Original author: Minerva
Original translation by: Block unicorn
It has been ten years since Tether launched the first USD-backed cryptocurrency. Since then, stablecoins have become one of the most widely adopted products in the cryptocurrency space, with a market cap nearing $180 billion. Despite this significant growth, stablecoins still face many challenges and limitations.
This article delves into the problems with existing stablecoin models and attempts to predict how we might end the monetary civil war.
I. Stablecoin = Debt
Before we dive into the discussion, let's first introduce some basic concepts to better understand the meaning of stablecoins.
A few years ago, when I started researching stablecoins, I was confused by how people described them as debt instruments. But as I delved deeper into how money is created in the current financial system, I began to understand this.
In the fiat currency system, money is primarily created when commercial banks (hereinafter referred to as 'banks') provide loans to customers. However, this does not mean banks can create money out of thin air. Before money can be created, banks must first receive something of value: your promise to repay the loan.
Suppose you need financing to purchase a new car. You apply for a loan at a local bank, and once approved, the bank will deposit an amount matching the loan into your account. At this point, new money is created in the system.
When you transfer these funds to a car seller, if the seller has an account at another bank, the deposit may transfer to that bank. However, this money still remains within the banking system until you start repaying the loan. Money is created through loans and destroyed through repayments.
Figure 1: Creating Money Through Additional Loans
Source: (Money Creation in Modern Economies) (Bank of England)
Stablecoins operate in a somewhat similar manner. Stablecoins are created when the issuer provides loans and are destroyed through repayments from borrowers. Centralized issuers like Tether and Circle mint tokenized dollars, which are essentially digital IOUs issued based on the dollar deposits made by borrowers. DeFi protocols (like MakerDAO and Aave) also mint stablecoins through loans, but this issuance is backed by crypto assets as collateral instead of fiat currency.
Since their debts are backed by various forms of collateral, stablecoin issuers effectively act as crypto banks. Sebastien Derivaux, founder of Steakhouse Financial, further explores this analogy in his research (Cryptodollars and the Hierarchy of Money).
Figure 2: Two-Dimensional Matrix of Crypto Dollars
Source: (Cryptodollars and the Hierarchy of Money), September 2024
Sebastien classifies stablecoins using a two-dimensional matrix based on the reserve nature of the stablecoins (e.g., off-chain RWA assets vs. on-chain crypto assets) and whether the model is fully reserved or partially reserved.
Here are some notable examples:
USDT: Primarily backed by off-chain reserves. Tether's model is partially reserved, as each USDT is not backed 1:1 by cash or cash equivalents (like short-term government bonds) and includes other assets like commercial paper and corporate bonds.
USDC: USDC is also backed by off-chain reserves, but unlike USDT, it maintains a fully reserved status (1:1 backed by cash or cash equivalents). Another popular fiat-backed stablecoin, PYUSD, also falls into this category.
DAI: DAI is issued by MakerDAO and is supported by on-chain reserves. DAI operates on a partially reserved structure through its over-collateralization.
Figure 3: Simplified Balance Sheet of Current Crypto Dollar Issuers
Source: (Cryptodollars and the Hierarchy of Money), September 2024
Like traditional banks, the goal of these crypto banks is to create significant returns for shareholders by taking on moderate balance sheet risks. The risks are enough to be profitable, but not so high as to jeopardize collateral and face bankruptcy risk.
II. Problems with Existing Models
While stablecoins have ideal characteristics such as lower transaction costs, faster settlement speeds, and higher yields compared to traditional financial (TradFi) alternatives, existing models still face many issues.
(1) Fragmentation
According to data from RWA.xyz, there are currently 28 active stablecoins pegged to the dollar.
Figure 4: Market Share of Existing Stablecoins
Source: RWA.xyz
As Jeff Bezos famously said, 'Your profit margin is my opportunity.' While Tether and Circle continue to dominate the stablecoin market, the recent high-interest-rate environment has birthed a new wave of entrants attempting to carve out a share of these high profits.
The problem with having so many stablecoin options is that while they all represent tokenized dollars, they are not interoperable. For example, a user holding USDT cannot seamlessly use it at a merchant that only accepts USDC, even though both are pegged to the dollar. Users can exchange USDT for USDC through centralized or decentralized exchanges, but this adds unnecessary trading friction.
This fragmented landscape is reminiscent of the era before central banks, where individual banks issued their own banknotes. During that time, the value of banknotes fluctuated due to their credibility and stability, and if the issuing bank collapsed, they could even become worthless. The lack of standardization in value led to market inefficiencies, making cross-regional trade difficult and costly.
The establishment of central banks was to solve this problem. By requiring member banks to maintain reserve accounts, they ensure that the banknotes issued by banks can be accepted at face value throughout the system. This standardization achieves what is called 'monetary singularity,' allowing people to view all banknotes and deposits as equivalent, regardless of the issuing bank's credibility.
However, DeFi lacks a central bank to establish monetary uniformity. Some projects, such as M^ 0 (@m 0 foundation), are attempting to address interoperability issues by developing decentralized crypto dollar issuance platforms. I personally look forward to their grand vision, but the challenges are significant, and their success is still a work in progress.
