Original Author: Minerva
Original Compilation: Block unicorn
It has been ten years since Tether launched the first US dollar-backed cryptocurrency. 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 remarkable growth, stablecoins still face multiple challenges and limitations.
This article delves into the issues with the existing stablecoin models and attempts to predict how we might end the currency civil war.
I. Stablecoins = Debt
Before diving in, 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 deeper into how money is created in the current financial system, I began to understand this point.
In the fiat currency system, money is primarily created when commercial banks (hereafter "banks") extend loans to their customers. But 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.
Suppose you need financing to buy a new car. You apply for a loan at your local bank, and once approved, the bank will deposit a deposit 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 be transferred to that other bank. However, the money remains within the banking system until you start repaying the loan. Money is created through lending and destroyed through repayment.
Figure 1: Creating money through additional lending
Source: "Money creation in the modern economy" (Bank of England)
Stablecoins operate in a similar way. Stablecoins are created when the issuer extends loans, and they are destroyed through the borrower's repayment. Centralized issuers like Tether and Circle mint tokenized US dollars (Tokenized USD), which are essentially digital IOUs issued against the US dollar deposits made by borrowers. DeFi protocols (such as MakerDAO and Aave) also mint stablecoins through lending, but this issuance is collateralized by crypto assets rather than fiat currency.
Since their debt is backed by various forms of collateral, stablecoin issuers effectively play the role of crypto banks. Sebastien Derivaux, the founder of Steakhouse Financial, further explores this analogy in his research paper "Cryptodollars and the Hierarchy of Money".
Figure 2: A two-dimensional matrix of cryptodollars
Source: "Cryptodollars and the Hierarchy of Money", September 2024
Sebastien classifies stablecoins using a two-dimensional matrix based on the nature of their reserves (such as off-chain fiat assets vs. on-chain crypto assets) and whether their 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 (such as short-term government bonds), but also includes commercial paper and corporate bonds.
USDC: USDC is also backed by off-chain reserves, but unlike USDT, it maintains a fully reserved state (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 uses an over-collateralized structure to maintain partial reserve status.
Figure 3: Simplified balance sheets of current cryptodollar issuers
Source: "Cryptodollars and the Hierarchy of Money", September 2024
Similar to traditional banks, the goal of these crypto banks is to create shareholder value by taking on moderate balance sheet risk. The risk is sufficient to be profitable, but not so high as to jeopardize the collateral and face insolvency.
II. Issues with the Existing Models
While stablecoins have more desirable features than traditional finance (TradFi) alternatives, such as lower transaction costs, faster settlement, and higher yields, the existing models still face many problems.
(1) Fragmentation
According to data from RWA.xyz, there are currently 28 active US dollar-pegged stablecoins.
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 spawned a wave of new entrants trying to grab a piece of these high-profit margins.
The problem with having so many stablecoin options is that, although they all represent tokenized US dollars, they are not interoperable with each other. For example, a user holding USDT cannot seamlessly use it at a merchant that only accepts USDC, even though both are pegged to the US dollar. The user can convert USDT to USDC through a centralized or decentralized exchange, but this adds unnecessary transaction friction.
This fragmented landscape is similar to the pre-central banking era, when individual banks issued their own banknotes. In that era, the value of bank notes fluctuated based on the issuing bank's creditworthiness, and they could even become worthless if the issuing bank failed. The lack of standardized value made the market inefficient and hindered cross-regional trade, which was costly and difficult.
The establishment of central banks was meant to solve this problem. By requiring member banks to maintain reserve accounts, they ensured that the banknotes issued by banks could be accepted at face value throughout the system. This standardization achieved the so-called "monetary unity," 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 unity. Some projects, like M^ 0 (@m 0 foundation), are attempting to address the interoperability issue by developing decentralized cryptodollar issuance platforms. I'm personally excited about their ambitious vision, but the challenges are significant, and their success remains a work in progress.
(2) Counterparty Risk
Imagine you have an account at JPMorgan Chase (JPM). Although the official currency of the United States is the US dollar (USD), the balance in your account actually represents a bank note, which we can call jpmUSD.
