Stablecoins: Is there hope?

Arhat

0x1dE1

August 23rd, 2023

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This research was originally posted on May 23, 2022.

This research aims to answer one question that has bugged me:

Does the significant fall in crypto prices and the possibility of de-pegging of stablecoins pose a more systemic risk for broader financial markets?

Executive Summary
Instability in the Stablecoin Universe
What are Stablecoins?
What are Stablecoins, EXACTLY NOT?
Stablecoins: Categorized
Stablecoin Mint & Burn Transaction Process
Stablecoin Market Players’ Revenue Models
Deep Dive on UST
Regulate Stablecoins Like Banks?
What Caught my Eye?
Final Thoughts and Where to Look Next?
What does it mean for the crypto-financial ecosystem?

Executive Summary

Instability in the Stablecoin Universe: We have been busy with the global macroeconomic conditions, but it still hasn’t shifted our focus from crypto and other digital assets. This has been the most active period for crypto retail investors since the crypto winter of 2017. Last week, Algorithmic Stablecoin, Terra (UST), lost its peg against the $1. This was one of the consequences of the falling prices of cryptocurrencies. While most stablecoins are backed by stable liquid assets such as the dollar, UST’s $1 peg was supported by its own native cryptocurrency, LUNA, which algorithmically incentivizes arbitragers to increase or decrease the supply of the token for a profit while also pushing UST closer to its peg.

Even as the broader cryptocurrency market has been under pressure recently, the market cap of stablecoins has continued to stabilize the liquidity & tension in the market, reinforcing the notion that stablecoins are, in fact, the cash of the crypto ecosystem. I have always had a contrarian view, especially on algorithmic stablecoins, ever since the shutdown of Basis stablecoin in 2018. My underlying reason was that long as yields are high, people will be willing to take the risk, but eventually, there will be a point where yields will go low enough that investors will stop taking the risk and (hopefully) hit an equilibrium. The fear, in my view, was that algorithmic stablecoins are not as safe as one backed by the dollar (i.e., USDC) and have added runoff risk.

Stablecoins backed by other cryptocurrencies needs stablecoin issuers to quickly adjust supply and demand if the cryptos supporting them face a period of weakness. Retail investors will do that if they expect to make a return and trust the coin’s issuer and system. Crypto backed by another crypto increases risk.

What are Stablecoins? Stablecoins are digital assets that offer price stability by pegging their market value to an external asset. The idea of stablecoins grew out of the need to trade efficiently in and out of native cryptocurrencies such as Bitcoin. Most stablecoins use USD as their benchmark asset.

So, What are Stablecoins, EXACTLY NOT? My contrarian view objects to certain expectations of Stablecoins. Stablecoins are supposed to function as another currency. But, in my opinion, Stablecoins do not fit the proper definition of a currency because 1) there are a lot of stablecoins backed by different types of collateral, 2) these collaterals are not necessarily stable assets, and 3) bank deposits earn yield directly while stablecoins earn a yield if the holders deposit the coins for lending in a marketplace.

To reasonably comprehend this, let’s categorize stablecoins into two different classes; 1) Collateralized Stablecoins: which derive their stability from an underlying asset, further classified into fiat-backed, commodity-backed, and crypto-backed, and 2) Algorithmic Stablecoins: achieve specific crypto-asset-monetary targets by adjusting the supply of tokens to match demand.

Stablecoins may be public or private, but from an organizational perspective, stablecoin networks usually each have an issuer and several third parties (exchanges, wallets, etc.), which support the overall adoption and usage of the network.

Further down the report, I try and visualize the underlying transaction process of a mint and burn on a stablecoin network.

Stablecoin Market Players Revenue Model: I further map out various revenue model possibilities for main stablecoin participants: Banks, Exchanges, Stablecoin issuers & Wallets. I believe stablecoin development and adoption for use in commerce is perhaps the most significant revenue opportunity for the industry. I expect stablecoin issuers to develop a revenue model similar to the current interchange/merchant discount model.

What happened to Terra was good for the community: I further dive deep into the Terra Luna controversy. It took Terra four years to build the community and just a week to lose all its credibility. In short, UST was, in essence, backed by its own token, which had no underlying reserves. At its core, this “stablecoin” was based on trust rather than underlying collateral. The UST de-pegging highlighted that when an algorithmic stablecoin loses the trust of its community and users no longer find value in the LUNA and UST tokens underpinning the Terra ecosystem, the entire mechanism falls apart. While UST-LUNA has brought FUD to stablecoins overall, let me stipulate that not all stablecoins are made the same, and UST is not representative of the rest of the stablecoins industry.

