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 five 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 them.
As a payment innovation, stablecoins simplify the way of value transfer. It has constructed a market parallel to the traditional financial infrastructure, and its annual transaction volume has even exceeded that of major payment networks.
History is a mirror for understanding the rise and fall of things. If we want to understand the limitations and scalability of stablecoin design, a useful perspective is the history of banking, to see what works and what doesn’t, and the reasons behind it. Like many products in cryptocurrencies, stablecoins may replicate the history of banking development, starting with simple bank deposits and bills, and then enabling increasingly complex credit to expand the money supply.
Therefore, this article will provide a reference from the history of the development of the US banking industry to look at the future development of stablecoins by compiling the article A Useful Framework for Understanding Stablecoins: Banking History by a16z partner Sam Broner.
The article will first introduce the development of stablecoins in recent years, and then compare the development history of the US banking industry to enable a valid comparison between stablecoins and the banking industry. In the process, the article will explore the three stablecoin currency forms that have emerged recently: legal-backed stablecoins, asset-backed stablecoins, and strategy-backed synthetic dollars, in order to look forward to the future.
Key Takeaways
I was deeply inspired by the compilation. In essence, it cannot escape the three principles of banking and monetary theory.
- Although the payment innovation of stablecoins seems to have subverted traditional finance, the most important thing is to understand that the essential attributes (value scale) and core functions (medium of exchange) of currency remain unchanged. Therefore, stablecoins can be said to be the carrier or form of expression of currency.
- Since it is essentially money, the development laws of modern and contemporary currency history over the past few hundred years are of great reference value. This is also the merit of Sam Broner's article. He not only saw the issuance of currency, but also saw that banks used credit as a tool for money creation. This directly guides the direction of stablecoins, which are still in the currency issuance stage.
- If the stablecoins backed by legal tender are the public’s choice in the current currency issuance stage, then the stablecoins backed by assets will be the choice in the subsequent credit creation stage. My personal opinion is that as more and more illiquid RWA tokenized assets come to the chain, their mission is not to circulate, but to be pledged and used as underlying assets to create credit.
- Let’s look at the synthetic dollar supported by the strategy. Due to the design of the technical structure, it is bound to be challenged by regulation and obstacles to user experience. At present, it is more applicable to DeFi yield products, and it is difficult to break through the impossible triangle of investment in traditional finance: income, liquidity and risk. However, we have seen that some recent interest-bearing stablecoins with US bonds as underlying assets, or innovative model applications such as PayFi, are breaking through this limitation. PayFi integrates DeFi into payments, turning every dollar into smart and autonomous funds.
- Finally, we need to return to the essence: the birth of stablecoins, synthetic dollars or special currencies aims to further highlight the essential attributes of currency, strengthen its core functions, improve the efficiency of currency operation, reduce operating costs, strictly control risks, and give full play to the positive role of currency in promoting value exchange and economic and social development through digital currency and blockchain technology.
1. Development History of Stablecoins
Since Circle launched USDC in 2018, the developments over the years have provided enough evidence to show which paths stablecoins work and which don’t.
Early adopters of stablecoins use fiat-backed stablecoins for transfers and savings. While stablecoins produced by decentralized over-collateralized lending protocols are useful and reliable, actual demand is lackluster. So far, users seem to strongly prefer stablecoins denominated in USD over stablecoins in other (fiat or novel) denominations.
Some categories of stablecoins have failed outright. Decentralized, low-collateralization stablecoins like Luna-Terra, for example, looked more capital efficient than fiat-backed or over-collateralized stablecoins, but ultimately ended in disaster. Other categories of stablecoins remain to be seen: while interest-bearing stablecoins are intuitively exciting, they face user experience and regulatory hurdles.
