Author: Will Awang, Web3 Lawyer
Although stablecoins are already used by millions of people and trillions of dollars in value have been traded, the definition and understanding of the category remains fuzzy.
Stablecoins are a way of storing value and a medium of exchange, usually (but not necessarily) pegged to the US dollar. Although stablecoins have only been around for 5 years, their evolution in two dimensions is very instructive: 1. From undercollateralization to overcollateralization, 2. From centralization to decentralization. This is very helpful in helping us understand the technical structure of stablecoins and eliminating market misunderstandings about stablecoins.
Stablecoins, as a payment innovation, simplify the way value is transferred. They have constructed a market parallel to traditional financial infrastructure, with annual trading volumes even surpassing major payment networks.
History serves as a guide. If we want to understand the design limitations and scalability of stablecoins, a useful perspective is the history of banking development to see what works, what doesn’t, and the reasons behind it. Like many products in cryptocurrency, stablecoins may replicate the historical development of banking, starting from simple bank deposits and notes, and then achieving increasingly complex credit to expand the money supply.
Thus, this article provides a framework for understanding the future of stablecoins by compiling insights from a16z partner Sam Broner's article 'A Useful Framework for Understanding Stablecoins: Banking History.'
The article will first introduce the development of stablecoins in recent years, then compare it to the history of American banking, so as to enable effective comparisons between stablecoins and the banking industry. In this process, the article will explore three recently emerged forms of stablecoin: fiat-backed stablecoins, asset-backed stablecoins, and strategy-backed synthetic dollars, to look ahead to the future.
Key Takeaways
By compiling, inspired, in essence, it cannot escape the three-pronged approach of bank monetary theory.
Although the payment innovations of stablecoins may seem to disrupt traditional finance, it is important to understand that the essential properties of money (value measure) and core functions (medium of exchange) remain unchanged. Therefore, stablecoins can be seen as the medium or form of money.
Since it is essentially money, the development patterns of modern monetary history over the past few centuries are highly relevant. This is also the strength of Sam Broner's article; he not only observes the issuance of money but also sees subsequent banks using credit as a tool for money creation. This directly guides the current stablecoins, which are still in the money issuance phase.
If fiat-backed stablecoins are currently the choice of the masses in the money issuance phase, then asset-backed stablecoins will likely be the choice in the subsequent phase of credit-creating money. In my view, as more illiquid RWA tokenized assets come on-chain, their mission is not to circulate but to serve as collateral for credit creation as underlying assets.
Looking at strategy-backed synthetic dollars, due to the design of the technical structure, they will inevitably face regulatory challenges and user experience barriers. Currently, they are more commonly applied in DeFi yield products, struggling to break through the impossible triangle of traditional finance: yield, liquidity, and risk. However, we see some recent income-generating stablecoins that use U.S. treasury bonds as underlying assets or innovative models like PayFi are breaking through these limitations. PayFi integrates DeFi into payments, transforming every dollar into smart, autonomous funds.
Finally, it is essential to return to the essence: the birth of stablecoins, synthetic dollars, or dedicated currencies aims to further highlight the essential properties of money through digital currencies and blockchain technology, strengthening its core functions, enhancing the efficiency of money operation, reducing operational costs, controlling risks, and fully leveraging money's positive role in promoting value exchange and economic and social development.
1. The development of stablecoins
Since Circle launched USDC in 2018, there has been sufficient evidence over the years to show where stablecoins work and where they don’t.
Early adopters of stablecoins used fiat-backed stablecoins for transfers and savings. While stablecoins produced by decentralized over-collateralized lending protocols are useful and reliable, actual demand has been lacking. So far, users seem to strongly prefer dollar-denominated stablecoins over others (fiat or new denominations).
Some categories of stablecoins have already failed completely. For example, decentralized, low-collateral stablecoins like Luna-Terra appeared to be more capital-efficient than fiat-backed or over-collateralized stablecoins but ultimately ended in disaster. Other categories of stablecoins remain to be seen: while income-generating stablecoins are intuitively exciting, they face user experience and regulatory barriers.
With the successful product-market fit of currently adopted stablecoins, other types of dollar-denominated tokens have also emerged. For example, strategy-backed synthetic dollars like Ethena are a new product category that has yet to be fully defined. While similar to stablecoins, they have not yet reached the safety standards and maturity required for fiat-backed stablecoins and are currently more adopted by DeFi users, who take on higher risks for higher returns.