Should we regulate stablecoins like banks? Stablecoins present significant run risks and financial stability risks to the degree they spill over to other parts of the financial markets. Furthermore, there are payment risks, custodial risks, money laundering risks, etc., that could arise and that are beyond the scope of this research and my experience. Now, regulating stablecoins has implications for the financial markets and the comprehensive banking system. I believe regulating stablecoins could decentralize or disintermediate the traditional financial system as I dive deep. Isn’t that the whole point of blockchain and cryptocurrency—to eliminate intermediaries and decentralize strenuous activities?

Final Thoughts. We are maybe five to six years too early to assess the impact of stablecoins on the vast multiverse of crypto commerce. Perhaps the widespread adoption of stablecoins can hedge against volatile fluctuations in the market. I see three prominent use cases for stablecoin: 1) C2B payments, especially in Emerging Markets, 2) International remittances, and 3) International B2B payments.

Where to Look Next? My skepticism around algorithmic stablecoins persists. The market should look at the quality and liquidity of the assets that back the stablecoin to assess the probability of the stablecoin returning to its pegged value.

So to answer the question, I first asked myself: Does the significant fall in crypto prices and the possibility of de-pegging of stablecoins pose a more systemic risk for broader financial markets? I believe that the systemic risk is limited due to the limited interaction between stablecoins and the broader banking system and is more dependent on the regulatory environment that is set for the long term.

What does it mean for the crypto-financial ecosystem? A critical impact of greater oversight would presumably be more straightforward access to the domestic and commercial banking system. The most likely result would be a new entrant to the already crowded market for short-term investments—a new entrant that is modest in size for now but with the documented potential to grow rapidly.

Instability in the Stablecoin Universe

The world has been a little busy with the rising interest rates, inflation, geopolitical tensions in Eastern Europe, and the fall of TerraLuna. Still, it hasn’t stopped the world from shifting its focus from cryptocurrencies & other digital assets. Arguably, this has been the most active period, where the crypto collective has come together to hodl during this crypto winter of 2022 since the crypto winter of 2017.

To all those who are wondering what happened with Terra, here’s a short overview:

The biggest loser among all cryptos is Terra Luna (LUNA) which has crashed ~100% from its all-time peak of $118 in April 2022. And the reason behind this is the ‘de-pegging’ of TerraUSD (UST) stablecoin.

The Terra ecosystem had adopted UST as a stablecoin, leading to the interlinking of LUNA and UST. A stablecoin is linked to an underlying asset, such as a precious metal like gold or the USD. UST recently ‘de-pegged’ to $0.45 from its value of $1, marking a drop of about 55%. Since both UST and LUNA are interlinked, the massive decline in UST value has resulted in LUNA's overall drop.

UST maintains its $1 peg by algorithmically incentivizing arbitragers to increase or decrease the supply of the token for a profit while also pushing UST closer to its peg.

For the arbitrage mechanism to properly function, there needs to be sufficient liquidity for arbitragers to perform transactions. This week, there proved to be insufficient liquidity to maintain the peg, as billions of dollars attempted to exit UST, and the incentives mechanism can only support an estimated $300m in volume per day.

This fall in UST price also led to additional minting of Luna. Billions of tokens were added to the supply every minute before the blockchain was halted. As the price drop shows, this vastly increased supply added selling pressure on LUNA tokens. Currently, there are ~6.87T LUNA tokens and ~11.28B UST.

But, I have always had a contrarian view, especially on algorithmic stablecoins, ever since the shutdown of Basis stablecoin in 2018. Specifically, stablecoin project Basis (BAC), which raised $133M back in 2018 from venture capital firms like a16z and Alphabet’s GV, failed as a project on concerns that regulators would view the tokens as securities and impose federal securities laws and regulations. Interestingly, and as reported by CoinDesk, the CEO of Terra and creator of Terraform Labs, Do Kwon, was one of the pseudonymous co-founders behind the project.

My underlying reason for a contrarian view on algorithmic stablecoins was that long as yields are high, people will be willing to take the risk, but eventually, there will be a point where yields will go low enough that investors will stop taking the risk and (hopefully) hit an equilibrium. The fear, in my view, was that algorithmic stablecoins are not as safe as one backed by the dollar (i.e., USDC) and have added runoff risk.

