The intention of a stablecoin is to provide price stability in a notably volatile market. Learn why they’ve become a frequent topic of conversation for the US government.
The US Senate Committee on Banking, Housing, and Urban Affairs held a hearing to discuss stablecoin regulation on December 14, 2021.
The committee expressed skepticism about stablecoins and concern that this type of digital asset could lead to increased incidents of fraud and market disruption.
Distrust in stablecoins comes from a few sources, but the biggest concerns related to investor protections include:
- Risk of bank runs in the event of a large market liquidity event
- Possible financial dependency on stablecoins in the current financial marketplace
- Fear the USD could lose its status as the global reserve currency
- Lack of regulatory clarity and reporting requirements of issuers
Below, we discuss the different types of stablecoins, various advantages and potential risks, how stablecoins are taxed, and potential next steps for regulations.
What is a stablecoin?
A stablecoin is a type of cryptocurrency where the price is fixed to an external reference; the reference could be another type of cryptocurrency, a fiat currency, or a commodity.
Additionally, stablecoins are an essential element of decentralized finance (DeFi) applications, and help to attract new participants to the tokenized economy.
Incumbent players such as banks and hedge funds, which rely on fees and lending platforms to generate income, have expressed fears that stablecoins could potentially steal a portion of their business; the evolving landscape is moving faster than regulations can occur, which has also been a cause for concern.
What are the advantages of stablecoins?
The intention of a stablecoin is to provide price stability in a notably volatile market. In theory, since it’s pegged to an external reference such as fiat currency, the price shouldn’t change as much as other crypto—where the price could fluctuate greatly on a day-to-day basis.
Given that stablecoins tend to experience less market volatility, crypto investors could use them as a risk-off asset in times of uncertainty; stablecoins tend to earn higher yields through interest and staking activities when interest rates are low.
What are the different types of stablecoins?
There are four types of stablecoins:
- Fiat-collateralized stablecoin
- Crypto-collateralized stablecoin
- Commodity-backed stablecoins
- Algorithmic stablecoins
What is a fiat-collateralized stablecoin?
A fiat-collateralized stablecoin holds a reserve of fiat currency to back the coin. For example, if one million stablecoins are issued, and the coin is tied to USD, the platform would hold $1 million USD or short-term liquid assets and cash equivalents.
In this instance, the purchase of a USD denominated stablecoin typically wouldn’t be accompanied by transaction fees when purchasing with USD on an exchange. When crypto is bought with stablecoins, transaction fees are generally lower than buying crypto directly with fiat. Additionally, many exchanges don’t charge fees when exchanging USD-denominated stablecoins to USD fiat and vice versa, which allows for easier liquidity transactions between crypto and fiat currencies.
The largest stablecoins currently in the market are pegged to fiat, mostly USD, and make up roughly 95% of the stablecoin market by value. The issuers claim to hold a 1-to-1 ratio of dollars to stablecoins in reserve. However, as noted in the report from the President’s Working Group on Financial Markets discussed in detail below, at times there’s little transparency into their reserve assets and lending practices; more information is needed to verify these claims.
What is a crypto-collateralized stablecoin?
A crypto-collateralized stablecoin is pegged to another cryptocurrency. To account for price fluctuations, the platform holds a larger amount of the cryptocurrency than the stablecoin; it’s not a one-to-one match per unit. The overcollateralization helps dynamically maintain the stability and liquidity of the coin even in turbulent market conditions.
Crypto-collateralized stablecoins play a major role in DeFi where they’re used as collateral for activities like lending and borrowing. Unlike most fiat-backed stablecoins on exchanges, crypto-collateralized stablecoins usually charge a contract-creation fee upon exchange to effectuate the smart contract.
Crypto-collateralized stablecoins can also be placed in DeFi savings accounts to generate higher yields than traditional fixed-interest investments. Given the less volatile nature of stablecoins, there’s less chance that price drops will offset an investor’s earnings from staking and yield farming activities when price drops occur on the underlying asset.
The Dai stablecoin—an Ethereum-based protocol—is one of the most popular crypto-collateralized stablecoins. Dai is created by leveraging Ethereum-based tokens as collateral through unique smart contracts. Every Dai in circulation is directly backed by excess collateral, meaning the value of the collateral is higher than the value of the Dai debt. All Dai transactions are public on the Ethereum blockchain.
What is a commodity-backed stablecoin?
A commodity-backed stablecoin functions similar to a fiat-collateralized stablecoin with one important difference; instead of being pegged to a fiat currency, it’s pegged to a commodity—most typically gold.
What is an algorithmic stablecoin?
An algorithmic stablecoin isn’t pegged to fiat currency or another crypto; it uses a smart contract—transactional protocols or computer programs that automatically execute when relevant events tied to the agreement take place—to oversee its value.
