The Stablecoin Situation
Stablecoins play a vital role in the adoption and growth of the cryptocurrency ecosystem, with a market capitalisation of over $200bn and a daily trading volume of over $120bn.
While stablecoins play an essential role in the ecosystem’s development, I believe that they will disappear entirely as the long-term vision of a decentralised world takes form.
What is a stablecoin?
Relative to the complexity of the cryptocurrency ecosystem, the concept of a stablecoin is quite straightforward.
A stablecoin is a cryptocurrency pegged to the value of a fiat currency or another reserve asset. For example, 1 USDC stablecoin will always be worth 1 USD.
The largest stablecoins by market capitalisation are Tether (USDT), USD Coin (USDC), Binance USD (BUSD), Terra USD (UST) and Dai (DAI), each pegged to the US Dollar. There are other types of stablecoins, such as crypto-collateralised and algorithmic stablecoins, but we’ll stick to fiat-backed stablecoins today.
In order to maintain their pegged value, stablecoins are collateralized. The stablecoin provider maintains a fiat currency reserve of US Dollars and claims that each issued cryptocurrency token is backed by an equal amount of US Dollars. Users of the stablecoins then have faith that the reserves are maintained and audited by independent custodians to ensure compliance.
The role of stablecoins
Stablecoins have a few important functions in the current crypto market:
- Reducing trading friction
- Crypto onboarding
- Providing liquidity for borrowers
1/ Reducing trading friction
As Naval Ravikant said on his recent podcast with Tim Ferriss, ‘cryptocurrencies do best when everything is on the blockchain, when everything’s electronic and digital and controlled by computers in the cloud’.
Stablecoins are digital money, functionally the same as looking at your money in an online banking application. Instead of your bank account in AUD representing collateral AUD held by Westpac, my USDC (hopefully) represents collateral USD held by Circle, the stablecoin issuer.
Since stablecoins exist as cryptocurrencies on various blockchains, they can easily be traded with other cryptocurrencies. Rather than (1) transferring AUD into an online exchange, (2) converting it into a stablecoin, and (3) converting it into another cryptocurrency like Bitcoin, I can simply park my money in stablecoin and trade in and out of other cryptocurrencies at a moment’s notice.
Stablecoins make it easier to trade cryptocurrencies, and keeps all financial activities on-chain.
2/ Crypto onboarding
Getting started with cryptocurrencies is still extremely difficult. You have to understand how wallets work and the differences between browser wallets, hardware wallets, custodial models vs non-custodial models, private keys, and that’s before you’ve even begun to understand the differences between cryptocurrencies.
Stablecoins are a relatively simple product to understand. Your $1 in the real world is worth $1 in crypto land. This makes it easier for people to get started in cryptocurrencies and learn the process of moving funds between the fiat and crypto universes.
Although you still need to set up a wallet and KYC on an exchange, it’s easy to understand and access.
3/ Providing liquidity for borrowers
Stablecoins are currently paying out interests rates upwards of 8–9% while interest rates in standard interest-bearing accounts at a bank are virtually at 0%. Screams ponzi scheme. But it’s not. In fact, it’s exactly the same model that the banks employ.
Let’s take a look at a simplified model for retail banks. In traditional finance (TradFi), banks take deposits from everyday people. As a reward for depositing the money, they pay interest, which at current rates is close to 0%. Banks then use the money you deposit to make loans, for example to people looking to buy a house. They charge those people a higher rate of interest, e.g. 3%, and then pocket the difference as profit. Straightforward. Makes sense.
Cryptocurrency deposit-taking institutions, such as BlockFi and Celcius, operate with a similar model. You deposit your crypto (which may or may not be locked up for a period of time), you receive interest. They then lend the cryptocurrencies out to borrowers, charge interest, and pocket the difference.
The difference is that liquidity in cryptocurrencies is extremely valuable. Borrowers are willing to pay extremely high rates of interest (think 15–20%) to borrow cryptocurrencies. Especially stable cryptocurrencies like stablecoins. This allows these companies to pay out extremely high interest rates while retaining their profit margins. Everyone wins.
Further, these institutions are willing to pay out 80% of the interest they receive from borrowers (e.g. if Celcius charges 10% to somebody looking to borrow a cryptocurrency, they pay out 8% in their interest-bearing deposit accounts). This is a considerably larger payout ratio than traditional institutions.
Here is a look at the current reward rates:
Why earn 0% on your money when you can earn 10%?
Make no mistake, these yields will decrease over time as the market matures, but for now, it’s a great incentive to get involved.
