Author: Web3 Xiaolu
Despite millions currently using stablecoins and trading trillions of dollars in value, the definition of the stablecoin category and people's understanding of it remain vague.
Stablecoins are a way to store value and serve as a medium of exchange, typically (but not necessarily) pegged to the dollar. Although stablecoins have only developed over a short period of five years, the evolution of their two dimensions has significant reference value: 1. From under-collateralization to over-collateralization, 2. From centralization to decentralization. This is very beneficial for helping us understand the technical structure of stablecoins and dispelling market misunderstandings about them.
Stablecoins, as a payment innovation, simplify the way value is transferred. They have constructed a market parallel to traditional financial infrastructure, with annual transaction volumes even surpassing major payment networks.
History teaches us about rise and fall. If we want to understand the limitations and scalability of stablecoin design, a useful perspective is the history of banking development, to see what works, what doesn't, and the reasons behind them. 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 will provide a perspective on the future development of stablecoins through a compilation of a16z partner Sam Broner's 'A Useful Framework for Understanding Stablecoins: Banking History', drawing on the development history of American banking.
The article will first introduce the developments in stablecoins in recent years and then compare them with the development history of American banking to enable effective comparisons between stablecoins and banking. In the process, the article will explore three recently emerging forms of stablecoin: fiat-backed stablecoins, asset-backed stablecoins, and strategy-backed synthetic dollars, in order to look ahead to the future.
Key Takeaways
Through compilation, deeply inspired, it ultimately cannot escape the three pillars of banking monetary theory.
Although the payment innovation of stablecoins seems to disrupt traditional finance, the most important thing is to understand that the essential properties of money (measure of value) and its core functions (medium of exchange) remain unchanged. Therefore, stablecoins can be said to be carriers or manifestations of money.
Since the essence is money, the development patterns of modern monetary history over the past few centuries are highly relevant. This is also the merit of Sam Broner's article, which not only observes the issuance of money but also sees that subsequent banks treat credit as a tool for money creation. This directly guides stablecoins, which are still in the monetary issuance phase, on their path.
If fiat-backed stablecoins are currently the choice for the general public in the monetary issuance phase, then asset-backed stablecoins will be the choice for the subsequent phase of credit creation. Personally, I believe that as more illiquid RWA tokenized assets come on-chain, their mission is not to circulate but to serve as collateral, acting as underlying assets for credit creation.
Now let's look 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 applicable in DeFi yield products and struggle to break through the impossible triangle of traditional finance: yield, liquidity, and risk. However, we have recently seen some income-generating stablecoins backed by U.S. Treasury bonds or innovative models like PayFi that are breaking through these limitations. PayFi integrates DeFi into payments, transforming every dollar into intelligent, autonomous capital.
Finally, it is essential to return to the essence: the birth of stablecoins, synthetic dollars, or specialized currencies aims to further highlight the essential attributes of money, strengthen its core functions, enhance the efficiency of monetary operations, reduce operational costs, strictly control risks, and fully play the positive role of money in promoting value exchange and economic and social development applications.
1. The development history of stablecoins
Since Circle launched USDC in 2018, the developments over the years have provided ample evidence of which paths stablecoins can successfully take and which cannot.
Early adopters of stablecoins use fiat-backed stablecoins for transfers and savings. While stablecoins generated by decentralized over-collateralized lending protocols are useful and reliable, the actual demand remains lacking. So far, users seem to strongly prefer dollar-pegged stablecoins over others (fiat or new denominations).
Certain categories of stablecoins have already completely failed. For example, decentralized, low-collateral stablecoins like Luna-Terra seemed 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 current successful product-market fit of stablecoin adoption, other types of dollar-denominated tokens have also emerged. For example, strategy-backed synthetic dollars like Ethena represent 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 such as Tether-USDT and Circle-USDC, which are attractive due to their simplicity and security. The adoption of asset-backed stablecoins lags behind, and this asset class accounts for 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 development history of the U.S. banking industry: bank deposits and U.S. currency
Understanding how current stablecoins mimic the banking system is particularly helpful in understanding the history of the U.S. banking industry.
Before the Federal Reserve Act of 1913, especially before the National Bank Act of 1863-1864, different forms of currency had different risk levels, and therefore 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 insured against bank risks.
During this period, one dollar ≠ one dollar.
Why is this? Because banks face (and continue to face) the contradiction of maintaining profitability from deposit investments while ensuring deposit security. To achieve profitable deposit investments, banks need to release loans and take on investment risks, but to ensure deposit security, they also need to manage risks and hold positions.
