stablecoinThe collateral for stablecoins: does it matter?
The collateral backing stablecoins is not simply a technicality; it is the cornerstone of their stability and credibility. The aim of stablecoins is to maintain a stable value, typically pegged to a fiat currency such as the dollar or euro, and this stability hinges on the quality and management of their collateral. Furthermore, the type of assets held as collateral directly impacts the stablecoin’s reliability and market confidence. In recognising this, regulators (e.g. the Bank of England and BIS) have launched initiatives such as Project Pyxtrial, a pioneering effort designed to monitor and evaluate the balance sheets of stablecoins. Project Pyxtrial uses advanced technology to ensure that the assets backing these digital currencies consistently exceed their liabilities, providing a crucial layer of oversight in a rapidly evolving and largely unregulated sector. This initiative represents a significant step toward enhancing transparency and trust in the stablecoin market, addressing potential risks before they can undermine financial stability.
Using an historical connection, the Trial of the Pyx (dating back to 1282) is among the UK’s oldest and most symbolic ceremonies dedicated to maintaining the integrity and accuracy of its coinage with the name “Pyx” being derived from the Latin “pyxis”, signifying a small box used for storing coins for evaluation. Each year, coins from various batches are selected at random, sealed and placed in Pyx boxes and these coins undergo detailed testing to confirm their weight, composition and compliance with legal standards. Moreover, this tradition underscores the critical role of trust and transparency in monetary systems. In a modern-day parallel, Project Pyxtrial adapts this tradition to the digital age, serving as a quality control mechanism for stablecoins. Insomuch as the Trial of the Pyx ensures the integrity of physical coins, Pyxtrial monitors the balance sheets of stablecoins, ensuring that their collateral backing remains sound — this project bridges the gap between historical ceremonial practices and contemporary digital finance, safeguarding trust in new forms of currency. Meanwhile, in the world of fiat-backed stablecoins, Tether (USDT) and USD Coin (USDC) are prominent players, both supported by traditional currency reserves. Tether’s holdings include $90 billion in US Treasuries, $4.7 billion in Bitcoin and $3.8 billion in gold, offering significant security. However, this strength has also brought intense scrutiny. In 2021, Tether was required to pay $18.5 million by the New York Attorney General for making misleading claims about its reserves. Yet, despite these controversies, Tether made $5.2billion in the first half of 2024 — impressive for a company that employs only 125 staff. USD Coin, issued by Circle and partly owned by Coinbase, along with Tether’s USDT, commands a 73.5% market share among top stablecoins. As of June 2024, Circle’s compliance with the EU’s MiCA regulations and its e-money license in France have strengthened its regulatory position; these fiat-backed stablecoins promise stability but are not immune to the challenges and regulations of traditional financial systems.
Assets that back Circles’ USDC
Source: Circle
On the other hand, crypto-backed stablecoins (such as DAI) provide a decentralised option by using volatile cryptocurrencies as their collateral. The strategy of over-collateralisation — where the collateral exceeds the value of the stablecoin issued — aims to shield against market volatility. Yet, this decentralisation introduces its own set of issues. In a market decline, the value of the collateral might drop sharply, challenging the stablecoin’s capacity to keep its peg. This creates a tension between the advantages of decentralisation and the stability that users desire, leading to concerns about their long-term stability in a market characterised by swift and unpredictable movements. Taking a different approach, commodity-backed stablecoins such as Paxos Gold (PAXG) tie their value to physical assets, i.e. gold. And this connection to tangible reserves offers a sense of real-world stability that fiat or crypto-backed coins might lack. Yet, managing these physical assets introduces its own set of complexities. The challenges of storing and auditing these commodities, along with navigating the regulatory landscape, raise an important question: Does this model truly offer a safer alternative or does it simply shift the risks in a different direction?
Ultimately, the nature of collateral behind a stablecoin plays a pivotal role in determining its future. Essentially, traditional assets back Tether and USD Coin, volatile cryptocurrencies support DAI and tangible reserves underpin Paxos Gold, with each of these options presenting its own set of security features and risks. Understanding these differences will be essential as the stablecoin market develops.
