Cryptocurrencies have been gaining momentum in recent years, notwithstanding various concerns and critiques about the use-case of cryptocurrencies. Cryptocurrencies are digital or virtual currencies built on the Blockchain, secured by cryptography and typically designed to operate as a medium of exchange.
Cryptocurrencies had a bull run in 2021 with Bitcoin, the first cryptocurrency, rising from approximately USD7,000 in 2020 to an all-time high of approximately USD69,000 in 2021. However, by July 2022, the price of Bitcoin fell to as low as USD17,800. Despite its volatility, or perhaps because of it, cryptocurrencies have gained global attention.
The volatile nature of most cryptocurrencies brought to bear the need to create a cryptocurrency that possesses the core qualities of cryptocurrencies but has a level of stability that makes it a trustworthy asset. This category of cryptocurrencies is referred to as “Stablecoins.” Stablecoins are cryptocurrencies whose value is pegged to some other assets such as fiat currency or commodities. Thus, Stablecoins are designed to avoid the volatility inherent in other cryptocurrencies whose prices are entirely market-driven.
Accordingly, Stablecoins are similar to our traditional conception of money in comparison to other cryptocurrencies and have received more acceptance than other cryptocurrencies.
It has been noted that, in the presence of an appropriate regulatory framework, Stablecoins would have the potential to play an important role in retail and cross-border payments. Nevertheless, the regulatory and licensing requirement for the issuance of Stablecoins are quite knotty and require a lot of nuances based on the manner the Stablecoin in question operates.
General overview of Stablecoins
As earlier highlighted, Stablecoins are cryptocurrencies pegged to some other assets which could be a fiat currency such as Naira or US Dollars or could be a commodity such as gold. This stability is essential to the use-case of Stablecoins, and coins that lose their peg (i.e. that are unable to maintain parity with the commodity or currency to which they are pegged) often do not survive their depegging.
Issuers of Stablecoins may achieve price stability by (a) using collaterals, (b) using algorithms, or (c) merging collaterals and algorithms.
Where the Issuer chooses to use collaterals, such collateral may be fiat currency, commodities, or other cryptocurrencies.
Fiat collateralized Stablecoins are wholly or partly backed by a government-issued fiat currency such as the Naira, Pound or US Dollar, often with a ratio of 1:1. A central entity, acting as an independent custodian, usually manages the process and ensures that the equivalent fiat currency is held in collateral for every token that is issued.
Commodity-backed Stablecoin operates in a manner similar to fiat-collateralized coins. However, instead of being backed by fiat currency, this type uses other kinds of interchangeable assets and goods, such as gold, diamonds and valuable commodities, as collateral.
For the final category, the value of crypto collateralized Stablecoins is backed by other cryptocurrencies, rather than by fiat or commodities – such Stablecoins are often overcollateralized to account for the volatility of the collaterals.
The essence of using collaterals is that the Stablecoin can be redeemed or exchanged for the collateral held by the Issuer. The collaterals may be redeemable at a fixed value or at a variable value.
Where the Issuer chooses to use an algorithm, the Issuer may either use a rebase system or a seigniorage system. For Rebasing algorithmic Stablecoins, otherwise called single token model, the total supply of the Stablecoin is elastic and said supply is automatically adjusted to maintain the peg of the Stablecoin. For example, where the Stablecoin is trading below its peg, the algorithm automatically reduces the supply of the Stablecoin to drive up the price. Where the Stablecoin is trading above its peg, the algorithm automatically increases the supply of the Stablecoin to reduce the price.
For Seigniorage algorithmic Stablecoins, otherwise called multiple token model, the Stablecoin is issued alongside at least one Sharecoin. Typically, when the price of the Stablecoin is trading below its peg, the Sharecoins are utilized to reduce the supply of the Stablecoins and when the price of the Stablecoin is trading above its peg, the Sharecoins are utilized to increase the supply of the Stablecoins. For example, under the UST/LUNA framework, 1 UST can be exchanged for 1 Dollar worth of LUNA regardless of the actual trading value of UST and vice versa.
Consequently, where UST is trading for less than a Dollar, Investors/Users are incentivized to purchase UST and exchange it for LUNA (this increases demand for UST and drives up the price of UST, thereby allowing it to regain its peg) and where UST is trading for above a dollar, Investors/Users are incentivized to purchase LUNA and exchange same for UST (this increases the supply of UST and drives down its price thereby allowing it regain its peg).
Merging collaterals and algorithms
As earlier stated, Issuers of Stablecoins may also merge collaterals and algorithms. This merger is referred to as fractional algorithmic Stablecoins which combine the features of fully-algorithmic and fully collateralized Stablecoins. These Stablecoins avoid over-collateralization and have fewer custodial risks. In contrast to solely algorithmic designs, it seeks to enforce a somewhat tight peg with a higher level of stability.
While Nigeria, like most countries of the world, does not have a regulatory framework dealing with the issuance of Stablecoins, the way and manner a Stablecoin is issued and how it maintains its peg determines the regulatory requirements the Issuer will be required to meet under the existing Nigerian Legal Framework. It must, however, be emphasized that this is uncharted territory in Nigeria and there are several grey areas.
We will consider these different grey areas, as well as the position of the regulators when it comes to regulating virtual assets in Nigeria.
Davidson Oturu is a Partner and Head of the Intellectual Property and Innovation Practice Group at AELEX and Agboola Dosunmu is an Associate at the firm.