As mentioned earlier, jpmUSD is pegged to the US dollar at a 1:1 ratio through an agreement between JPM and the central bank. You can either redeem jpmUSD for physical cash or swap it 1:1 with other banks' notes (such as boaUSD or wellsfargoUSD) within the banking system.
Figure 5: Schematic of the monetary hierarchy
Source: #4 | Monetary Taxonomy: From Tokens to Stablecoins (Dirt Roads)
Just as we can stack different technologies to create digital ecosystems, various forms of money can also be hierarchically constructed. The US dollar and jpmUSD are both forms of money, but jpmUSD (or "bank money") can be seen as a layer on top of the US dollar ("token"). In this hierarchy, bank money relies on the trust and stability of the underlying token, supported by the formal agreement between the Federal Reserve and the US government.
Fiat-backed stablecoins (such as USDT and USDC) can be described as a new layer on top of this hierarchical structure. They retain the basic 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 on top of the existing monetary stack, they remain closely tied to the traditional banking system, thus introducing counterparty risk.
Centralized stablecoin issuers typically invest their reserves in safe and liquid assets such as cash and short-term US government securities. While credit risk is low, counterparty risk is relatively high due to only a small portion of bank deposits being insured by the Federal Deposit Insurance Corporation (FDIC).
Figure 6: Volatility in stablecoin prices during the SVB collapse
Source: "Stablecoins and tokenized deposits: Implications for monetary singularity" (BIS)
For example, in 2021, of the approximately $10 billion in cash held by Circle at regulated financial institutions, only $1.75 million (about 0.02%) was covered by FDIC deposit insurance.
When Silicon Valley Bank (SVB) collapsed, Circle faced the risk of losing the majority of its deposits at that bank. If the government had not taken special measures to guarantee all deposits, including those above the $250,000 FDIC insurance limit, USDC could have permanently de-pegged from the US dollar.
(3) Yield: A race to the bottom
In this cycle, the dominant narrative around stablecoins has been the concept of "returning yield to users".
For regulatory and financial reasons, centralized stablecoin issuers retain all the profits generated from user deposits. This has created a disconnect between the parties driving value creation (users, DeFi applications, and market makers) and those capturing the yields (the issuers).
This disparity has paved 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 costs in order to gain a larger market share. The intensity of this yield grab is evident when I review the tokenized money market fund proposals for the Spark Tokenization Grand Prix, which aims to aggregate $1 billion in tokenized financial assets as collateral for MakerDAO.
Ultimately, yield or fee structure cannot be a long-term differentiating factor, as they are likely to converge towards the minimum sustainable rate required for operations. Issuers will need to explore alternative monetization strategies, as the issuance of stablecoins itself does not accrue value.
III. Predicting an Unstable Future
The Romance of the Three Kingdoms is a beloved classic in East Asian culture, set against the backdrop of the late Han dynasty, a time of constant warfare and regional fragmentation.
A key strategic thinker in the story is Zhuge Liang, who proposed the famous strategy of dividing China into three independent regions, each controlled by one of the three warring factions. His "Three Kingdoms" strategy aimed to prevent any single kingdom from gaining dominance, creating a balanced power structure to restore stability and peace.
I am no 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) the Middleware layer (all the content in between).
Payments: Stablecoins provide a seamless, low-cost cross-border settlement solution. USDC currently leads in this area, and its collaboration with Coinbase and Layer 2 may further solidify its position. DeFi stablecoins should avoid direct competition with Circle in the payments domain and instead focus their efforts on the DeFi ecosystem where they have clear advantages.
Yields: RWA protocols issuing yield-bearing stablecoins should learn from Ethena, which has already cracked the secret to generating high and relatively sustainable yields through native crypto products and related products. Whether it's leveraging other delta-neutral strategies or creating synthetic credit structures that replicate traditional finance (TradFi) swaps, this domain has room for growth, as USDe faces scalability limitations.
Middleware: For low-yield decentralized stablecoins, there is an opportunity to unify fragmented liquidity. An interoperable solution will maximize the ability of DeFi to match lenders and borrowers, further simplifying the DeFi ecosystem.
The future of stablecoins remains uncertain. But a balanced power structure between these three domains 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.