The collateral that supports a stablecoin is fundamental to its risk and stability profile, not just a technical detail. For fiat-backed stablecoins, the security provided by traditional currency reserves can offer reassurance, although this stability is linked to centralised systems and is thus vulnerable to regulatory and financial shifts. Conversely, crypto backed stablecoins present the benefit of decentralisation but face their own set of challenges. During market disruptions, the assets meant to stabilise these coins can contribute to their volatility and finding the right balance between stability and decentralisation is a nuanced challenge, with collateral choice being crucial. And, as stablecoins gain traction in the digital finance arena, the complexity of regulatory issues intensifies. The Bank of England’s discussion paper, dated July 30th, 2024, underscores the need for a flexible regulatory framework that can adapt to swift innovations while ensuring ongoing stability and trust. Andrew Bailey, the Governor of the Bank of England, has emphasised that the way money is used is evolving rapidly, pointing out that policymakers must be humble in their approach and acknowledging that predictions made today might be outdated tomorrow. Essentially, to maintain the effectiveness of money, two key criteria must be met: the singleness of money (ensuring different forms of money are exchangeable), and the finality of settlement (assuring that payments are made at par value). In addition, although the Bank of England is advocating for industry innovation to develop new infrastructure for digital money, it has made clear that current stablecoins fall short of the standards required for widespread use in payments.
Moreover, trust and transparency are critical in the stablecoin sector. PayPal launched a stablecoin in August 2023 which has grown to have over $1billion of assets, works with Paxos and also has attestation reports issued by WithumSmith+Brown PC, an independent third-party accounting firm. Regular audits, such as those by Deloitte for the USDC (USD Coin), are essential in sustaining confidence. These audits ensure a detailed review of a stablecoin’s reserves, affirming that each coin is fully backed and so build trust among users and investors. For instance, the GBPT (Poundtoken) is subject to monthly audits by KPMG, another top accounting firm, further enhancing transparency. In contrast, Tether (USDT) has faced scrutiny due to its reliance on quarterly attestations by BDO Italia, rather than full audits from a ‘big four’ accounting firm. Unsurprisingly, the lack of a comprehensive audit has fuelled controversies and scepticism about Tether’s reserves, highlighting the risks of opaque practices. When stablecoin issuers fail to provide transparent reporting, trust can quickly deteriorate so leading to market instability. Therefore, ensuring regular, transparent audits is essential to sustaining trust in this fast-evolving market. Market forces present considerable challenges for stablecoins, particularly during periods of stress, and the nature of the collateral behind a stablecoin significantly influences its capacity to remain stable in turbulent conditions. Furthermore, fiat-backed stablecoins such as USDC usually benefit from the stability provided by traditional reserves. Nonetheless, they can still be subject to scrutiny in extreme market scenarios, leading to concerns about their durability. Crypto-backed stablecoins, such as DAI, offer decentralisation but often struggle with higher volatility and these coins are usually over-collateralised to guard against price swings. Yet, during major market declines, the value of the collateral can fall drastically, challenging the stablecoin’s ability to stay pegged. And this raises an important issue: is this built-in risk manageable or does it reveal a fundamental flaw? In practical terms, the ability of stablecoins to endure market volatility is essential. Whilst some may handle these stresses successfully, others might not, whereby highlighting the limitations of their collateral structures. Hence, evaluating stablecoins requires attention to their utility and adoption; the type of collateral that supports a stablecoin influences its real-world applications. Fiat-backed stablecoins such as USDC are commonly used for everyday transactions due to their stability and user-friendliness and so they serve as an effective means for trading, remittances and fitting into traditional financial systems. Conversely, crypto backed stablecoins bring a fresh perspective, especially within decentralised finance (DeFi) — they offer greater flexibility and better integration with blockchain environments but also carry increased risk due to market volatility.
And so, striking a balance between practical use in daily transactions and the pursuit of cutting-edge financial innovations is challenging. As stablecoins advance, achieving this equilibrium will be key to widespread adoption whereby ensuring they are dependable for everyday use whilst supporting new financial models. In summary, collateral transcends a mere technical detail; it is a fundamental building block that dictates the stability and dependability of stablecoins. As we envision the future of digital currency, we must ask ourselves: are we establishing a robust and secure financial system, or are we forming a delicate structure susceptible to collapse? The manner in which we manage and comprehend stablecoin collateral will influence their future and their role in the global financial landscape. Reflecting on this, we need to determine if we are laying a strong foundation or not.
