A simple and naive definition of Stablecoins is defined as cryptocurrencies whose value is pegged to an asset such as the US Dollar. However, stablecoins are much more complex than meets the eye. I would argue that stablecoins are much more than cryptocurrencies, these special-purpose tokens are more akin to NeoBanks.
Not All Stablecoins are the Same
First of all, not all stablecoins are the same. In fact not all stablecoins are even decentralized. For example, the stablecoin Tether is controlled by a centralized cryptocurrency exchange named Bitfinex. The $80Bn market cap Tether token (USDT) is supposedly backed 1:1 with a U.S. Dollars and other assets, although many, including myself, are skeptical of these claims. On the other side of the stablecoin spectrum, there is another type of stablecoin that is native to the blockchain, as a result these types of tokens are decentralized. Native blockchain stablecoins come in two flavors:
- cryptocurrency-backed stablecoins
- Algorithmic stablecoins
One of Ethereum blockchain’s largest DeFi dapp, the Maker Protocol has a stablecoin called Dai which is an example of a cryptocurrency-back stablecoin. The Dai stablecoin is created by a user who deposits approved cryptocurrencies into a smart contract called a vault, on the Ethereum blockchain.
Conversely, algorithmic stablecoins are not backed by any assets. Algorithmic stablecoins are the alchemy of financial engineering. A prime example of an algorithmic stablecoin would be UST which was in the headlines for its incredible fall back in the beginning of May. Algorithmic stablecoins use sophisticated math and algorithms to maintain a peg with an asset (usually USD) based on supply and demand for that asset.
Banks and Money
A bank is a financial institution that have two major functions:
- Receive deposits
- Lend (create) Money
Banks are in the business of pooling money by receiving deposits. Banks market and compete for customers by marketing and providing financial services. However, the primary service a bank provides their customer is the creation of money via loans and credit cards. Many people may be surprised to learn that banks create and conversely destroy money. In fact, banks create most of the money in our economy today.
To get a better understanding of how money works one must grasp that there are various forms of money. The US monetary system has a spectrum of money. From a technical perspective money in the United States is categorized into buckets M0-3.
The electronic deposits that sit in our bank account or credit cards are classified as M2. There is nothing special about these bits on the computer screen other than one small detail, those bits on the screen are backed by the full faith in credit of the United States government. So when you borrow $500,000 from the bank to buy a house and the bank credits your account, the bank just created money. For completeness, when you pay off the loan, the balance on the screen is deleted, hence the money has been destroyed. If you would like to learn more about how money works, read this online resource from the Bank of England.
Stablecoins are DeFi NeoBanks
Just like a bank, stablecoins take deposits. The business model for many of these stablecoins are to entice customers to create deposits often by providing yield incentives. The yield generation portion of the model is one of the ways that stablecoins create money! This in fact expands the money supply that is beyond direct control of the Fed Reserve but that is a topic for another post.
To be clear, an entity that only creates accounts i.e. deposits does not make it a bank. The entity must also create and destroy money. The yield generated by some stablecoins by staking in a smart contract is an example of money creation and the burning of tokens is the destruction of the stablecoin. There is another important utility of stablecoins; leverage. For example, users of MakerDao can seamlessly use the Dai stablecoin to take leverage trading positions on a number of DeFi DEXes such as 1inch, Curve or Uniswap amongst others.
Regulation the Inescapable Reality
As a financier it is important that I approach investment with as much pragmatism as possible, focusing on keeping a clear eye. There is no question that stablecoin is a modern innovation that is disrupting banking. However stablecoins are banks and many are fractional reserve banks which poses additional layers of risk for users. Unfortunately, many people are not aware of the risk of these complex financial systems, as seen with the investors and holders of LUNA and UST. The fractional reserve banking system is a type of banking system where only a fraction of the bank deposits are backed by actual cash or cash like assets on hand. This type of system was designed in part to help expand the monetary system by freeing up capital for lending or the creation of money, as a result expanding productivity and value.
In essence banks are the lifeblood of a country’s economy. That is why governments heavily regulate the banking industry so that they have mechanisms to control the money supply which is a critical lever of any government, especially for the United States of America. Regulation is coming to crypto and it is coming fast. That is why stablecoin players such as Circle have embraced regulation. Circle has indicated that they are going to submit an application to regulators for a bank license. Circle along with a consortium of other companies control USDC as a centralized stablecoin. USDC is Tether’s largest and most fierce competitor.
To that end, because Tether is such a critical component to the DeFi space, it would behoove DeFi participants to keep a close eye on Tether as it defends itself on multiple fronts. Currently, Tether is in a legal battle with crypto news publication Coindesk about getting access to sealed records of Tether’s balance sheet by the NYAG under the Freedom of Information Act. Tether is also trying to fend off stiff competition from the second largest stablecoin USDC. Lastly, regulators around the world are circling (no pun) Tether as they pose a threat to the Global financial order. The importance of Tether in the DeFi ecosystem can not be understated. If market confidence for Tether suddenly falls and the token violently loses its peg unexpectedly just as UST did, it could cause extreme calamity and destruction in the DeFi ecosystem. Unlike UST which has proven so far to be a contained event, a collapse in Tether poses an existential risk to DeFi and the crypto industry as a whole.