It wasn't until the Federal Reserve Act of 1913 was enacted that, in most cases, one dollar = one dollar.
Today, banks use dollar deposits to purchase Treasuries 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 and to reduce retail banks' speculative activities, thereby lowering bankruptcy risks.
Although retail banking customers may think all their money is in their deposit accounts and very safe, this is not the case. Looking back at the 2023 collapse of Silicon Valley Bank due to a mismatch of funds leading to liquidity depletion serves as a bloody lesson for our market.
Banks earn profits by investing deposits (lending), balancing profit-making and risks behind the scenes, while users are largely unaware of how banks handle their deposits, even though during turbulent times, banks can generally ensure deposit safety.
Credit is a particularly important part of banking and is how banks increase the money supply and economic capital efficiency. Despite federal oversight, consumer protection, widespread adoption, and improved risk management, consumers can view deposits as relatively risk-free unified balances.
Returning to stablecoins, they provide users with many experiences similar to bank deposits and notes—convenient and reliable value storage, mediums of exchange, and lending—but in an unbundled, 'self-custodied' form. Stablecoins will follow in the footsteps of their fiat predecessors, starting from simple bank deposits and notes, but as on-chain decentralized lending protocols mature, asset-backed stablecoins will become increasingly popular.
3. From the perspective of bank deposits looking at stablecoins.
Based on this background, we can evaluate 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. banknotes during the National Banking Era (1865-1913). During this period, banknotes were bearer instruments 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 banknotes may vary depending on the issuer's reputation, accessibility, and solvency, most people trust banknotes.
Fiat-backed stablecoins follow the same principles. They are tokens that users can directly redeem for easily understood and trusted fiat currency—but there are similar warnings: while paper currency is an anonymous note that anyone can redeem, holders may not live near the issuing bank, making redemption difficult. Over time, people have accepted the fact that they can find traders to exchange their paper money for dollars or coins. Similarly, users of fiat-backed stablecoins are becoming increasingly confident that they can reliably find quality stablecoin redeeming parties using platforms like 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, collectively issuing over $150 billion worth of dollar-pegged fiat-backed stablecoins.
But why should users trust the issuers of fiat-backed stablecoins?
After all, fiat-backed stablecoins are centrally issued, and it is easy to imagine the risk of a 'bank run' during redemption. To address these risks, fiat-backed stablecoins undergo audits by reputable accounting firms and obtain local licensing qualifications and compliance requirements. For example, Circle regularly undergoes audits by Deloitte. These audits aim to ensure that the stablecoin issuer has sufficient fiat currency or short-term Treasury reserves to pay any short-term redemptions, and that the issuer has sufficient total fiat collateral to support the redemption of each stablecoin at a 1:1 ratio.
Verifiable proof of reserves and decentralized issuance of fiat stablecoins is a viable path, but has not been widely adopted.
Verifiable proof of reserves will enhance auditability, currently achievable through zkTLS (Zero Knowledge Transport Layer Security, also known as network proof) and similar methods, although it still relies on trusted centralized authorities.
Decentralized issuance of fiat-backed stablecoins may be feasible, but there are significant regulatory issues. For example, to issue decentralized fiat-backed stablecoins, the issuer needs to hold U.S. Treasuries on-chain that have similar risk profiles to traditional government bonds. 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 products of on-chain lending protocols; they mimic how banks create new money through credit. Decentralized over-collateralized lending protocols like Sky Protocol (formerly MakerDAO) have issued new stablecoins that are supported by highly liquid on-chain collateral.
To understand how it works, imagine a checking account where the funds are part of the creation of new money, achieved through a complex system of lending, 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, business loans, inventory financing, etc., while on-chain lending protocols use on-chain assets as collateral to create asset-backed stablecoins.
The system that enables credit to create new money is known as fractional reserve banking, which truly originated with the Federal Reserve Act of 1913. Since then, fractional reserve banking has gradually matured and underwent significant updates in 1933 (the establishment of the FDIC), 1971 (President Nixon's end of the gold standard), and 2020 (when reserve ratios dropped to zero).
With each revolution, consumers and regulators are 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 been steadily improving their practices and processes to reduce risks. For the past 110 years, the proportion of credit in the U.S. money supply has been steadily increasing, now accounting for the vast majority.
Traditional financial institutions use three methods to safely issue loans:
1. Targeting assets with liquid markets and rapid settlement practices (margin loans);
2. Conducting large-scale statistical analysis on a set of loans (mortgages);
3. Providing thoughtful and tailored underwriting services (commercial loans).
On-chain decentralized lending protocols still account for only a small portion of the stablecoin supply, as they are just getting started and have a long way to go.
