It has been ten years since Tether launched the first cryptocurrency backed by the US dollar. Since then, stablecoins have become one of the most widely adopted products in the cryptocurrency field, 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 (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.
Suppose you need financing to buy a new car. You apply for a loan from 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.
Stablecoins operate in a similar way. Stablecoins are created when the issuer grants loans and 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 based on 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 supported 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 "Cryptodollars and the Hierarchy of Money".
Sebastien categorizes stablecoins using a two-dimensional matrix based on the nature of their reserves (such as off-chain real-world assets and on-chain crypto assets) and whether their model is fully reserved or partially reserved.
Here are some notable examples:
· USDT: Primarily supported 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 supported 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 supported by on-chain reserves. DAI uses an over-collateralized structure to operate on a partially reserved basis.
Similar to traditional banks, the goal of these crypto banks is to create substantial returns for shareholders by taking on moderate balance sheet risks. The risks are sufficient to generate profits, but not high enough to jeopardize the collateral and face insolvency.
II. Issues with the Existing Models
While stablecoins have ideal characteristics such as lower transaction costs, faster settlement speeds, and higher yields compared to traditional finance (TradFi) alternatives, the existing models still face many problems.
(1) Fragmentation
According to data from RWA.xyz, there are currently 28 active US dollar-pegged stablecoins.
As Jeff Bezos famously said, "Your margin is my opportunity." Although Tether and Circle continue to dominate the stablecoin market, the high-interest rate environment in recent years has spawned a wave of new entrants trying to grab a slice 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. Users can convert USDT to USDC through centralized or decentralized exchanges, but this adds unnecessary transaction friction.
This fragmented landscape is similar to the era before central banking, when individual banks issued their own banknotes. In that era, the value of bank notes fluctuated based on the issuing bank's creditworthiness, and if the issuing bank failed, the notes could become worthless. The lack of standardized value led to market inefficiencies and made 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 ensured that the paper currency issued by banks could be accepted at face value throughout the system. This standardization achieved the so-called "monetary unity," allowing people to view all paper currency 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 solve the interoperability issue by developing decentralized crypto-dollar issuance platforms. I'm personally excited about 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 (JPM). Although the official currency of the United States is the US dollar (USD), the balance in this 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 exchange jpmUSD for physical cash or swap it 1:1 with other banks' notes (such as boaUSD or wellsfargoUSD) within the banking system.
Just as we can stack different technologies to create digital ecosystems, various forms of currency can also be layered to build a currency hierarchy. 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 hierarchical structure, bank money relies on the trust and stability of the underlying token, and is 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 currency hierarchy. They retain the basic characteristics of bank money and tokens, while adding the advantages of blockchain networks and interoperability with DeFi applications. Although they serve as an enhanced payment rail layer on top of the existing currency stack, they are still closely tied to the traditional banking system, and thus carry counterparty risk.
Issuers of centralized stablecoins typically invest their reserves in safe and highly liquid assets such as cash and short-term U.S. government securities. While credit risk is relatively low, counterparty risk is relatively high due to the fact that only a small portion of bank deposits are insured by the Federal Deposit Insurance Corporation (FDIC).
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 most 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 U.S. dollar.
(3) Yield: A race to the bottom
In this cycle, the dominant narrative around stablecoins is 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 that drive value creation (users, DeFi applications, and market makers) and the parties that capture the yield (the issuers).
This gap has paved the way for a new wave of stablecoin issuers who use short-term wealth or tokenized versions of these assets to mint stablecoins, and redistribute the underlying yield 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 war 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 to 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 of 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 one 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) Yield, and (3) the Middleware (everything 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.
· Yield: 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 offerings. 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: There is an opportunity to unify the fragmented liquidity of low-yield decentralized stablecoins. An interoperable solution will maximize the DeFi ecosystem's ability to match lenders and borrowers, and further simplify the DeFi landscape.
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.
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