in the United States, authorities are moving to regulate stablecoins, out of concern that stablecoins might affect dollar supply and demand. In fact, Facebook’s DM (formerly Libra) was announced with the plan to create a stablecoin backed by a basket of global fiat currencies but floundered among concerns and pressure from US and other regulators.

On March 10th, US President Joe Biden signed the first executive order on crypto, directing federal agencies to draft cryptocurrency regulations. The order requires the US Department of the Treasury to draft regulations on stablecoins and other cryptocurrencies. Besides pressure from the United States, another issue comes from countries with high inflation rates, which could block stablecoins pegged to foreign currencies to protect demand for their local currency. For stablecoins backed by commodities such as gold, there is the additional challenge that it may take months to obtain the physical product and the process may require expensive shipping to a physical vault.

Yet despite these risks, some maintain that the stablecoin market can turn into a financial system comparable to fiat currencies. “To me, what is happening is that the crypto ecosystem is growing into a kind of shadow banking system with its own leverage, its own fractional reserve kind of setup”, said Brent Donnelly, president of Spectra Markets. “Over time, the crypto ecosystem just becomes a separate parallel system and as air comes out of crypto prices, the sellers leave their cash in stablecoins as there’s no real point moving it back and forth to and from fiat”.

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