Unfortunately, there’s no such thing as a free lunch. Crypto ‘banks’ can afford to pay high interest rates because the industry is still in its infancy. Naval highlighted a few of these risks in this tweet
Crypto-backed stablecoins are linked to the value of other cryptocurrencies, which can be very volatile. ‘Blowup’ risk is the risk that the collateral cryptocurrency blows up in price, which breaks the stablecoin peg. This is less of a concern for fiat-backed cryptocurrencies because fiat currencies aren’t particularly volatile.
The industry is still mostly unregulated. There is a very real possibility that the US government cracks down on all privately-issued stablecoins. If you hold your stablecoins on a centralised exchange like Coinbase or Binance, you’re basically just holding US Dollars. The government can simply say to the exchange ‘hey we don’t like this person, turn off their accounts and seize their holdings’.
Alternatively, you park your stablecoins in BlockFi or Celcius, and the government decides, ‘we don’t like this business model, we’re shutting them down’. Maybe you get your stablecoins back, maybe you don’t. You’re definitely not getting 10% interest anymore, that’s for sure.
At the start, I noted that each stablecoin is hopefully backed by a US Dollar, held in the reserve of the stablecoin issuer. Since the industry is not as strictly regulated as the banking sector, there are no strict capital ratio requirements or official audits. Tether, for example, has faced considerable scrutiny from regulators and the community. For years, a group of online critics have continuously berated Tether, claiming that the Tether stablecoin is not actually backed by an equal amount of USD, but rather a plethora of high-risk short-term instruments based in China. Officials at Tether have continued to skirt around the issue, claiming that audits are in progress and more detailed accounting is on the way.
At the end of the day, you’re exposed to the possibility that the stablecoin provider is fraudulent, and the stablecoin could go to zero.
A longer-term look
The Future for Stablecoins
So stablecoins play an important role in the ecosystem, but they also have some risks. However, I hope it’s also evident that fiat-collateralised stablecoins rely on a centralised finance system in which the US Dollar reigns supreme.
Despite lofty visions of a cryptocurrency world where fiat currencies become extinct, a key value proposition of stablecoins is that they aren’t exposed to the same risks and volatility as other cryptocurrencies.
Fiat-collateralised stablecoins simply cannot exist in a world where cryptocurrencies are the main medium of exchange and store of value. If the dollar is truly going to become defunct, there doesn’t seem to be much value in a cryptocurrency pegged to a worthless asset.
It doesn’t really make sense to me that people think stable coins are a solution to the volatility of traditional cryptocurrencies, like Bitcoin and Ethereum. Fiat-pegged stablecoins as simply cryptographic representations of Fiat currency, and are therefore exposed to the same inflationary pressures we’re currently experiencing. These stablecoins won’t be the transaction currency of the future.
Crypto-maximalists believe in a fully decentralised future where goods and services are exchanged for cryptocurrencies rather than fiat currency. For the vision of crypto maximalist to pan out, fiat currencies will need to be phased out.
The Future for Stablecoin Providers
It will be interesting to see how large stablecoin issuers will adapt and overcome this transition. I have a few thoughts on this:
1/ My best guess is that companies like BlockFi and Celcius will establish their own blockchains and cryptocurrencies. Celcius, for example, has a CEL token, which they offer to clients as an alternative interest payment currency. With large crypto-native user bases, this seems like the logical shift.
For anybody who already has a crypto interest account with one of these providers, it might be worth receiving your 10% stablecoin interest payments in a decentralised cryptocurrency.
2/ As crypto markets mature and price discovery continues to take place, certain cryptocurrencies are likely to stabilise as mediums of exchange. Fiat-backed stablecoins will be replaced by crypto-backed stablecoins, and existing providers will shift their focus to fully-fledged crypto-collateralised stablecoins i.e. a stablecoin pegged to the value of BTC.
In fact, crypto-backed stablecoins may be necessary to allow for day-to-day transactions to occur. Bitcoin is currently at around $56k, which isn’t very helpful if I want to pay for an $8 beer at the pub. I anticipate that we will see stablecoins pegged to, for example, 1/100,000 BTC. Therefore, if BTC is at $100k, the stablecoin reflect $1. Furthermore, it is perfectly practical for this type of stablecoin to be fully decentralised because the peg is mathematically based.
Stablecoins are an ecosystem accelerator. Companies like Celcius and BlockFi are helping to fund new and exciting crypto projects by providing liquidity to the market as a whole and onboarding crypto newbies into the ecosystem. For as long as it lasts, that function is extremely valuable to all participants in the crypto market.