SECTION I: INTRODUCTION, TYPES, ADVANTAGES AND LIMITATIONS

1. Introduction

 In a world dominated by digitalization, the emergence of digital currencies has significantly impacted the trading economy. One such virtual currency is cryptocurrencies, which serve as a medium of exchange for payments through an encrypted system. Unlike traditional currencies regulated by government authorities and banks, cryptocurrencies operate in a decentralized manner, resulting in high volatility. This volatility often leads to price fluctuations, posing financial risks for individuals engaging in everyday transactions of goods and services. To address this challenge, the concept of stablecoins was introduced as a more reliable form of cryptocurrency, offering stability, and minimizing the risks associated with price fluctuations.

Stablecoins have gained immense popularity in recent years due to their ability to maintain a stable value. These unique cryptocurrencies are designed to be pegged to a less volatile reserve asset, such as the U.S. dollar or gold. This pegging mechanism ensures that the stablecoin’s value remains consistent and less susceptible to market volatility. For instance, a stablecoin pegged to the U.S. dollar will maintain a value equivalent to that of one U.S. dollar, regardless of market conditions.

2. Types Of Stablecoins

Source: Modified diagram, Primary source: https://www.wonder.fi/resources/what-are-stable-coins

i. Fiat backed stablecoins^[1]:

Fiat-backed stablecoins have gained immense popularity due to their underlying reserves in major fiat currencies such as the U.S. Dollar, Euro, and GBP. For every stablecoin in circulation, there is an equivalent amount of US Dollars held in reserve by the issuing entity. For instance, if an investor intends to acquire a stablecoin worth 200 Euros, they must deposit an equivalent amount of cash or cash equivalents with the custodian. Similarly, when selling stablecoins, users have the option to exchange them for the corresponding fiat currency or utilize them to purchase other cryptocurrencies. Fiat-backed stablecoins are designed to minimize price fluctuations. However, while these coins aim for stability, they may experience minor fluctuations due to factors such as market demand and changes in the underlying fiat currency.

ii. Commodity-backed stablecoins:

Commodity-backed stablecoins are a type of cryptocurrency that derives its value from a reserve of tangible commodities, such as precious metals (gold, silver), and energy resources (oil, natural gas). Each stable coin represents a specific amount of the underlying commodity held in reserve. For example, a stablecoin may be backed by one gram of gold, one barrel of oil, or a specific quantity of another chosen commodity. The reserve ensures that the stablecoin maintains its value based on the price of the underlying commodity. The holders can redeem the commodity-backed stable coin and get their underlying asset back. In other phrase, if an investor holding physical gold cannot use it for a general trading purpose – a commodity-backed stable coin breaks that hindrance and allows the user to exchange the stablecoin for the purchase of goods or services.

iii. Crypto-backed stablecoins:

Crypto-backed stablecoins are a type of digital currency that derives their stability from collateralized cryptocurrencies. Unlike other stablecoins that rely on fiat currencies or commodities as backing assets, crypto-backed stablecoins use cryptocurrencies as collateral to maintain their value. This collateralization allows for stability while leveraging the benefits of blockchain technology and the transparency of cryptocurrencies.

iv. Algorithmic stablecoins:

Algorithmic stablecoins are a type of cryptocurrency designed to maintain a stable value using mathematical algorithms and smart contracts. Unlike traditional stablecoins, which rely on backing assets, algorithmic stablecoins adjust their supply dynamically to stabilize their value without the need for external collateral.  For example: if the supply is higher, the coin circulation is reduced and hence increasing the value of the coin that is issued.

3. What Makes Investors Go For Stablecoins?

Some of the reasons are discussed below:

i. Low volatility: The volatility of the prices is low compared to other cryptocurrencies as it is pegged with the reserve asset including fiat currency. Hence, the price of stable coins changes only when the value of the asset that is backed for changes. Stablecoins are usually treated as stable assets that make trading easier to use as a medium of exchange for any transfer of goods or services.

ii. Enabling payments faster: Stablecoins enable cross-border payments faster compared to that of the traditional payments system. The current methods of settling payments via international money exchanger centers consume a lot of time and the cost are higher due to overcrowding of the network. However, in stablecoins the transfer can be made faster and only the transaction costs/ fees are involved in it, without involving any intermediaries.

iii. Redemption made easier: Since stablecoins are issued for a reserve asset the issuer may at any time or on-demand, redeem them at par value. The redemption process is similar to that of the issuance. However, the issuer instructs the user to deposit the stablecoin to the network of accounts and then withdraw from circulation. Once the process of withdrawal is complete, the crypto exchange receives a notification for the transfer of assets that are held with as a reserve and transferred back to the user.

4. Limitations Of Uses Of Stablecoins:

i. Centralization Risks: One of the limitations of stablecoins is the potential for centralization. Some stablecoins rely on centralized entities to manage collateralization, issuance, and maintenance of stability. This centralization introduces counterparty risk, where the stability and value of the stablecoin depend on the trustworthiness and competence of the central entity.

ii. Collateral Risk and Volatility: Stablecoins that are collateralized by assets, such as fiat currencies or commodities, are susceptible to the risks associated with those underlying assets. For example, if a stablecoin is backed by a specific fiat currency, any volatility or economic instability affecting that currency can impact the stability of the stablecoin. Similarly, if a stablecoin is backed by a commodity like gold, fluctuations in the commodity’s price can influence the value of the stablecoin. These collateral risks introduce a level of uncertainty and potential volatility, albeit to a lesser extent than non-stable cryptocurrencies.