We have also witnessed the rapid adoption of fiat-backed stablecoins like Tether-USDT and Circle-USDC, which are attractive due to their simplicity and security. The adoption of asset-backed stablecoins has lagged, as this asset class occupies the largest share of deposit investments in the traditional banking system.
Analyzing stablecoins from the perspective of the traditional banking system helps explain these trends.
2. The history of the development of American banking: bank deposits and U.S. currency
To understand how current stablecoins mimic the banking system's development, it is especially helpful to understand the history of American banking.
Before the Federal Reserve Act was enacted in 1913, especially before the National Banking Act of 1863-1864, different forms of currency had different risk levels, and thus their actual values also differed.
The 'real' value of bank notes (cash), deposits, and checks can vary significantly based on three factors: the issuer, the ease of redemption, and the issuer's credibility. Especially before the establishment of the Federal Deposit Insurance Corporation (FDIC) in 1933, deposits had to be specially underwritten against bank risks.
During this period, one dollar ≠ one dollar.
Why is this? Because banks face (and continue to face) the dilemma of balancing profitable investment of deposits with ensuring the safety of those deposits. To achieve profitable investment of deposits, banks need to release loans and take on investment risks, but to ensure deposit safety, banks also need to manage risks and hold positions.
Until the Federal Reserve Act was enacted in 1913, in most cases, one dollar = one dollar.
Today, banks use dollar deposits to buy treasury bonds and stocks, issue loans, and participate in simple strategies like market making or hedging under the Volcker Rule. The Volcker Rule was introduced in the context of the 2008 financial crisis to limit banks' engagement in high-risk proprietary trading activities, reduce speculative activities in retail banking, and lower bankruptcy risks.
Although retail banking customers may believe that all their money is in deposit accounts and very safe, this is not the case. Looking back at the 2023 collapse of Silicon Valley Bank due to mismatched funds leading to liquidity depletion serves as a stark lesson for our markets.
Banks earn profits by investing deposits (lending) to earn interest spread, balancing profit-making and risk behind the scenes, while users are largely unaware of how banks handle their deposits, even though banks can essentially guarantee the safety of deposits during turbulent times.
Credit is a particularly important part of banking operations and is how banks enhance the efficiency of money supply and economic capital. Even though consumers can view deposits as relatively risk-free unified balances due to federal oversight, consumer protection, widespread adoption, and improvements in risk management.
Returning to stablecoins, they offer users many experiences similar to bank deposits and notes—convenient and reliable value storage, exchange medium, lending—but in an unbundled, 'self-custodial' form. Stablecoins will follow in the footsteps of their fiat currency predecessors, starting with simple bank deposits and notes, but as on-chain decentralized lending protocols mature, asset-backed stablecoins will become increasingly popular.
3. Stablecoins from the perspective of bank deposits
In this context, we can assess three types of stablecoins from the perspective of retail banking—fiat-backed stablecoins, asset-backed stablecoins, and strategy-backed synthetic dollars.
3.1 Fiat-backed stablecoins
Fiat-backed stablecoins are similar to U.S. bank notes during the National Banking Era (1865-1913). During this period, bank notes were anonymous notes issued by banks; federal regulations required customers to be able to redeem them for equivalent dollars (e.g., special U.S. treasuries) or other fiat currencies ('coins'). Therefore, although the value of bank notes may vary based on the issuer's reputation, accessibility, and solvency, most people trust bank notes.
Fiat-backed stablecoins follow the same principles. They are tokens that users can directly redeem for easy-to-understand, trustworthy fiat currency—but there are similar caveats: while cash is an anonymous note that anyone can redeem, the holder may not live near the issuing bank, making redemption difficult. Over time, people have accepted the fact that they can find someone to trade with and then exchange their cash for dollars or coins. Similarly, users of fiat-backed stablecoins are becoming more confident that they can reliably find high-quality stablecoin brokers using Uniswap, Coinbase, or other exchanges.
Today, the combination of regulatory pressure and user preferences seems to be attracting more and more users to fiat-backed stablecoins, which account for over 94% of the total supply of stablecoins. Circle and Tether dominate the issuance of fiat-backed stablecoins, issuing over $150 billion in dollar-denominated fiat-backed stablecoins.