(2) Counterparty Risk
Imagine you have an account at JPMorgan Chase (J.P. Morgan, JPM). While the official currency of the U.S. is the dollar (USD), the balance in that account actually represents a type of bank note, which we can call jpmUSD.
As mentioned earlier, jpmUSD is pegged to the dollar at a 1:1 ratio through an agreement between JPM and the central bank. You can redeem jpmUSD for physical cash or swap it with notes from other banks (like boaUSD or wellsfargoUSD) at a 1:1 exchange rate within the banking system.
Figure 5: Schematic of the Currency Hierarchy Structure
Source: #4 | Classification of Money: From Tokens to Stablecoins (Dirt Roads)
Just as we can stack different technologies to create a digital ecosystem, various forms of currency can also be layered to build a currency hierarchy. Both the dollar and jpmUSD are forms of currency, but jpmUSD (or 'bank coin') can be seen as a layer above the dollar ('token'). In this hierarchy, bank coins rely on the trust and stability of the underlying tokens and are supported by formal agreements from the Federal Reserve and the U.S. government.
Fiat-backed stablecoins (like USDT and USDC) can be described as a new layer above this hierarchy. They retain the essential characteristics of bank coins and tokens while adding the advantages of blockchain networks and interoperability with DeFi applications. While they serve as an enhanced payment layer on top of the existing money stack, they remain closely tied to the traditional banking system, bringing associated counterparty risks.
Centralized stablecoin issuers typically invest their reserves in safe and highly liquid assets, such as cash and short-term U.S. government securities. While the credit risk is low, the counterparty risk is high due to only a small portion of bank deposits being insured by the Federal Deposit Insurance Corporation (FDIC).
Figure 6: Price Fluctuations of Stablecoins During the SVB Collapse
Source: (Stablecoins and Tokenized Deposits: The Impact on Monetary Singularity) (BIS)
For example, in 2021, out of approximately $10 billion in cash held by Circle at regulated financial institutions, only $1.75 million (about 0.02%) was protected by FDIC deposit insurance.
When Silicon Valley Bank (SVB) collapsed, Circle faced the risk of losing most of its deposits at the bank. If the government had not taken special measures to guarantee all deposits, including those exceeding the $250,000 FDIC insurance limit, USDC could permanently decouple from the dollar.
(3) Yield: Competition at the Bottom
In this cycle, the dominant narrative around stablecoins has been the concept of 'returning yields to users.'
For regulatory and financial reasons, centralized stablecoin issuers retain all profits generated from user deposits. This leads to a disconnect between the parties that actually drive value creation (users, DeFi applications, and market makers) and the parties that receive the profits (issuers).
This divergence paves the way for a new wave of stablecoin issuers who mint stablecoins using short-term wealth or tokenized versions of these assets and redistribute the underlying yields to users through smart contracts.
While this is a step in the right direction, it also compels issuers to significantly cut fees to gain a larger market share. The intensity of this yield scramble is evident when I review the tokenized money market fund proposals from the Spark Tokenization Grand Prix, which aims to integrate $1 billion of tokenized financial assets as collateral for MakerDAO.
Ultimately, yield or fee structures cannot be a long-term differentiating factor, as they may tend to maintain the minimum sustainable rate needed for operations. Issuers will need to explore alternative monetization strategies since the issuance of stablecoins itself does not accumulate value.
III. Predicting an Unstable Future
(Romance of the Three Kingdoms) is a beloved classic in East Asian culture, set during the late Han Dynasty when warlords were vying for power and conflict was rampant.
A key strategist in the story is Zhuge Liang, who proposed a famous strategy of dividing China into three independent regions, each controlled by rival warlords. His 'Three Kingdoms' strategy aimed to prevent any one kingdom from gaining dominance, thereby creating a balanced power structure to restore stability and peace.
I'm not Zhuge Liang, but stablecoins may also benefit from a similar tripartite strategy. The future landscape may be divided into three domains: (1) payments, (2) yields, and (3) middle layer (everything in between).
Payments: Stablecoins provide a seamless and low-cost way to settle cross-border transactions. USDC currently leads in this regard, and its collaboration with Coinbase and Base Layer 2 may further cement its position. DeFi stablecoins should avoid competing directly with Circle in the payment space and instead focus on the DeFi ecosystem where they have clear advantages.
Yields: RWA protocols issuing yield-bearing stablecoins should learn from Ethena, which has cracked the code for generating high yields and relatively sustainable returns through crypto-native products and related offerings. Whether utilizing other delta-neutral strategies or creating synthetic credit structures that replicate traditional finance (TradFi) swaps, there is room for growth in this area due to USDe facing scalability limits.
Middle Layer: For decentralized stablecoins with low yields, there is an opportunity to unify fragmented liquidity. An interoperable solution would maximize DeFi's ability to match lenders and borrowers and further streamline the DeFi ecosystem.
The future of stablecoins remains uncertain. However, a balanced power structure among these three segments may end the 'monetary civil war' and bring much-needed stability to the ecosystem. Rather than a zero-sum game, this balance will provide a solid foundation for the next generation of DeFi applications and pave the way for further innovation.
