Can Stablecoins Get Past Their Instability?

This post is part of Consensus Magazine’s Trading Week, sponsored by CME. Rajeev Bamra is a senior vice president and head of DeFI and digital assets at Moody’s Investors Service.

Stablecoins, cryptocurrencies designed to hold a stable value through a peg to an underlying asset, such as the U.S. dollar, have gained popularity for their potential to provide the flexibility of cryptocurrency without its price volatility. Their design — whether fiat-backed, as most are, or algorithmic (i.e. backed by other assets or cryptocurrencies) — is meant to offer users a refuge from the price gyrations of traditional cryptocurrencies like bitcoin (BTC) and ether (ETH).

One significant advantage of stablecoins is their operational efficiency and cost-effectiveness in cross-border transactions. Stablecoin transactions can take place with far fewer intermediaries than are involved in traditional bank transfers, for example, making them cheaper and faster to use for sending remittances abroad.

However, although such use cases are promising, stablecoins have not always lived up to their promised stability. In recent years there have been several instances of price depegging, when stablecoins fell below the value of their referenced assets.

These depegging events have been driven by a range of factors, including regulatory actions, security breaches and imbalances in digital asset pools supporting decentralized exchanges. Investors have responded by divesting their holdings, citing a lack of transparency in underlying reserves and the allure of higher yields from traditional assets in a rising interest rate environment.

Below is a closer look at how several events, as well as changing market conditions, have led to flows away from stablecoins:

• Terra: risk of unregulated stablecoins. The collapse of the algorithmic stablecoin, UST, on the Terra network in 2022 showcased the risks associated with unregulated stablecoins. The dramatic fall in UST’s value had a cascading effect on tether (USDT), the largest stablecoin, causing it to temporarily trade below its $1 peg. UST’s reliance on market anticipation and demand for both LUNA and UST left it vulnerable to market fluctuations.

• FTX: risks from links to traditional finance. The collapse of FTX, a once high-valued centralized crypto exchange, raised concerns about contagion in the industry and led to a decline in USDT’s value on major exchanges. These events underscore the interconnection between traditional finance and the cryptocurrency space.

• Curve and Uniswap: liquidity pool imbalances. Another challenge has been liquidity pool imbalances within decentralized finance (DeFi) platforms, such as Curve Finance and Uniswap. These imbalances, often driven by arbitrage and market fluctuations, have led to deviations from the intended peg of 1:1 for USDT, eroding trust within the DeFi community.

• Competition from high-yielding, low-risk assets. The inverse correlation between U.S. Treasury yields and stablecoin demand has further complicated the landscape. Rising yields have enticed risk-averse investors to move funds into Treasuries, affecting the market share of stablecoins.

In addition to price volatility and competition from higher-yielding, lower-risk assets like U.S. Treasuries, regulatory ambiguity remains a significant hurdle to expansion of stablecoin usage. The lack of clear regulatory frameworks in the U.S. has left investors cautious and prompted withdrawals from DeFi platforms. The potential adoption of a widely used global stablecoin raises concerns about a shift in purchasing power from sovereign money to private payment services.

Despite these obstacles, Moody’s believes that stablecoins are likely to play a notable role in a developing digital economy, because they offer an accessible bridge between traditional finance and DeFi. Indeed, some large financial firms are investing in the future of stablecoins. Recently, PayPal introduced an institutional stablecoin, and Visa has extended support for USDC payments within its own operations.

Stablecoins do face competition from more stable alternatives, such as central bank digital currencies (CBDCs) and tokenized bank deposits. However, the demand for stability and security in digital currencies remains. Until these alternatives become widely available, in Moody’s view stablecoins will likely be a significant force in shaping the future of digital money.

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