Decoded: What are stablecoins, and why is the US regulating them?

Stablecoins are digital assets that are designed to maintain a stable value relative to a specific reference asset, like a fiat currency such as the US dollar

On July 18, United States (US) President Donald Trump signed the GENIUS Act—Guiding and Establishing National Innovation for US Stablecoins—introducing America’s first federal framework for dollar-pegged cryptocurrencies. The act mandates full reserve backing in liquid assets, monthly audits, and stronger consumer safeguards.

 

While signing the act into law, Trump said that it creates "a clear and simple regulatory framework to establish and unleash the immense promise of dollar-backed stablecoins". He further stated that the act "could be perhaps the greatest revolution in financial technology since the birth of the internet itself".

 

Trump’s endorsement of the act has reignited interest in stablecoins. But what exactly are they? And how do they differ from traditional cryptocurrencies? 

 

 

What are stablecoins?

 

Stablecoins are digital assets, which means they have a value attached to them and can be used for transactions. They are designed to maintain a stable value relative to a specific reference asset, like a fiat currency such as the US dollar. Unlike cryptocurrencies, which experience significant price fluctuations due to speculation and limited supply mechanisms, stablecoins intend to provide price predictability.

 

What backs stablecoins?

 

Stablecoins can be broadly categorised based on their collateral mechanisms. Each category presents a different method for maintaining price stability:

 

1. Fiat-collateralised stablecoins: These stablecoins are backed by reserves of fiat currency held in bank accounts or other arrangements. The most common examples—such as Tether (USDT) and USD Coin (USDC)—are pegged to the US dollar. For every unit of stablecoin issued, an equivalent amount in fiat currency is supposedly held in reserve.

 

These stablecoins rely heavily on trust in the issuer and the auditing of reserve holdings. Concerns have been raised in the past regarding the transparency and adequacy of these reserves, prompting countries to explore regulatory frameworks for the same, like the GENIUS Act.

 

2. Crypto-collateralised stablecoins: These are backed by other cryptocurrencies, which are typically over-collateralised to account for price volatility. For example, DAI, a widely known decentralised stablecoin, is backed by Ethereum and other crypto assets held in smart contracts on the blockchain.

 

Blockchain is a distributed digital ledger that records transactions in a secure way, allowing assets to be tracked across a network.

 

Smart contracts are digital contracts stored on a blockchain that are automatically executed when predetermined terms and conditions are met. For example, DAI is liquidated when the value of the cryptocurrency backing it falls below a certain threshold.

 

These are still exposed to the inherent volatility of the underlying crypto assets and may face issues during market stress.

 

3. Algorithmic (non-collateralised) stablecoins: Algorithmic stablecoins use mathematical formulas and incentive mechanisms to manage the coin supply and maintain a peg without relying on actual collateral. They automatically expand or contract the supply of tokens based on demand. TerraUSD (UST), which collapsed in 2022, was one such example.

 

4. Commodity-collateralised stablecoins: Some stablecoins are backed by physical commodities such as gold or silver. These include coins like PAX Gold (PAXG), where each coin represents ownership of a specific amount of physical gold held in reserve.

 

Uses of stablecoins

 

Stablecoins serve several purposes across retail, institutional, and decentralised finance sectors:

 

• Payments: Due to lower transaction fees and faster settlement times, stablecoins are increasingly used for cross-border transfers, particularly in regions with limited access to banking infrastructure.
• Stablecoins are also integral to decentralised finance platforms, where they serve as collateral for loans, liquidity provision, and decentralised exchanges.
• Hedging against volatility: Investors often convert volatile crypto holdings into stablecoins to preserve value during market downturns.

Risks associated with stablecoins

 

Despite their intended stability, stablecoins are not without risks. As their market capitalisation has grown, regulators and policymakers have raised several concerns.

 

One of the most prominent concerns is whether stablecoin issuers actually hold sufficient, liquid, and accessible reserves to honour redemptions. Here's where legislation like the GENIUS Act steps in. It requires 100 per cent reserve backing with liquid assets like US dollars or short-term Treasuries and requires issuers to make monthly, public disclosures of the composition of reserves. According to the White House press release, "In the event of insolvency of a stablecoin issuer, the GENIUS Act prioritises stablecoin holders’ claims over all other creditors, ensuring a final backstop of consumer protection".

 

Alternatives to stablecoins

 

As stablecoins gain popularity, several alternatives are being explored to address their risks and limitations—particularly by regulators and central banks.

 

• Central Bank Digital Currencies (CBDCs) are the most prominent alternative. Unlike stablecoins, CBDCs are issued by central banks and carry sovereign backing. They aim to offer secure, programmable digital payments without the volatility of crypto. India also has a CBDC backed by the Reserve Bank of India, known as the digital rupee or e-rupee.
• Tokenised deposits: These are digital versions of regular bank deposits issued on blockchain platforms, allowing instant settlement and integration with smart contracts.
• E-money and digital wallet balances, while not blockchain-based, are widely used. These are backed by fiat reserves and regulated under existing financial rules.

 

As countries continue to shape regulatory frameworks and central banks explore digital alternatives, the journey ahead for stablecoins will likely depend on their ability to operate securely and transparently within the financial system.