What are stablecoins, and their potential in building a global payment rail

What are Stablecoins?

Stablecoins are a type of crypto designed to maintain a stable value by being pegged or tied to another currency, commodity, or financial instrument. They offer a solution to the high volatility in popular cryptos like Bitcoin (BTC), which has limited their suitability for everyday transactions.

Types of stablecoins and their significance

• Crypto-backed stablecoins

As the name suggests, these stablecoins are backed by other large cryptos (such as Ethereum) held in reserve. They offer decentralisation but can be susceptible to the volatility of the backing cryptos.

Some stablecoins are backed by other cryptos rather than fiat currencies. These crypto-backed stablecoins can be designed to track the price of the underlying cryptos or even a fiat currency. One notable example is Wrapped Bitcoin (WBTC), a stablecoin backed by Bitcoin reserves and issued on the Ethereum blockchain. This innovative approach allows users to leverage the benefits of Bitcoin on the Ethereum network, seamlessly integrating the two ecosystems.

• Fiat-backed stablecoins

Backed by fiat currencies like the US dollar and held in a bank account, they offer stability but rely on trust in the custodians of the fiat reserves. Examples of fiat-based stablecoins include USD Coin (USDC), Tether (USDT), and Binance (BUSD).

• Algorithmic stablecoins

Algorithmic stablecoins utilise strategic algorithms to adjust the coin supply to maintain price stability dynamically. They aim to be decentralised and not rely on fiat reserves, but their stability mechanisms can be complex and untested. Some notable examples include Dai (DAI), Ampleforth (AMPL), and Frax (FRAX).

• Commodity-backed stablecoins

Commodities like gold or silver back these stablecoins. They offer stability linked to the value of the commodity but require trust in the custodian holding the reserves. Two notable examples of these commodity-backed stablecoins are PAX Gold (PAXG) and Silver Token (SLVT). PAXG is pegged to the value of gold, while SLVT is backed by silver.

The need for improved payment systems

As digital transactions become more prevalent globally, the need for improved payment systems is increasingly evident. Cross-border payments are most popularly facilitated by SWIFT. SWIFT (Society for Worldwide Interbank Financial Telecommunications) is a global messaging system between banks, used to settle transactions. However, transactions using SWIFT can be slow and expensive. The total fees often exceed 7% of the international transaction amount - largely going towards SWIFT fees levied by banks, and the forex markup charges. Retail payments must also improve efficiency, their limited access to digital payment options in many regions and their lack of financial infrastructure to support seamless transactions.

These challenges hinder economic growth and limit financial inclusion, as many individuals and businesses, especially in underdeveloped or developing countries, are excluded from the financial system.

Improved payment systems can help reduce the cost of remittances, which are a lifeline for many families in developing countries. According to the World Bank, the average cost of sending remittances was 6.8% in the first quarter of 2022 - clearly highlighting the need for more affordable solutions.

How are stablecoins used in the global payment system? 

Four main types of blockchain-based payment rails are gaining prominence, each with distinct features: cryptos, stablecoins, tokenised deposits, and blockchain-based central bank digital currencies (CBDCs). Unlike cryptos and CBDCs, stablecoins and tokenised deposits are characterised by low volatility.

Stablecoins typically use public blockchains, offering greater accessibility and user control, whereas tokenised deposits utilise private blockchains for improved scalability and cost efficiency.

Stablecoins are usually backed by assets like cash or low-risk securities and issued by private entities. Tokenised deposits are backed by deposits on their balance sheets and are issued by regulated financial institutions. Their integration with the financial system also differs, with tokenised deposits closely tied to fractional reserve banking, offering consumer protection, while stablecoins are gradually aligning with regulations and the financial system's evolution.

The differences suggest that stablecoins and tokenised deposits will serve different purposes, with stablecoins being used extensively in retail payments and remittances, while tokenised deposits are likely to focus on interbank settlements. Both are expected to overlap in cross-border payments for corporations.

Benefits of using stablecoins for global payments

Stablecoins play a crucial role in the global payment system, particularly in facilitating international transactions. These digital currencies offer several key advantages over traditional methods:

• Transparency and security:

Stablecoin transactions are recorded on a transparent, immutable ledger, allowing real-time tracking. This transparency helps mitigate fraudulent activities and builds trust in the system. And of course, decentralisation saves us against conventional attack vectors targeting centralised systems.

• Economic efficiency: 

Stablecoins can bypass the need for multiple intermediaries, reducing international transaction costs. Using smart contracts, transactions can be streamlined and automated, further diminishing the cost per transaction. This efficiency is especially beneficial for remittances, where high international transaction fees disproportionately affect lower-income individuals.

• Expediency and efficacy: 

Thanks to the underlying blockchain technology, stablecoin transactions can be authenticated and executed almost in real time. This speed significantly enhances the effectiveness of cross-border transactions, which often involve protracted settlement periods due to regulatory compliance checks.

• Financial inclusion: 

Stablecoins might promote financial inclusion. According to World Bank reports, approximately 1.7 billion adults globally lack access to a bank account. For these unbanked individuals, stablecoins offer a means to engage in transactions using a smartphone and internet connectivity, potentially expanding opportunities for economic participation.

Popular Stablecoins Used for Cross-Border Payments

• Tether (USDT)

Tether is one of the most well-known stablecoins designed to be pegged to the value of the US dollar ($).

• TrueUSD (TUSD)

This is a stablecoin pegged to the US dollar and is known for its regulatory compliance and transparency.

• Paxos Standard (PAX)

Paxos Standard is a stablecoin issued by Paxos Trust Company and is fully backed by US dollars held in FDIC-insured banks.

• USD Coin (USDC)

This is another stablecoin created by Coinbase and Circle. It is pegged 1:1 to the US dollar and backed by fully reserved assets.

• Dai (DAI)

Dai is an algorithmic stablecoin created by the MakerDAO platform and is pegged to the US dollar through a system of collateralised debt positions.

The Bottomline

The rise of stablecoins presents a promising solution to the inefficiencies of traditional cross-border payment systems. By offering stability, transparency, and reduced transaction costs, stablecoins can enhance global financial inclusion and drive economic growth. 

As web3 and crypto technology continue to evolve, they hold the potential to transform the way businesses and individuals engage in international transactions. For more updates on the world of crypto and blockchain, stay tuned to India Crypto Research