But why should users trust the issuers of fiat-backed stablecoins?
After all, fiat-backed stablecoins are centrally issued, making it easy to imagine a 'bank run' risk during stablecoin redemptions. To address these risks, fiat-backed stablecoins undergo audits by well-known accounting firms and obtain local licensing and compliance qualifications. For example, Circle is regularly audited by Deloitte. These audits aim to ensure that stablecoin issuers have sufficient reserves of fiat currency or short-term treasury bills to cover any short-term redemptions and that issuers have sufficient overall fiat collateral to support the redemption of each stablecoin at a 1:1 ratio.
Verifiable proof of reserves and decentralized issuance of fiat stablecoins are viable paths, but there has been little adoption.
Verifiable proof of reserves would enhance auditability and can currently be achieved through zkTLS (Zero-Knowledge Transport Layer Security), although it still relies on trusted centralized authorities.
Decentralized issuance of fiat-backed stablecoins may be feasible, but there are numerous regulatory issues. For example, to issue a decentralized fiat-backed stablecoin, the issuer would need to hold U.S. treasuries on-chain that have a risk profile similar to traditional treasuries. This is not possible today, but it would make it easier for users to trust fiat-backed stablecoins.
3.2 Asset-backed stablecoins
Asset-backed stablecoins are the products of on-chain lending protocols that mimic how banks create new money through credit. Decentralized over-collateralized lending protocols like Sky Protocol (formerly MakerDAO) issue new stablecoins that are backed by highly liquid collateral on-chain.
To understand how it works, imagine a checking account, where the funds in the account are part of the new funds created through a complex system of loans, regulation, and risk management.
In fact, most of the money in circulation, known as the M2 money supply, is created by banks through credit. Banks create money using mortgages, auto loans, commercial loans, inventory financing, etc., similarly, on-chain lending protocols use on-chain assets as collateral, thereby creating asset-backed stablecoins.
The system that allows credit to create new money is known as fractional reserve banking, which truly originated from the Federal Reserve Act in 1913. Since then, the fractional reserve banking system has gradually matured and undergone significant updates in 1933 (the establishment of the Federal Deposit Insurance Corporation), 1971 (President Nixon ended the gold standard), and 2020 (when the reserve requirement was lowered to zero).
With each reform, both consumers and regulators have become increasingly confident in the system of creating new money through credit. First, bank deposits are protected by federal deposit insurance. Second, despite major crises such as those in 1929 and 2008, banks and regulators have steadily improved their practices and processes to reduce risk. Over the past 110 years, the proportion of credit in the U.S. money supply has increased significantly, now accounting for the vast majority.
Traditional financial institutions employ three methods to safely issue loans:
1. For assets with liquid markets and fast settlement practices (margin loans);
2. Large-scale statistical analysis of a set of loans (mortgages);
3. Provide thoughtful and tailored underwriting services (commercial loans).
On-chain decentralized lending protocols still only account for a small portion of stablecoin supply, as they are just getting started and have a long way to go.
The most famous decentralized over-collateralized lending protocols are transparent, thoroughly tested, and conservative. For example, the most renowned collateral lending protocol, Sky Protocol (formerly MakerDAO), issues asset-backed stablecoins against the following assets: on-chain, exogenous, low-volatility, and high liquidity (easy to sell). Sky Protocol also has strict regulations regarding collateral ratios and effective governance and liquidation protocols. These attributes ensure that even if market conditions change, collateral can be sold safely, thereby protecting the redemption value of asset-backed stablecoins.
Users can evaluate mortgage protocols based on four criteria:
1. Governance transparency;
2. The proportion, quality, and volatility of the assets backing the stablecoins;
3. Security of smart contracts;
4. The ability to maintain loan-to-collateral ratios in real-time.
Similar to funds in a checking account, asset-backed stablecoins are new funds created through asset-backed lending, but their lending practices are more transparent, auditable, and easy to understand. Users can audit the collateral backing asset-backed stablecoins, which distinguishes them from the traditional banking system where users can only entrust their deposits to bank executives for investment decisions.