The algorithms in a smart contract calculate and adjust the amount of stablecoin needed to hit the intended value; coins are burned if the price relative value falls below a set price or minted when prices increase past a certain point. In essence, algorithmic stablecoins act as a central bank and adjust the supply based on demand to keep a relatively stable value.
If you own an algorithmic stablecoin, the amount of stablecoin will always be changing, but your percentage will stay the same until you buy more or dispose of it.
How are stablecoins taxed?
Stablecoins, like other cryptocurrency, are considered property for US tax purposes. Exchanging a stablecoin for another stablecoin or cryptocurrency is considered a taxable event.
The proceeds received are compared to the asset’s cost basis to determine the capital gain or loss of any given transaction.
Since most stablecoins are pegged to the USD, it’s not likely you’d accumulate capital gains tax when transacting with USD-backed stablecoins; fiat-backed stablecoins aren’t appreciating assets and generally don’t give rise to capital gains or losses.
This might not be the case for crypto-, commodity-, or algorithm-backed coins given that each of these underlying assets’ value changes relative to USD. For instance, if a stablecoin is pegged 1:1 with BTC, although it is stable relative to BTC, as BTC price changes relative to USD, appreciation or loss is likely to occur on transactions.
One of the many applications of stablecoins is yield farming or staking. Any increase in coins received from these activities is deemed income for US tax purposes and reportable as such.
For more information, please see our resources:
- Taxbit’s Cryptocurrency Tax Guide
- How to Report Crypto Losses on Your Taxes
- Crypto Tax Loss Harvesting: A Complete Guide
- A Quick Guide to the Wash Sale Rule and Cryptocurrency
- The Infrastructure Bill Has Passed: What’s Next for Crypto?
What are the potential risks of stablecoins?
Critics of stablecoins have also voiced concern over whether or not there are actually reserves to back the asset.
For example, in August 2021, the stablecoin Tether released an attestation statement that it had a reserve of approximately $63 billion in USD to back the coin. Prior to August 2021, Tether was being investigated by New York Attorney General Letitia James for claims around its backing; Tether settled out of court, but James blocked the platform, alongside its affiliated exchange Bitfinex, from conducting trading activity in the state.
In October 2021, Tether ultimately paid a settlement of $41 million to the US Commodity Futures Trading Commission (CFTC); the CFTC alleged that trading activity conducted by Tether between June 2016 and February 2019 wasn’t fully backed in USD as it had previously claimed.
Why is Congress so interested in stablecoins?
During the committee hearing on December 14, 2021, multiple senators expressed worry that a run on stablecoins would cause major disruption to US financial markets.
They raised concerns that this asset class has the potential to grow and affect the broader financial system in the event of a failure, run, or default—similar to the financial devastation caused by subprime mortgage lending practices that created a liquidity crisis and caused a recession in 2008.
Another concern surrounding the existence of stablecoins is their potential ability to limit or replace the powers and effectiveness of central banks and the USD as the global reserve currency.
What is a run?
A run occurs when a large group of consumers withdraw their support for an asset because they no longer believe an asset is financially solvent—in other words, large numbers of an asset are sold off at the same time because the public believes its liabilities exceed its potential benefits.
How Is the US Department of the Treasury Involved?
The committee’s concern likely originates from a report on stablecoins issued by the President’s Working Group on Financial Markets headed by Treasury Secretary Janet Yellen. In a statement regarding the report, the Treasury outlined what it sees as potential risks:
“Failure of stablecoins to maintain a stable value could expose stablecoin users to unexpected losses and lead to stablecoin runs that damage financial stability. Disruptions to the payment chain that allow stablecoins to be transferred among users could lead to a loss of payments efficiency and, depending on the extent to which stablecoins are used, undermine functioning in the broader economy. The potential for stablecoin arrangements to rapidly scale raises additional issues related to systemic risk and concentration of economic power.”
What happens next?
While the future remains unclear, regulations do need to be established for stablecoins.
As Representative Jake Auchincloss commented in the House Hearing on Financial Innovation and Digital Currency:
“Congress needs to provide clarity and predictability by statute… The rules of the road for Web3 can be a bipartisan initiative. The United States needs a primary crypto regulator that is tech and market structure neutral and that has three imperatives: it compels disclosure and transparency, it prevents fraud and abuse, and it promotes the efficiency and the resilience of the market. And this primary regulator should work with a self-regulatory organization as a counterpart in the private sector to establish one light touch rule book for spot and derivatives listings, custody requirements, token issuance, asset servicing, cross margining settlement, know your customer and anti-money laundering, disclosure and auditing, and, of course, stablecoin standards.”
The hope is that Congress and other regulators will work closely with industry professionals and thought leaders to determine what regulations could be put in place to help mitigate the risks associated with stablecoins.
Clear and uniform guidance surrounding reserve and liquidity requirements, disclosures and reporting requirements, daily attestations, and auditability would be a strong step towards risk mitigation. When and how these regulations will come about is uncertain, but they’re imperative to the ongoing adoption of stablecoins in the broader financial ecosystem.
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