It’s been a decade since Tether launched the first USD-backed, crypto-enabled digital currency. Since then, stablecoins have become one of the most widely adopted products in crypto, with a market cap of nearly $180 billion. Despite this remarkable growth, stablecoins continue to face significant challenges and limitations.

This post delves into the issues surrounding existing stablecoin models and tries to predict how we can end the civil war for money.

I. Stablecoins = Debt

Before diving in, let’s cover some basics to get a better understanding of what stablecoins represent.

When I started researching stablecoins a couple of years ago, I was confused about people describing them as debt instruments. It began to make more sense when I looked deeper into how money is created in our current financial system.

In a fiat monetary system, money is primarily created when commercial banks (hereafter simply referred to as “banks”) extend loans to their customers. But this doesn’t mean banks can create money out of thin air. Before money can be created, the bank must first receive something of value: your promise to repay the loan.

Assume you need financing to buy a new car. You approach your local bank for a loan and once approved, the bank will credit your account with a deposit matching the loan amount. This is when new money is created in the system.

When you transfer these funds to the car seller, the deposit may move to another bank if the seller banks elsewhere. However, the money stays within the banking system until you start repaying the loan. Money is created through lending and destroyed through repayment.

Figure 1: Money creation through making additional loans

Source: Money Creation in the Modern Economy (Bank of England)

Stablecoins operate in a somewhat similar fashion. They are created when an issuers grant a loan and destroyed through borrower’s repayment. Centralized issuers like Tether and Circle mint tokenized USD, which are essentially digital IOUs issued against USD deposits from the borrowers. DeFi protocols such as MakerDAO and Aave also mint stablecoins through loans, though in this case the issuance is backed by crypto collateral rather than fiat.

With their liabilities backed by varying forms of collateral, stablecoin issuers function as de facto crypto banks. Sebastien Derivaux (@SebVentures"">@SebVentures), the founding chef at Steakhouse Financial, further explores this analogy in his research “Cryptodollars and the Hierarchy of Money.”

Figure 2: Two-by-two matrix of cryptodollars

Source: Cryptodollars and the Hierarchy of Money (Sep 2024)

Sebastien classifies stablecoins using a 2x2 matrix based on the nature of their reserves (offchain assets like RWAs vs. onchain crypto assets) and whether the model is fully or fractionally reserved.

Here are a few notable examples:

• USDT: Primarily backed by offchain reserves. Tether’s model is fractionally reserved as each USDT is not 1:1 backed by cash or cash equivalents like short-term treasuries, but also includes other assets like commercial paper and corporate bonds.
• USDC: USDC is also backed by offchain reserves, but unlike USDT, it maintains full reserve status (1:1 backed by cash of cash equivalents). PYUSD, another popular fiat-backed stablecoin, also fits this category.
• DAI: DAI is issued by MakerDAO and backed by onchain reserves. DAI is fractionally reserved through its overcollateralized structure.

Figure 3: Simplified balance sheets of current cryptodollar issuers

Source: Cryptodollars and the Hierarchy of Money (Sep 2024)

Like traditional banks, these crypto banks aim to generate attractive returns for equity holders by taking on a measured level of balance sheet risk. Enough to be profitable, but not so much that it endangers the collateral and risks insolvency.

II. Issues with Existing Models

While stablecoins provide desirable features like lower transaction costs, faster settlement, and higher yields than the TradFi alternatives, existing models still face several issues.

(1) Fragmentation

According to RWA.xyz (@RWA_xyz"">@RWA_xyz), there are currently 28 active USD-pegged stablecoins.

Figure 4: Market share of existing stablecoins

Source: RWA.xyz

As Jeff Bezos famously said, “your margin is my opportunity”. While Tether and Circle continue to dominate the stablecoin market, recent years of high interest rates have spurred a wave of new entrants seeking to claim their share of these high margins.

The issue with having so many stablecoin options is that, while each represent tokenized USD, they are not interoperable. For instance, a user holding USDT cannot seamlessly use it with a merchant who only accepts USDC, even though both are pegged to the dollar. While users can swap USDT for USDC via centralized or decentralized exchanges, this adds unnecessary transaction friction.

This fragmented landscape resembles the pre-central bank era, when individual banks issued their own banknotes. In those times, the value of a bank’s notes fluctuated based on its perceived stability and could even become worthless if the issuing bank failed. The lack of standardization in value caused inefficiencies in the market and made cross-regional trade difficult and costly.

Central banks were established to address this issue. By requiring member banks to maintain reserve accounts, they ensured that bank-issued notes could be accepted at face value across the system. This standardization achieved what’s known as “singleness of money,” which allowed people to treat all banknotes and deposits as equivalent, regardless of the issuing bank’s creditworthiness.

But DeFi lacks a central bank to establish a monetary unity. Some projects, like M^0 (@m0foundation"">@m0foundation), are attempting to solve the interoperability problem by developing a decentralized cryptodollar issuance platform. I’m personally rooting for their ambitious vision, but the challenges are significant and their success is still a work in progress.