With the successful product-market fit of the current stablecoin adoption, other types of dollar-denominated tokens have also emerged. For example, strategy-backed synthetic dollars such as Ethena are a new product category that has not yet been fully defined. Although similar to stablecoins, they have not actually reached the security standards and maturity required for legal currency-backed stablecoins. Currently, they are more adopted by DeFi users, taking higher risks and obtaining higher returns.
We have also witnessed the rapid adoption of Fiat-Backed Stablecoins such as Tether-USDT, Circle-USDC, which are attractive for their simplicity and security. The adoption of Asset-Backed Stablecoins lags behind, an asset class that accounts for the largest share of deposit investments in the traditional banking system.
Analyzing stablecoins through the lens of the traditional banking system helps explain these trends.
II. History of U.S. Banking: Bank Deposits and U.S. Currency
To understand how current stablecoins are developing in an attempt to mimic the banking system, it is particularly helpful to understand the history of U.S. banking.
Prior to the Federal Reserve Act of 1913, and especially prior to the National Banking Act of 1863–1864, different forms of money had different levels of risk and therefore different actual values.
The "real" value of bank notes (cash), deposits, and checks can vary widely, depending on three factors: the issuer, how easy it is to cash it, and the issuer's trustworthiness. Especially before the creation 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? Because banks faced (and still face) the contradiction between making deposit investments profitable and ensuring deposit safety. To achieve profitable deposit investments, banks need to release loans and bear investment risks, but to ensure deposit safety, banks need to manage risks and hold positions.
Until the Federal Reserve Act of 1913, one dollar = one dollar in most cases.
Today, banks use dollar deposits to buy Treasury bonds and stocks, make loans and engage in simple strategies such as market making or hedging under the Volcker Rule, which was introduced in the context of the 2008 financial crisis to limit banks from engaging in high-risk proprietary trading activities and reduce retail banks' speculative activities to reduce bankruptcy risks.
Although retail banking customers may think that all their money is safe in their deposit accounts, this is not the case. Looking back at the collapse of Silicon Valley Bank in 2023 due to mismatched funds and liquidity depletion, it is a bloody lesson for our market.
Banks make money by investing (lending) deposits and earning a spread. Banks balance money making and risk behind the scenes, and users are mostly unaware of how banks handle their deposits, although in turbulent times, banks can generally guarantee the safety of deposits.
Credit is a particularly important part of the banking business and is how banks increase the money supply and the capital efficiency of the economy. Although consumers can view deposits as relatively risk-free flat balances, thanks to improvements in federal supervision, consumer protection, widespread adoption, and risk management.
Back to stablecoins, which provide users with many similar experiences to bank deposits and bills - convenient and reliable value storage, medium of exchange, lending - but in an unbundled "self-custodial" form. Stablecoins will follow the example of their fiat currency predecessors, and adoption will start with simple bank deposits and bills, but as on-chain decentralized lending protocols mature, asset-backed stablecoins will become increasingly popular.
3. Stablecoins from the perspective of bank deposits
Against this backdrop, we can evaluate three types of stablecoins through the lens of retail banks – fiat-backed stablecoins, asset-backed stablecoins, and strategy-backed synthetic dollars.
3.1 Stablecoins backed by fiat currencies
Stablecoins backed by fiat currencies are similar to US Bank Notes from the era of the US National Bank (1865-1913). During this period, bank notes were bearer instruments issued by banks; federal regulations required that customers could redeem them for an equivalent amount of US dollars (e.g., special US Treasury bonds) or other legal tender (“coins”). Therefore, while the value of a bank note can vary depending on the reputation, accessibility, and solvency of the issuer, most people trust bank notes.
Fiat-backed stablecoins follow the same principle. They are tokens that users can directly redeem for well-understood, trusted fiat currencies — but with similar caveats: while paper money is a bearer instrument that anyone can redeem, the holder may not live near the issuing bank and have difficulty redeeming it. Over time, people have come to accept that they can find someone to trade with and then exchange their paper money for dollars or coins. Similarly, users of fiat-backed stablecoins have grown more confident that they can use Uniswap, Coinbase, or other exchanges to reliably find high-quality stablecoin acceptors.
