Stablecoins have become one of the hottest success stories of the year for the crypto market. Now that new stablecoin legislation (the GENIUS Act) has passed, stablecoins are likely going to gain even more momentum.
But here's the thing: Some crypto watchers are already warning that stablecoins might not be as "stable" as they first appear to be, and could introduce all sorts of systemic risk into the financial system. Here are three risk factors you need to know.
Stablecoins can lose their peg
Stablecoins are digital currencies that are pegged 1:1 to the value of the U.S. dollar. At all times, you should be able to exchange one stablecoin for $1. And, indeed, if you look at a chart for a top stablecoin such as Tether (USDT -0.03%) or USDC (USDC -0.01%), you'll see this immediately. Yes, there are tiny fluctuations on a daily basis, but by and large, a stablecoin always trades for $1.
However, stablecoins can lose their peg. That's because stablecoins are backed by a mix of cash and cash equivalents, and if there is any impairment to the value of this backing, then the stablecoin will also lose its value.
During the 2023 regional banking crisis, for example, USDC briefly lost its dollar peg and fell to $0.87. That shouldn't happen -- USDC is known for its transparency, liquidity, and regulatory compliance. Circle Internet Group (CRCL -8.38%), the issuer of USDC, backs every stablecoin with cash and cash equivalents. It did everything right.
The problem was that over $3 billion in cash was being held at Silicon Valley Bank, which was one of the banks impacted by the regional banking crisis. Once Circle could prove that it still had access to the cash, USDC regained its peg. But there were certainly some tense moments.
Image source: Getty Images.
This is actually a best-case scenario. A worst-case scenario is that a stablecoin turns out to be backed by a bunch of worthless dreck and falls all the way to zero. This happened in 2022, during the crypto market meltdown, when "algorithmic" stablecoins (i.e., stablecoins backed by algorithms, not cash) were all the rage. In a span of just 24 hours, the value of a top stablecoin (TerraUSD) fell all the way to $0.12.
In many ways, the new stablecoin legislation is supposed to fix this problem. It clearly mandates what counts in terms of "cash equivalents," and it makes clear that cryptocurrencies and commodities (such as gold) cannot be used for backing. It also mandates regular audits to make sure the cash is actually there.
Limited use cases (for now)
In theory, stablecoins will completely change the world of payment transactions. Instead of using a credit card to pay for a transaction, you will use stablecoins. In doing so, you will be able to avoid the 2% to 3% credit card processing fees typically incurred.
While everyone is talking about how popular stablecoins are, the reality is that relatively few brick-and-mortar businesses actually accept them. That should change, now that new stablecoin legislation is on the books. However, you might be disappointed to learn that your favorite stablecoin might not be as useful as you originally thought.
As an experiment, go to the website AcceptUSDC.com and click on "Merchant Directory." You'll see a map of the USA, with pins in cities where businesses accept USDC. Unless you live in California, Florida, Texas, or one of the major cities along the Eastern Seaboard, good luck finding anyone to accept your USDC.
And, even if you do find a business that accepts USDC, it usually requires a workaround, like using a third-party crypto app or using your USDC to buy a gift card instead. In many ways, it reminds me of the early days of Bitcoin (BTC -1.59%), when it seemed almost impossible to spend your Bitcoin at a legitimate business.
For now, the most common way to use stablecoins is as part of a passive income yield strategy. Essentially, you are staking your stablecoins in return for yield. For example, if you buy and hold USDC on Coinbase Global (COIN -16.57%), you can generate an annual yield of 4.1%. If you buy and hold PayPal USD (PYUSD 0.04%) on PayPal (PYPL -2.38%), you can generate an annual yield of 4%.
Moral hazard
Finally, there's a very squishy kind of risk known as "moral hazard." It refers to the potential for a person or entity to behave badly, despite safety guardrails being in place. That's what concerns me the most. Powerful lobbying forces went into the passage of the new stablecoin legislation, and powerful bipartisan political forces ensured that certain risk factors were conveniently excluded from the legislation.
One of the primary concerns about the new stablecoin legislation was that it failed to spell out exactly whether publicly elected officials could get involved in stablecoins. It also said nothing about their ability to potentially profit from their financial interest in stablecoins. That's a big deal, because World Liberty Financial, a crypto venture affiliated with the Trump family, also happens to have a stablecoin with a $2 billion market cap.
In order to eliminate as much risk as possible, I'm only putting my money into stablecoins that are issued by publicly traded corporations based in the USA. For now, that means USDC (issued by Circle) and PayPal USD (issued by PayPal). Both offer a way to get involved in stablecoin transactions in the near future, and both offer a modest yield. There are a lot of stablecoins out there, but I think these are two of the best for the average investor.
