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U.S. Federal Reserve analysis suggests that stablecoins have a huge potential to grow and could serve as a digital safe haven currency during periods of crypto market distress.
Earlier this week (January 31), the Fed published a paper titled "Stablecoins: Growth Potential and Impact on Banking", discussing the current use cases and growth opportunities of stablecoins.
The analysis of historical behaviours suggests that the price of stablecoins surged during past episodes of distress when the cryptocurrency market experienced a downfall.
In the past year, U.S. dollar-pegged stablecoins have seen tremendous growth.
During the first five months of 2021, stablecoin market was tracking at an average monthly growth of around 30 percent. While this growth rate slowed in subsequent months, as of September 2021, it had reached a market value of nearly $130bn representing a more than 500 percent increase from the year before.
Although the product is still at a nascent stage, the Fed notes it has a high potential for innovation as a result of two defining features that differentiate these assets from other digital forms of money, such as bank deposit accounts.
First, stablecoins are cryptographically secured, which means they can be settled near-instantaneously without double-spending or the need for an intermediary. This allows transactions to be processed around the clock 24/7/365.
Then, stablecoins can be programmed to interoperate with smart contracts on the blockchain to create payment and other financial services.
These features have already enabled stablecoins to be widely used in various different ways, adding to its growing popularity.
Stablecoins during crypto market distress
One of its most important use cases is that stablecoins facilitate trading between crypto-assets. Instead of exchanging crypto to fiat and then back to crypto, these transactions typically involve stablecoins, which allow for much faster and cheaper transactions.
Because they are used widely in crypto transactions, public stablecoins serve as a store of value on public blockchain-based markets.
During crypto market distress, as investors rushed to liquidate their speculative positions into stablecoins, demand for the value-pegged digital currency jumped, the paper found.
“We find that dollar-pegged stablecoins have exhibited safe asset qualities in that their prices in the secondary market temporarily rise above the peg during times of extreme market distress, incentivizing the issuance of more stablecoins,” the authors of the paper said.
The counter-cyclical demand for stablecoins in the secondary market suggests that they can mitigate the risks of redemption runs during times of broader market downturns.
“With appropriate safeguards and regulations, stablecoins have the potential to provide a level of stability that is on par with traditional forms of safe value,” the Fed notes, adding that “these episodes demonstrate the potential for stablecoins to serve as a digital safe haven during market distress.”
Current and future use cases
Currently, stablecoins are primarily used in cryptocurrency trading, limited peer-to-peer payments, and decentralized finance (DeFi).
In payments, stablecoins have the potential to revolutionize cross-border payments.
Most cross-border payments (in value terms) are processed through a chain of correspondent banking relationships, and can typically take days to settle, have high costs and little transparency as to what stage the transactions are at.
In a November report, J.P.Morgan, which has its own tokenized asset called JPM Coin, estimates that blockchain-based cross-border transactions could save global corporates $100bn in costs annually.
However, the Fed paper stresses that although stablecoin technologies are “in their infancy,” they have a “high potential for innovation.”
It notes that stablecoins may facilitate more inclusive payments and financial systems as they could lower payment barriers and exert pressure on existing payment systems to provide better services.
In addition, the Fed suggests that stablecoins could add to next-generation innovations, such as Web 3.
In that scenario, search engines and social media platforms would make their revenues from carrying out microtransactions via their stablecoins rather than advertisements or selling user data.
Although it is definitely an appealing proposition, it is perhaps a little too late for Meta, which has announced plans to sell its Diem stablecoin technology to Silvergate following several years of a challenging relationship with regulators.
There is also a potential for stablecoins to grow along with DeFi platforms.
Although DeFi at its current stage faces various challenges, the platforms could become more integrated with the broader financial market and could encourage a more inclusive financial system that allows investors to directly participate in markets without intermediation.
Finally, the Fed sees an opportunity for stablecoins to play a key role in tokenizing financial markets. This would entail converting securities into digital tokens on distributed ledger technology and trading and servicing them with stablecoins.
