Risks and Realities of Stablecoins

Last modified on September 20, 2023

Over the last few years, stablecoins have been growing in relevance in conversations about Bitcoin. So much so that a lot of comparisons are being made nowadays about which of the two is the better solution to move value over the internet.

Empirical data and anecdotal evidence clearly point toward stablecoins being increasingly preferred for payments.

For those considering these stablecoins and assessing what they are, it is important to understand the risks that these thing bring with them.

This is what we want to address in this issue of our newsletter. We take a look at dollar-backed stablecoins issued on smart contract platforms in particular as they are the most widely used form of stablecoins.

There are three important risks in stablecoins that users need to be aware of:

1. Lack of accountability

2. Smart contract risks

3. Fragmented ecosystems

1. Lack of accountability

The Federal Reserve is the apex institution that sets policies that the US Dollar adheres to. This includes policies related to benchmark interest rates, regulation of supply and cost of credit.

They are not directly accountable to people living outside of the United States, especially so to people using stablecoins backed by the US Dollar. Letting such an entity determine the fate of the currency they use is detrimental to their well-being.

The Fed sets the cost of credit, benchmark rates and backs such decisions with data pertaining to the citizens of the United States, and hence is accountable only to its mandate of maintaining price stability and maximum employment in the US, not to those living outside its borders. They are directly accountable to those living outside the country.

As a result, a jurisdiction that chooses to use a dollar-backed stablecoin as money invariably gets exposed to the risk of currency devaluation and inflation caused by the US monetary expansion and debt accumulation. As inflation can be exported by the US to other regions, this can erode the purchasing power and savings of the people who use the dollar-backed stablecoins as money.

What’s more, the issuers of these stablecoins are often corporations who have their own interests as priority, rather than those who use the stablecoins they issue. They will even have veto over which fork they use, in the case of a contentious fork of the base chain.

2. Smart contract risks

Stablecoins are created with lines of code called smart contracts.

Almost all the issuing corporations will have ownership access to their respective stablecoin, which allows them to make changes to the code.

So, its important that users have the ability to vet and verify these contracts without trusting a third party. To do so, they have to run a full node of their own. If they are technically sound and understand how these contracts work, this can allow them to understand its code and verify it.

The problem is almost all the smart contract networks make it quite expensive or complicated for average users to run a full node. The hardware and bandwidth requirements are beyond the reach of most ordinary users, who may have to rely on centralised services or third-party providers to access the contracts of these Stablecoins. As the cost of running a full node is too high, the cost of verifying these contracts without trusting a third party becomes quite high.

Normal, non-technical users will have to be wary of the kind of ownership privileges the issuing corporation has granted themselves in these smart contracts.

They often have the ability to freeze users’ addresses, denying them access to the contract. This essentially means the power to financially deplatform and censor users from using these contracts. This has happened in several cases, such as when Tether froze $30 million worth of USDT in 2017, or when Circle blacklisted an address holding $100,000 worth of USDC in 2020.

It’s a tough ask to expect people to understand smart contract languages of the networks they use and verify all this.

Moreover, smart contracts are not immune to bugs and vulnerabilities that can be exploited by hackers or malicious actors. According to a report by Forbes, smart contracts have suffered from over 40 hacks in 2021-2022, resulting in losses of more than $1 billion. These incidents show that smart contracts are not always reliable and secure, and that users need to exercise caution and due diligence when interacting with them.

In the case of such unfortunate events, users who have access to a US Dollar exchange and bank account can easily redeem the stablecoins back from the issuing corporations directly or by selling the stablecoins on an exchange for dollars. If you’re a person who lives in Lebanon or Argentina and have no access to any of these, you’ll find yourself in a precarious situation.

3. Fragmented ecosystem

People use stablecoins on different smart contract networks. There is no standard network on which these stablecoin transactions happen.

And in order to use them, they need to have the native coin of these networks in their wallets to pay for transaction fees, each with a variable monetary policy, and hence have uncertain valuations, which is an additional risk on top of accounting headaches.

For example, if a user wants to send USDT, a stablecoin pegged to the US dollar, on the Ethereum network, they need to have some ETH, the native coin of Ethereum, in their wallet to pay for the gas fee. However, the price of ETH fluctuates constantly, and sometimes it can spike dramatically due to network congestion or market volatility. This means that the user may end up paying more than they expected for their transaction, or they may not have enough ETH to cover the fee at all. Moreover, different networks have different fee structures and mechanisms, which can make it hard for users to compare and optimise their costs.

If a merchant accepts stablecoins on Ethereum but the customer only has them on Tron, the payment cannot happen. One of them will have to use a trusted bridge, and obtain the coin of the network they bridge to in order to perform a transaction. A bridge is a service or a protocol that allows users to transfer tokens or assets across different smart contract networks. Bridges are not trustless or decentralised, which means they come with their set of problems. This introduces additional risks such as censorship, fraud, or theft. Furthermore, using a bridge may incur extra fees or delays, which can affect user experience.

Conclusion

To summarise: The lack of accountability, driven by the dominance of the US Dollar and corporate issuers, poses risks to users of dollar-backed stablecoins outside the United States. Smart contract vulnerabilities and censorship incidents demonstrate a lack of security and transparency in stablecoin systems. The fragmented ecosystem, with interoperability challenges, adds complexity and potential pitfalls for users and merchants.

It’s easy to dismiss all of these risks and say ‘regular users don’t care’, and point to the data-backed evidence of stablecoin adoption to emphasise this claim.

To be fair, the ease with which Stablecoins are obtainable makes it an attractive instrument to those living in dollarised economies. This is especially true of countries with broken monetary systems whose populace organically decided that the US Dollar can serve the function of money far more effectively than their respective native currency.

As dollars can be quite hard to obtain and use outside the United States digitally or physically, the ease with which anyone in these economies can set up a wallet on a smart contract network and receive dollar-backed stablecoins is a radical improvement over the status quo.

A better articulation than just saying ‘users don’t care’ would be: The adoption and growth of stablecoins despite the existence of these risks and tradeoffs is a clear indication that the benefits and convenience that they bring to the users far outweigh their shortcomings and risks.

Users do care about protecting their wealth from being confiscated, but have merely chosen the option of stablecoins based on their own time preferences, situations and alternatives available to them, which have far worse shortcomings than stablecoins themselves.

They’re the lesser of existing evils.

Should Bitcoin become more liquid, spendable and widely accepted, it would prove to be a better alternative than Stablecoins, as it doesn’t have the same risks that have been underlined in this article.

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