Stablecoins backed by cryptocurrencies need stablecoin issuers to quickly adjust supply and demand if the cryptos supporting them face a period of weakness. Holders will do that if they expect to make a return and trust the coin’s issuer and system. Crypto backed by another crypto increases risk.

While Terra (UST) somewhat proved my contrarian view, I have realized that the existence of Stablecoins or simply the growing adoption of stablecoins has significant implications for retail investors and both banks and the broader money markets worldwide.

Why?

Stablecoins provide much-needed liquidity for the extended crypto ecosystem in a stricter regulatory environment worldwide.

Stablecoins need the market to trust the issuer and the system that backs them. They are cryptos that aim to keep a stable value versus the USD.

As asset-backed stablecoins paved the way for a dollar-pegged cryptocurrency, the extended crypto ecosystem has been attracted to higher returns of algorithmic stablecoins such as Terra. Now, stablecoins of all kinds have the potential to get more mainstream. UST proved it. Retail investors looked for incremental yield on a very complicated operational back-end.

And as stablecoins become more mainstream, they could fundamentally change the way households, businesses, and corporates bank, given their real-time nature and the ease of digital payments.

What are Stablecoins?

Stablecoins are digital assets that offer price stability by pegging their market value to an external asset (e.g., fiat currency, commodity, other stablecoins, cryptocurrencies, etc.). In so doing, stablecoins experiences minimal fluctuations in their price, unlike other cryptocurrencies prone to extreme volatility.

Typically, users convert their deposits into stablecoins in a 1:1 exchange and vice-versa. The ability of stablecoin issuers to engage in such an exchange relies on the reserve assets linked to the stablecoin. Currently, most stablecoins use USD as their benchmark asset, though a few are pegged to other fiat currencies and collateral.

The idea of stablecoins grew out of the need to trade efficiently in and out of native cryptocurrencies such as Bitcoin. Stablecoins are an attractive currency of choice as they can be used at any time of the day, anywhere in the world, without relying on traditional banks because:

many crypto exchanges initially didn’t have access to prevailing banking practices, and
crypto trading takes place 24/7

On top of this, stablecoins, and more broadly cryptocurrencies, have been repeatedly talked about as a form of digital payment, serving as an alternative to fiat currency or virtual payments in the exchange of cash for households and businesses. Using them as so would not only lower the costs of facilitating payments but also quicken the pace at which money is traded.

Visa, for example, has partnered with Crypto.com to accept USD Coin (USDC) to settle transactions on its payment network, thus providing a faster and easier way for online marketplaces to pay their merchants.

Given the numerous use cases of stablecoins, the growth potential for this market is enormous, especially considering the accumulation of the overall cryptocurrency market and the utility value stablecoins provide in various use case scenarios.

Stablecoins are also critical because they serve as the primary interaction point between the crypto-native and traditional financial systems through their reserve funds.

So, What are Stablecoins, EXACTLY NOT?

My contrarian view objects to certain expectations of Stablecoins.

Stablecoins are supposed to function as another currency.

A currency, by definition, must intrinsically provide

a store of value: it can be saved, retrieved, and exchanged in the future without depreciating in value.
be a medium of exchange: a financial instrument used to facilitate the sale, purchase, or trade of goods between parties

and perhaps most importantly,
be valued & redeemed at par: meaning when exchanged with other currencies or held at banks as deposits, they are swapped at equal value.

These attributes allow any currency to effectively exchange hands in an efficient financial system throughout any financial transaction. These are what enable bank deposits to be bank deposits.

In my view, Stablecoins do not fit the proper definition of a currency, especially right now.

First, many different types of stablecoin issuers and stablecoins exist, all backed by different types of collateral.
Second, these are not necessarily backed by stable assets.
Third, bank deposits earn yield directly, while stablecoins earn a yield if the holders deposit or stake the coins in a lending marketplace.

There are many differences between cash deposits and stablecoins. But most notably, as we have seen in the last week itself, my concern remains whether stablecoins can be redeemed at par—a defect that can reduce the efficacy of stablecoins as a medium of exchange and, in times of stress, can lead to depreciation of value.

To Reasonably Comprehend This, Let’s Categorize Stablecoins into Two Different Classes

Class I: Collaterized Stablecoins

A collateralized stablecoin derives its stability from an underlying asset. There are three subcategories of collateralized stablecoins:

FIAT-BACKED: These are the most widely used stablecoins, primarily because of their simplicity.