(2) Counterparty Risk

Imagine holding an account with J.P. Morgan (JPM). While the official currency of the U.S. is USD, the balance in the JPM account technically represents a type of banknote, which we can refer to as jpmUSD.

As mentioned earlier, jpmUSD is pegged to the USD at a 1:1 ratio through JPM’s agreement with the central bank. You can convert jpmUSD into physical cash or use it interchangeably with other bank’s notes, such as boaUSD or wellsfargoUSD at a 1:1 rate within the banking system.

Figure 5: An illustration of hierarchy of money

Source: #4 | A Taxonomy of Currency: from Coin to Stablecoin (Dirt Roads)

Just as we can stack different technologies to create a digital ecosystem, various of forms of money can be layered to build a monetary hierarchy. Both USD and jpmUSD serve as forms of money, but jpmUSD (or “bankcoin”) can be viewed as a layer over USD (the “coin”). Under this hierarchy, bankcoin relies on the trust and stability of the underlying coin, backed by formal agreements with the Federal Reserve and the U.S. government.

Fiat-backed stablecoins like USDT and USDC can be described as a new layer atop this hierarchy. They retain the fundamental qualities of both bankcoin and coin while adding benefits of blockchain networks and interoperability with DeFi applications. While they serve as enhanced payment rails layers on top of the existing monetary stack, they remain tethered (no pun intended) to the traditional banking system and bring counterparty risk.

Centralized stablecoin issuers typically invest their reserves in safe and liquid assets like cash and short-term U.S. government securities. While the credit risk is low, the counterparty risk is heightened because only a small portion of their bank deposits are insured by the FDIC.

Figure 6: Volatility in stablecoin prices during SVB collapse

Source: Stablecoins Versus Tokenized Deposits: Implications for the Singleness of Money (BIS)

For example, out of the ~$10 billion that Circle was holding in cash in regulated financial institutions in 2021, only a mere $1.75 million (or 0.02%) in aggregate was covered by FDIC deposit insurance.

When Silicon Valley Bank (SVB) went down, Circle was in danger of losing a majority of their deposits in the bank. Had the government not taken the extraordinary measures of guaranteeing all deposits, including those above the $250,000 FDIC insurance cap, USDC could have permanently de-pegged from the USD.

(3) Yields: A race to the bottom

The dominant narrative surrounding stablecoins this cycle has been the concept of returning yield to the users.

For both regulatory and financial reasons, centralized stablecoin issuers retain all profits generated from user deposits. This creates a disconnect between the parties actually driving value creation (users, DeFi applications, and market makers) and those capturing the upside (issuers).

The discrepancy has paved the way for new wave of stablecoin issuers that mint their coins using short-term treasures or tokenized versions of these assets, and redistribute the underlying yield back to users via smart contracts.

While a step in the right direction, this has prompted issuers to aggressively cut their fees to capture greater market share. And the intensity of this yield chicken game was evident when I reviewed the tokenized money market fund proposals for the Spark Tokenization Grand Prix, an initiative aimed at integrating $1 billion in tokenized financial assets as collateral for MakerDAO.

Ultimately, yields or fee structures can’t serve as a long-term differentiating factor because they will likely converge toward the lowest sustainable rate required to maintain operations. Issuers will need to explore alternative monetization strategies as value won’t accrue at stablecoin issuance.

III. Predicting the Unstable Future

Romance of the Three Kingdoms is a beloved classic in East Asian cultures, set in the tumultuous period at the end of the Han Dynasty when warlords struggled for control over China.

A key strategist in the story is Zhuge Liang, who famously proposed dividing China into three distinct regions, each controlled by one of the three warring factions. His “Three Kingdoms” strategy was designed to prevent any single kingdom from gaining dominance, thereby creating a balanced power structure that could restore stability and peace.

I’m no Zhuge Liang, but stablecoins may also benefit from a similar tripartite approach. The future landscape may be divided into three territories: (1) payments, (2) yield-bearing, and (3) middleware (everything in between).

• Payments: Stablecoins offer a seamless, low-cost way to settle transactions across borders. USDC currently leads this charge and its alignment with Coinbase and Base Layer 2 is likely to further strengthen its position. Rather than competing directly with Circle for payments, DeFi stablecoins should instead focus their efforts within DeFi ecosystems where they have a distinct advantage.
• Yield-bearing: RWA protocols issuing yield-bearing stablecoins should take notes from Ethena, which has cracked the code on generating high yet relatively sustainable yields through crypto-native and adjacent products. Whether by leveraging other delta-neutral strategies or creating synthetic credit structures that replicate TradFi swaps, there is room for growth in this segment as USDe faces a scalability ceiling.
• Middleware: For decentralized stablecoins that are not producing high yields, there is an opportunity to unify the fragmented liquidity. An interoperable solution will maximize DeFi’s capability to match lenders and borrowers more effectively and further streamline the DeFi ecosystem.

The future of stablecoins remain uncertain. But a balance power structure across these three segments could end the “civil war for money” and bring much needed stability to the ecosystem. Instead of playing 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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