iii. Regulatory Uncertainty: The regulatory landscape surrounding stablecoins is still evolving, and this uncertainty poses a challenge to their widespread adoption and use. Different jurisdictions may have varying approaches to stablecoins, treating them as securities, currencies, or something entirely different. The lack of clear regulatory frameworks can create barriers to entry and limit the growth and acceptance of stablecoins in certain markets.

iv. Counterparty and Custodial Risks: Stablecoins that rely on third-party custodians introduce counterparty and custodial risks. Users must trust the custodian to safeguard the underlying collateral and maintain the stability of the stablecoin. If the custodian faces security breaches, or operational issues, or fails to fulfill their responsibilities, it can have adverse effects on the stablecoin holders. These risks highlight the importance of choosing reputable and trustworthy custodians for the safekeeping of collateral and ensuring the stability of the stablecoin.

v. Lack of Transparency: Transparency is a crucial factor in building trust and credibility for stablecoins. However, some stable coins lack transparency in terms of their collateral holdings, issuance mechanisms, and auditing practices. The absence of transparency can raise concerns among users and investors, leading to a reduced level of trust in the stability and integrity of the stablecoin.

 vi. Liquidity Challenges: Maintaining sufficient liquidity is essential for stablecoins to function effectively. However, ensuring liquidity can be a challenge, especially during periods of market stress or increased demand for redemptions. Insufficient liquidity can result in price deviations from the stable coin’s target value, undermining its stability and usability. Stablecoin issuers must carefully manage liquidity to mitigate these challenges and maintain stability. There are limitations in the redemption value threshold, consumer protection, refunds, and charging of higher transaction fees.^[2]

SECTION II: LEGAL, FINANCIAL, AND TAX CONSIDERATIONS

1. Legal Considerations

i. Regulatory Framework: Stablecoins must navigate the complex web of regulatory frameworks. Depending on their structure, they may fall under securities regulations, commodity laws, or even banking regulations.

ii. Money Transmission Licensing: If a stablecoin operates as a payment system or facilitates money transmission, it may be subject to licensing requirements. Compliance with anti-money laundering (AML) and know-your-customer (KYC) regulations is essential in such cases.

iii. Consumer Protection: Stablecoin issuers must ensure proper measures for consumer protection. Clear and transparent terms of service, privacy policies, and dispute-resolution mechanisms should be in place. Any potential risks associated with the stablecoin, such as counterparty risk or issuer insolvency, should be clearly disclosed to users.

 2. Financial Considerations

i. Collateralization and Auditing: Stablecoins that are backed by assets, such as fiat currencies or other cryptocurrencies, should provide regular audits to verify their reserves. Transparency in collateralization builds trust among users and reduces the risk of insolvency.

ii. Smart Contract Security: Many stablecoins are built on blockchain platforms utilizing smart contracts. It is vital to ensure the smart contracts are secure and have undergone rigorous audits to prevent vulnerabilities or potential exploits that could compromise the stability of the stablecoin.

iii. Redemption and Liquidity: Stablecoins should provide a reliable mechanism for redemption, allowing users to convert their stablecoins back into the underlying reserve assets. Sufficient liquidity must be maintained to meet user demands and prevent destabilization of the stablecoin’s value.

 3. Tax Considerations

i. Classification: Tax authorities around the world are grappling with the classification of stablecoins. Depending on their characteristics, stablecoins may be treated as currencies, commodities, securities, or even property for tax purposes.

ii. Taxation of Transactions: Stablecoin transactions, including conversions, payments, or transfers, may trigger tax obligations. These transactions could be subject to capital gains tax, value-added tax, or other relevant taxes. Accurate record-keeping is essential to fulfill tax reporting requirements.

iii. Airdrops and Staking: If stablecoins are acquired through airdrops or earned through staking, they may be considered taxable events. The fair market value of the stablecoins received at the time of the event could be subject to income tax.

 Some of the possible instances of taxation of the transaction in stablecoins:

Sale of stablecoins for fiat: Sale of stablecoins for fiat may not result in any profits. However, if there are any changes during the sale/disposal of the coin (for ex. because of fx differences) then the difference should be accounted as capital gains or loss.

Purchase of goods and services: When the buyer of stablecoin uses it for the purchase of goods and services, that is considered a sale of stablecoin and it may generate taxable capital gains/losses.

Trading of cryptocurrency for stablecoins: When the buyer disposes of the cryptocurrency for the purchase of stablecoins, that is considered a sale of cryptocurrency, and it may generate taxable capital gains/losses.

Receiving stable coins as a payment: When a trader for the sale of goods or services receives stablecoins as a mode of payment, then it will be considered as an income from the sale of goods or services and accordingly will be taxed under the tax laws.

Interest: The interest gained out of the stablecoins would be taxable under income tax laws.

Conclusion:

Stable coins that serve as both means of payment and act as a storage of value for transactions that can be used on a daily basis and impose a good potential in cross-border transactions and remittances increase the stablecoin users and issuers. However, their legal, financial, and tax considerations should not be overlooked. Navigating the regulatory landscape, ensuring financial stability, and understanding the tax implications are vital for both stablecoin users and issuers.

[1] Cointelegraph, Stablecoins 101: What are crypto stablecoins, and how do they work?; see  https://cointelegraph.com/learn/stablecoins-101-what-are-crypto-stablecoins-and-how-do-they work#:~:text=The%20most%20apparent%20benefit%20of,cryptocurrencies%20by%20reducing%20price%20volatility.

[2] European Central Bank, Stablecoins’ role in crypto and beyond: functions, risks and policy; see  https://www.ecb.europa.eu/pub/financial-stability/macroprudential-bulletin/html/ecb.mpbu202207_2~836f682ed7.en.html