Today, a combination of regulatory pressure and user preference appears to be attracting more and more users to fiat-backed stablecoins, which account for more than 94% of the total stablecoin supply. Two companies, Circle and Tether, dominate the issuance of fiat-backed stablecoins, with more than $150 billion in USD-dominated fiat-backed stablecoins issued.
But why should users trust 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" when stablecoins are redeemed. To address these risks, fiat-backed stablecoins are audited by well-known accounting firms and obtain local licenses and meet compliance requirements. For example, Circle is regularly audited by Deloitte. These audits are designed to ensure that stablecoin issuers have sufficient fiat currency or short-term Treasury bills in reserve to cover any short-term redemptions, and that the issuer has sufficient total fiat collateral to back the acceptance of each stablecoin at a 1:1 ratio.
Verifiable Proof of Reserve and Decentralized Issuance of Fiat Stablecoins is a viable path, but it has not been widely adopted.
Verifiable proofs of reserves would improve auditability and is currently achievable through zkTLS (zero-knowledge transport layer security, also known as network proofs) and similar means, although it still relies on a trusted centralized authority.
Decentralized issuance of fiat-backed stablecoins may be feasible, but there are a lot of 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 similar risk profile 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 product of on-chain lending protocols, which mimic the way banks create new money through credit. Decentralized over-collateralized lending protocols like Sky Protocol (formerly MakerDAO) issue new stablecoins that are backed by extremely liquid on-chain collateral.
To understand how this works, think of a checking account. The money in it is part of the process of creating new money, through a complex system of lending, supervision, and risk management.
In fact, most of the money in circulation, the so-called M2 money supply, is created by banks through credit. Banks create money using mortgages, auto loans, business loans, inventory financing, etc. Similarly, 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 called fractional reserve banking, and it really began with the Federal Reserve Act of 1913. It has matured since then, with major updates in 1933 (creation of the FDIC), 1971 (President Nixon ended the gold standard), and 2020 (the reduction of reserve requirements to zero).
With each change, consumers and regulators have grown more 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 1929 and 2008, banks and regulators have steadily improved their practices and processes to reduce risk. Over the past 110 years, credit has accounted for an increasing share of the U.S. money supply and now accounts for the vast majority.
Traditional financial institutions use three methods to safely issue loans:
1. Targeting assets with liquid markets and fast liquidation practices (margin lending);
2. Conduct large-scale statistical analysis of a group of loans (mortgages);
3. Provide thoughtful and tailor-made underwriting services (commercial loans).
On-chain decentralized lending protocols still only account for 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 well-known collateralized lending protocol, Sky Protocol (formerly MakerDAO), issues asset-backed stablecoins for the following assets: on-chain, exogenous, low volatility, and highly liquid (easy to sell). Sky Protocol also has strict rules on collateralization ratios and effective governance and liquidation protocols. These properties ensure that collateral can be safely sold even if market conditions change, thereby protecting the redemption value of asset-backed stablecoins.
Users can evaluate mortgage agreements based on four criteria:
1. Transparency in governance;
2. The proportion, quality and volatility of the assets backing the stablecoin;
3. Security of smart contracts;
4. Ability to maintain loan-to-value ratio in real time.
Like funds in a current account, asset-backed stablecoins are new funds created through asset-backed loans, but their lending practices are more transparent, auditable, and easy to understand. Users can audit the collateral of asset-backed stablecoins, which is different from the traditional banking system where they can only entrust their deposits to bank executives for investment decisions.
Furthermore, the decentralization and transparency enabled by blockchains can mitigate the risks that securities laws are designed to address. This is important for stablecoins because it means that truly decentralized asset-backed stablecoins may be outside the scope of securities laws - an analysis that 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 by autonomous protocols rather than centralized intermediaries.
