Disclosure: The views and opinions expressed herein are those of the author only and do not represent the views and opinions of the crypto.news editorial.
As interest on central bank digital currencies rises, their use will continue to increase. This is despite recent turmoil over the recent USDC depeg or, much worse, the collapse of the TerraUSD (UST) stablecoin and sister coin LUNA.
But with all this attention, it becomes increasingly important to understand what kind of risks you may face with the use of CBDCs.
Stablecoins are digital currencies designed to maintain a stable value relative to a traditional currency, commodity, or other asset. Its stability is what makes it attractive for a number of use cases such as facilitating cross-border transactions, serving as a store of value, and even enabling decentralized finance (DeFi) applications.
In general, stablecoins were created with a big goal in mind – to address the high price volatility of native cryptocurrencies such as Bitcoin (BTC) and Ethereum (ETH). And while bitcoin’s volatility is great for traders who can use the cryptocurrency as an investment, it also makes it difficult to use it as a payment method, which also slows the broader adoption of blockchain technology.
This is where stablecoins come into play, as their close ties to fiat currency help them maintain a more stable value, allowing them to act as a means of payment. In addition, stablecoins can be sent and received faster and more inexpensively, regardless of borders and jurisdictions, and without the need for intermediaries such as banks.
Moreover, the development of stablecoins has increased exponentially in recent years, with major players such as tether (USDT), USD currency, and dai becoming increasingly prominent in the cryptocurrency market. The total market capitalization of stablecoins has grown rapidly over the past few years, reaching over $130 billion as of the time of writing. Moreover, as the Federal Reserve continues to consider creating a Central Bank Digital Currency (CBDC), stablecoins are only growing in popularity.
Broadly speaking, there are three types of stablecoins that depend on the mechanisms used to stabilize their value. The first and second are cryptocurrency fiat stablecoins that are backed by either digital or other cryptocurrencies. Most of the fiat-backed stablecoins are directly pegged to the US dollar. In addition, it is important to note that stablecoins secured by cryptocurrencies add volatility and all the technical liability of one blockchain or one token to another, thus adding an additional layer of risk to the asset.
The third type of stablecoin is algorithmic stablecoin, the reserves of which are controlled by a specially designed algorithm.
This can only mean one thing – buyers of stablecoins should be aware of the risks associated with holding them.
One of the main risks associated with owning stablecoins is counterparty risk. Stablecoins are usually issued by centralized entities that are responsible for holding their reserves, which means that if the issuer encounters financial difficulties or goes bankrupt, the value of the stablecoin could suffer, resulting in a loss of money for its holders.
Therefore, it is necessary to understand what happens in the liquidation process, under what jurisdiction this process must take place, and how long it usually takes. Creditors of the bankrupt Mt.Gox cryptocurrency exchange have been waiting for any kind of decision or judgment for more than nine years. It is very likely that in this liquidation process, the token holders will not receive the basic USD value of their token as they were initially promised.
Due to the fact that a stablecoin issuer can fail to fulfill its obligations, buyers of stablecoins should not only be aware of these risks but also actively push towards stablecoins that come with a guarantee of value protection.
This protection-of-value guarantee will only become important in the event that the stablecoin issuer defaults. In this case, the token holder will not become part of the liquidation procedure, but can go directly to the institution that provided the value protection guarantee and redeem their tokens for a fiat order at the promised 1:1 ratio. The only counterparty risk to the stablecoin buyer would be if the stablecoin issuer defaults at the same time the issuer of the PVS does. Although this is not entirely impossible, it can be considered highly improbable.
In addition, stablecoins are not immune to market risks, and their value can be affected by various market events, such as sharp price changes in the underlying asset to which they are tied or turmoil in the cryptocurrency market.
This is why buyers should do thorough due diligence and research before putting any money into stablecoins. Understanding the backing of the stablecoin they want to buy, looking at the regulatory status of the issuer, and researching where the funds are kept are just the first steps one should take before buying into a stablecoin.
Knowing about the liquidation process in the event that a stablecoin issuer fails to meet its obligations is another important way people can protect themselves when purchasing a new stablecoin. As explained above, the safe bet here is to buy a stablecoin that comes with value protection such as a bank guarantee, which provides the buyer with a risk shield against default from the stablecoin issuer.
In general, one must do thorough research and due diligence before buying stablecoins to understand their potential risks and benefits. Potential buyers should consider the specific type of stablecoin, its underlying asset, the issuer’s credibility, regulatory setup, and the offer to protect value in the event of liquidation. By understanding the potential risks and taking necessary precautions, buyers can make informed decisions about whether holding stablecoins is right for them.