In addition, the decentralization and transparency achieved by blockchain can mitigate the risks that securities laws aim to address. This is important for stablecoins because it means that truly decentralized asset-backed stablecoins may fall outside the scope of securities laws—this analysis may be limited to asset-backed stablecoins that rely entirely on digital native collateral (rather than 'real world assets'). This is because such collateral can be secured through autonomous protocols rather than centralized intermediaries.
As more economic activities move on-chain, we expect two things to occur: first, more assets will become collateral used in on-chain lending protocols; second, asset-backed stablecoins will occupy a larger share of on-chain money. Other types of loans may eventually be safely issued on-chain to further expand the supply of on-chain money.
Just as the growth of traditional bank credit, regulators lowering reserve requirements, and the maturation of credit practices took time, the maturation of on-chain lending protocols will also take time. We have reason to expect that in the near future, more people will use asset-backed stablecoins for transactions as easily as they use fiat-backed stablecoins.
3.3 Strategy-backed synthetic dollars
Recently, some projects have launched tokens pegged to $1 that represent a combination of collateral and investment strategies. These tokens are often confused with stablecoins, but strategy-backed synthetic dollars should not be viewed as stablecoins for the following reasons:
Strategy-backed synthetic dollars (SBSD) expose users directly to the trading risks of actively managed assets. They are usually centralized, under-collateralized tokens with attributes of financial derivatives. More accurately, SBSD are dollar shares in open hedge funds—this structure is difficult to audit and may expose users to risks of centralized exchanges (CEX) and asset price volatility, such as if the market experiences significant fluctuations or continued downturns.
These attributes make SBSD unsuitable as a reliable store of value or medium of exchange, which are the primary uses of stablecoins. While SBSD can be constructed in various ways, with differing levels of risk and stability, they all offer dollar-denominated financial products that people may wish to include in their portfolios.
SBSD can be built on various strategies—such as basis trading or participating in yield-generating protocols, like helping secure active validation services (AVSs) through Restaking protocols. These projects manage risk and return, often allowing users to earn returns based on cash positions. By managing risks with returns, including evaluating AVSs to reduce risks, seeking opportunities for higher yields, or monitoring basis trading inversions, projects can produce a strategy-supported synthetic dollar (SBSD) that generates returns.
Users should thoroughly understand the risks and mechanisms of any SBSD before using them (as with any new tool). DeFi users should also consider the implications of using SBSD in DeFi strategies, as decoupling can have severe ripple effects. When an asset decouples or depreciates suddenly relative to its tracked asset, derivatives relying on price stability and stable returns may become unstable abruptly. However, when a strategy includes centralized, closed-source, or un-auditable components, underwriting the risk of any given strategy may be difficult or impossible.
Although we have seen that banks do implement simple strategies for deposits and are actively managed, this only accounts for a small portion of overall capital allocation. It is challenging to use these strategies on a large scale to support the overall stablecoin supply because they must be actively managed, making these strategies difficult to decentralize or audit reliably. SBSD exposes users to greater risks than bank deposits. If users' deposits are held in such tools, they have reason to be skeptical.
In fact, users have always been cautious about SBSD. Although they are popular among users with higher risk appetites, very few users trade with them. Additionally, the SEC has taken enforcement actions against those issuing 'stablecoins' that function like shares in investment funds.
4. Finally
The era of stablecoins has arrived. There are over $160 billion in stablecoins used for trading worldwide. They fall into two main categories: fiat-backed stablecoins and asset-backed stablecoins. Other dollar-denominated tokens, such as strategy-backed synthetic dollars, have gained awareness but do not meet the definition of stablecoins as a store of value and medium of exchange.
The history of banking is a good indicator for understanding the asset class of stablecoins—stablecoins must first integrate around a clear, understandable, easily redeemable form of currency, similar to how Federal Reserve notes gained public recognition in the 19th and early 20th centuries.
Over time, we should expect the number of asset-backed stablecoins issued by decentralized over-collateralized lending protocols to increase, just as banks have increased the M2 money supply through deposit credit. Finally, we should expect DeFi to continue to grow, creating more SBSD for investors and improving the quality and quantity of asset-backed stablecoins.
While this analysis may be useful, we should focus more on the current situation. Stablecoins have become the cheapest way to remit funds, meaning stablecoins have a real opportunity to reconstruct the payment industry, creating opportunities for existing businesses. More importantly, it creates opportunities for startups to build on a new payment platform that is frictionless and costless.