As more economic activity is 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 account for a larger share of on-chain money. Other types of loans may eventually be safely issued on-chain to further expand the on-chain money supply.
Just as it took time for traditional bank credit to grow, regulators to reduce reserve requirements, and for the practice of credit to mature, it will take time for on-chain lending protocols to mature. It stands to reason that we will see more people transacting with asset-backed stablecoins as easily as fiat-backed stablecoins in the near future.
3.3 Strategy Supported Synthetic Dollar
Recently, some projects have launched tokens with a par value of $1 that represent a combination of collateral and an investment strategy. These tokens are often conflated with stablecoins, but synthetic dollars backed by strategies should not be considered stablecoins. Here are the reasons:
Strategy-backed synthetic dollars (SBSD) expose users to direct trading risk of active asset management. They are typically centralized, undercollateralized tokens with financial derivative attributes. More precisely, SBSDs are dollar shares in open-ended hedge funds - a structure that is both difficult to audit and can expose users to centralized exchange (CEX) risks and asset price volatility, for example, if there is a major market move or sentiment continues to decline.
These properties make SBSDs unsuitable for use as a reliable store of value or medium of exchange, which are the primary uses of stablecoins. While SBSDs can be constructed in a variety of ways, with varying levels of risk and stability, they all offer a dollar-denominated financial product that one might want to include in their portfolio.
SBSD can be built on top of a variety of strategies - for example, basis trading or participating in yield-generating protocols such as the Restaking protocol that helps secure active validation services (AVSs). These projects manage risk and reward, often allowing users to earn yield on top of their cash positions. By managing risk with yield, including evaluating AVSs to reduce risk, looking for higher yield opportunities, or monitoring basis trade inversions, projects can generate a yield-generating strategy to back synthetic dollars (SBSD).
Before using any SBSD, users should thoroughly understand its risks and mechanisms (as with any new tool). DeFi users should also consider the consequences of using SBSDs in DeFi strategies, as decoupling can have serious ripple effects. Derivatives that rely on price stability and stable returns can suddenly become unstable when assets decouple or suddenly depreciate relative to their tracking assets. However, when strategies contain centralized, closed-source, or unauditable components, it may be difficult or impossible to underwrite the risks of any given strategy.
While we do see banks implementing simple strategies on deposits that are actively managed, this represents a small portion of overall capital allocation. It is difficult to use these strategies at scale to support the overall stablecoin because they must be actively managed, which makes them difficult to reliably decentralize or audit. SBSDs expose users to greater risk than bank deposits. Users have reason to be skeptical if their deposits are held in such an instrument.
In fact, users have been wary of SBSDs. Despite their popularity among users with higher risk appetite, few users trade with them. In addition, the SEC has taken enforcement actions against those who issue “stablecoins” that function like shares in investment funds.
4. Final
The era of stablecoins has arrived. There are over $160 billion in stablecoins traded around the world. They fall into two broad categories: fiat-backed stablecoins and asset-backed stablecoins. Other dollar-denominated tokens, such as strategy-backed synthetic dollars, have grown in awareness but do not meet the definition of a stablecoin as a store of value and medium of exchange.
Banking history is a good indicator for understanding the stablecoin asset class — stablecoins must first coalesce around a clear, understandable, and easily redeemable form of money, similar to how Federal Reserve notes won popular recognition in the 19th and early 20th centuries.
Over time, we should expect the number of asset-backed stablecoins issued by decentralized overcollateralized lending protocols to increase, just as banks increase the M2 money supply through deposit credit. Ultimately, we should expect DeFi to continue to grow, both creating more SBSD for investors and increasing the quality and quantity of asset-backed stablecoins.
While this analysis may be useful, we should focus on the current situation. Stablecoins are already the cheapest way to send remittances, which means that stablecoins have a real opportunity to reshape the payments industry, creating opportunities for incumbents and, more importantly, for startups to build on a new frictionless and cost-free payment platform.
