Original author: Minerva
Original translation: Block unicorn
It has been ten years since Tether launched the first USD-backed crypto asset. Since then, stablecoins have become one of the most widely adopted products in the cryptocurrency space, with a current market capitalization of nearly $180 billion. Despite such significant growth, stablecoins still face many challenges and limitations.
This article delves into the issues with existing stablecoin models and attempts to predict how we can end the currency civil war.
1. Stablecoin = Debt
Before delving into the discussion, let’s introduce some basics to better understand the meaning of stablecoins.
A few years ago, when I started researching stablecoins, I was puzzled by people describing them as debt instruments. But as I delved into how money is created in the current financial system, I began to understand this perspective.
In the fiat currency system, currency is primarily created when commercial banks (hereinafter referred to as 'banks') provide loans to customers. However, this does not mean that banks can create money out of thin air. Before creating money, banks must first receive something of value: your promise to repay the loan.
Imagine you need financing to buy a new car. You apply for a loan at your local bank, and once approved, the bank will deposit an amount matching the loan amount into your account. At this point, new money has been created in the system.
When you transfer these funds to the car seller, if the seller has an account at another bank, the deposit may move to that other bank. However, this money 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)
The operation of stablecoins is somewhat similar. Stablecoins are created when the issuer provides loans and are destroyed through the repayments of borrowers. Centralized issuers like Tether and Circle mint tokenized USD, which are essentially digital IOUs based on the USD 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 rather than 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 (Crypto Dollars and the Hierarchy of Money).
Figure 2: Two-dimensional matrix of crypto dollars
Source: (Crypto Dollars and the Hierarchy of Money), September 2024
Sebastien classifies stablecoins using a two-dimensional matrix based on their reserve nature (such as off-chain RWA assets versus 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 1:1 backed by cash or cash equivalents (like short-term government bonds), but also includes other assets such as commercial papers 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 backed by on-chain reserves. DAI operates with a partially reserved structure through its over-collateralization.
Figure 3: Simplified balance sheets of current crypto dollar issuers
Source: (Crypto Dollars and the Hierarchy of Money), September 2024
Like traditional banks, these crypto banks aim to generate substantial returns for shareholders by taking on moderate balance sheet risks. The risks should be sufficient to generate profit but not so high as to jeopardize collateral and face bankruptcy risks.
2. Issues with existing models
Although 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 margin is my opportunity.' Although Tether and Circle continue to dominate the stablecoin market, the recent high-interest rate environment has birthed a wave of new entrants trying to carve out a share of these high profits.
The problem with having so many stablecoin options is that, although they all represent tokenized USD, 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 convert USDT to USDC through centralized or decentralized exchanges, but this adds unnecessary trading friction.
This fragmented landscape is reminiscent of the era before central banks, when each bank issued its own notes. In that time, the value of bank notes fluctuated based on their creditworthiness, and if the issuing bank failed, they could become worthless. The lack of standardization in value led to market inefficiencies, making interregional trade difficult and costly.
The establishment of central banks was to address this issue. 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 uniformity', allowing people to treat all banknotes and deposits as equivalent, regardless of the issuing bank's creditworthiness.
But DeFi lacks a central bank to establish monetary uniformity. Some projects, like 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 J.P. Morgan (JPM). While the official currency in the U.S. is the dollar (USD), the balance in that account actually represents a bank note, which we can refer to as 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 exchange jpmUSD for physical cash or swap it with the notes from other banks (such as boaUSD or wellsfargoUSD) at a 1:1 rate within the banking system.
Figure 5: Diagram of the hierarchy of money
Source: #4 | Classification of Money: From Tokens to Stablecoins (Dirt Roads)
Just as we can stack different technologies to create digital ecosystems, 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 money') can be seen as a layer above the dollar ('token'). In this hierarchy, bank money relies on the trust and stability of the underlying token and is supported by formal agreements with 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 fundamental characteristics of bank money and tokens while adding the advantages of blockchain networks and interoperability with DeFi applications. While they serve as an enhanced payment rail layer above the existing money stack, they remain closely tied to the traditional banking system, thus bringing in 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 credit risk is low, the counterparty risk is higher since only a small portion of bank deposits are insured by the Federal Deposit Insurance Corporation (FDIC).
Figure 6: Fluctuations in stablecoin prices during the SVB collapse
Source: (Stablecoins and Tokenized Deposits: Impacts on Monetary Uniformity) (BIS)
For example, in 2021, of the approximately $10 billion in cash held by Circle in regulated financial institutions, only $1.75 million (about 0.02%) was insured by FDIC.
When Silicon Valley Bank (SVB) collapsed, Circle faced the risk of losing most of its deposits at that bank. If the government had not taken special measures to guarantee all deposits, including those exceeding the $250,000 FDIC insurance limit, USDC could have permanently decoupled from the dollar.
(3) Yield: Competition to the bottom
In this round of the cycle, the dominant narrative surrounding stablecoins is the concept of 'returning yields to users.'
For regulatory and financial reasons, centralized stablecoin issuers retain all profits generated from user deposits. This creates a disconnect between those who actually drive value creation (users, DeFi applications, and market makers) and those who capture the earnings (issuers).
This difference 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 has also prompted issuers to significantly cut fees to gain larger market shares. The intensity of this yield competition is evident when I reviewed the tokenized money market fund proposals from the Spark Tokenization Grand Prix. The Spark Tokenization Grand Prix aims to consolidate $1 billion of tokenized financial assets as collateral for MakerDAO.
Ultimately, yield or fee structures cannot become long-term differentiators, as they may tend to maintain the minimum sustainable rate needed to operate. Issuers will need to explore alternative monetization strategies, as the issuance of stablecoins itself does not accumulate value.
3. Predicting an unstable future
(Romance of the Three Kingdoms) is a classic work beloved in East Asian culture, set in the late Han Dynasty when warlords divided the land and wars were constant.
A key strategist in the story is Zhuge Liang, who proposed dividing China into three independent regions, each controlled by three warring factions. His 'Three Kingdoms' strategy aimed to prevent any one kingdom from achieving dominance, thus creating a balanced power structure to restore stability and peace.
I am not Zhuge Liang, but stablecoins may also benefit from a similar tripartite strategy. The future landscape may be divided into three areas: (1) payments, (2) yields, and (3) intermediaries (everything in between).
· Payments: Stablecoins provide a seamless, low-cost method for cross-border transaction settlements. USDC currently leads in this area, and its partnerships with Coinbase and Base Layer 2 may further solidify its position. DeFi stablecoins should avoid directly competing with Circle in the payment space and instead focus on the DeFi ecosystem where they have clear advantages.
· Yield: RWA protocols issuing yield-bearing stablecoins should learn from Ethena, which has cracked the secret to generating high, relatively sustainable yields through crypto-native products and related offerings. Whether leveraging other delta-neutral strategies or creating synthetic credit structures that replicate traditional financial (TradFi) swaps, there is room for growth in this area due to USDe facing scalability limits.
· Intermediaries: For decentralized stablecoins with low yields, there is an opportunity to unify fragmented liquidity. An interoperable solution will maximize DeFi's ability to match lenders and borrowers and further streamline the DeFi ecosystem.
The future of stablecoins remains uncertain. However, the balance of power among these three components may end the 'currency civil war' and bring much-needed stability to the ecosystem. Rather than engaging in 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.
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