The most well-known decentralized over-collateralized lending protocols are transparent, well-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 on collateral ratios and effective governance and liquidation protocols. These attributes ensure that even if market conditions change, collateral can be safely sold, protecting the redemption value of asset-backed stablecoins.
Users can evaluate collateral loan protocols based on four criteria:
1. Governance transparency;
2. The proportion, quality, and volatility of assets supporting stablecoins;
3. Security of smart contracts;
4. The ability to maintain loan-to-value ratios in real-time.
Like funds in a checking account, asset-backed stablecoins are new funds created through asset-backed loans, but their lending practices are more transparent, auditable, and understandable. Users can audit the collateral of asset-backed stablecoins, which differs from the traditional banking system where deposits are entrusted to bank executives for investment decisions.
Moreover, the decentralization and transparency achieved by blockchain can mitigate the risks that securities laws aim to address. This is important for stablecoins, as 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 fully rely on digitally native collateral (rather than 'real-world assets'). This is because such collateral can be safeguarded through autonomous protocols rather than centralized intermediaries.
As more economic activities are moving on-chain, two things are expected to happen: first, more assets will become collateral used in on-chain lending protocols; second, asset-backed stablecoins will occupy a larger share of on-chain currency. Other types of loans may eventually be safely issued on-chain to further expand on-chain money supply.
Just as the growth of traditional bank credit, the lowering of reserve requirements by regulators, and the maturity of credit practices take time, the maturity of on-chain lending protocols also requires time. We have reason to expect 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, representing a combination of collateral and investment strategies. These tokens are often confused with stablecoins, but strategy-backed synthetic dollars should not be seen as stablecoins for the following reasons:
Strategy-backed synthetic dollars (SBSD) expose users directly to the trading risks of actively managed assets. They are typically centralized, under-collateralized tokens with financial derivative attributes. More accurately, SBSDs are dollar shares in open-ended hedge funds—this structure is both difficult to audit and may expose users to risks from centralized exchanges (CEX) and asset price fluctuations, for example, if the market experiences significant volatility or sustained downward sentiment.
These attributes make SBSDs unsuitable for reliable value storage or as a medium of exchange, which are the primary uses of stablecoins. While SBSDs can be constructed in various ways with differing levels of risk and stability, they all provide 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 to secure Active Verification Services (AVSs) through Restaking. These projects manage risks and returns, often allowing users to earn based on cash positions. By managing risks with returns, including assessing AVSs to reduce risk, seeking higher yield opportunities, or monitoring the inversion of basis trades, projects can create a yield-generating strategy-supported synthetic dollar (SBSD).
Before using any SBSD, users should thoroughly understand its risks and mechanisms (as with any new tool). DeFi users should also consider the implications of using SBSDs in DeFi strategies, as decoupling can have serious ripple effects. When an asset decouples or suddenly depreciates relative to its tracked asset, derivatives relying on price stability and stable yields can suddenly become unstable. However, when a strategy includes centralized, closed-source, or unauditable components, underwriting the risks of any given strategy may be difficult or impossible.
While we see that banks indeed implement simple strategies for deposits and are actively managed, this only accounts for a small fraction of overall capital allocation. It is challenging to scale these strategies to support the overall stablecoin supply, as they must be actively managed, making it difficult for these strategies to be reliably decentralized or audited. SBSDs expose users to greater risks than bank deposits. If a user's deposits are held in such tools, they have reason to be skeptical.
In fact, users have been cautious towards SBSDs. Although they are popular among users with higher risk appetites, very few users actually trade with them. Additionally, the U.S. Securities and Exchange Commission has taken enforcement actions against those issuing 'stablecoins' that function similarly to stocks in investment funds.
4. Finally
The era of stablecoins has arrived. There are over $160 billion worth of stablecoins in circulation for transactions. They are divided into two main categories: fiat-backed stablecoins and asset-backed stablecoins. Other dollar-pegged tokens, such as strategy-backed synthetic dollars, are gaining 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 be integrated around a clear, understandable, and 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 increased the M2 money supply through deposit credit. Finally, we should expect DeFi to continue to grow, creating more SBSDs for investors while improving the quality and quantity of asset-backed stablecoins.
This analysis may be useful, but we should focus more on the present situation. Stablecoins have already become the cheapest way to remit, which means they have a real opportunity to reconstruct the payment industry, creating opportunities for existing businesses. More importantly, they create opportunities for startups to build on a new payment platform that is frictionless and cost-free.