The fiat-backed stablecoin model has two parts:
1. In the issuance part, users buy a unit of stablecoin from the system by paying one unit of a fiat currency; this fiat is then stored on a custodial account.
2. In the redemption part, users liquidate their unit of stablecoin by selling it back to the system for a unit of fiat; the fiat comes from the custodial account.
Faults:
1. The biggest downside of fiat-backed stablecoins is the reliance on the custodial account. It doesn’t fully envision the idea of decentralization and less intermediary oversight.
2. Another flaw is that if the issuance and redemption processes happen too quickly, the system may run into logistical issues with its custodians. This implies that only large denominations of stablecoins are issued or redeemed from the more noteworthy stablecoin issuers.
Value Creation: Value flows in when collateral is exchanged for the stablecoin. When stablecoin users redeem their stablecoins for the underlying collateral asset, the value flows out. It’s pretty straightforward.

Revenue Model: Issuance and redemption fees; 1-3%.
COMMODITY-BACKED: stablecoins are pegged to an exchange-traded commodity such as gold.

The issuance and redemption model works the same way as in a fiat-backed stablecoin, albeit the collateral stored on a custodial account is a unit of the underlying commodity rather than a fiat currency. The upside of commodity-backed stablecoins is that they can sometimes be a better long-term store of value than fiat-backed ones.

Faults: commodity-backed stablecoins face the same issue as fiat-backed stablecoins - the reliance on a centralized custodial account. These stablecoins typically have even slower issuance and redemption processes due to the logistics of transporting commodities. Additionally, there are warehousing fees associated with the custody of the commodity, although this is offset by there is no inflation on commodities.

Value Creation: Value flows into the system when collateral is exchanged for the stablecoin. Value flows out of the system when a stablecoin user wants to redeem his stablecoin for the underlying collateral asset.

Revenue Model: issuance and/or redemption fees of the stablecoin and a warehousing fee dependent on the time the stablecoin was owned for.
CRYPTO-BACKED: crypto-backed stablecoins usually are pegged to a fiat currency; however, it uses other cryptocurrencies as collateral. Due to the highly volatile nature of cryptocurrencies, one cannot simply have a constant collateral ratio backing the crypto-backed stablecoin

Crypto-collateralized currencies attempt to solve the two issues fiat-backed cryptocurrencies face:
1. Reliance on a centralized custodial account, and
2. The slow issuance and redemption transaction speeds resulting from a fiat-backed stablecoin model featuring a decentralized issuance and redemption mechanism.
HOW DOES IT WORK?

A stablecoin is issued by depositing the crypto-collateral (usually ETH or BTC) into a smart contract called Collateralised Debt Position (CDP). The CDP then states the ratio of crypto-value to fiat-value.

For example, if a CDP was set to 500%, users will have to deposit $5 worth of Bitcoin into the system and get up to $1 of the stablecoin. When users want to retrieve their collateral, they pay the CDP smart contract in stablecoins plus any additional network fees.

The price stability of crypto-backed stablecoins is based on the incentive to create the stablecoin:

If the price falls, the CDP ratio increases, making it more expensive to create the stablecoin, thus lowering supply.

Conversely, if the price increases, the CDP ratio decreases, making it cheaper to create new stablecoins, thus increasing the supply and reducing the price of the stablecoin.

Faults:
1. Since cryptocurrencies are more volatile than the pegged fiat currency, the CDP ratio must be greater than 1. This makes the process very capital intensive.
2. Secondly, these coins are pegged to a fiat currency, but the collateral to back the peg is denominated in highly volatile cryptocurrency. There is a possibility that the price stability mechanism will not work fast enough in volatile cryptocurrency market movements, hence leading to a “run-off” risk situation.
3. To mitigate some of these flaws, it is sensible to have an emergency protocol that would allow a global liquidation at any particular point in time, so if there were a black swan event or negative implications of global economic conditions, all stablecoin owners would be paid out evenly.

MakerDAO minimum collateralization ratio

Value Creation: Value flows into the system when a new CDP smart contract is created by the system and sold to a user. In comparison, value flows out of the system when the user wants to liquidate his CDP smart contract, settling the contract by paying the stablecoin. Additionally, there is a network fee payable by anyone who withdraws a stablecoin from the smart contract. This fee is used to pay users for taking up risky CDP smart contracts.

Revenue Model: In the MakerDao ecosystem, the network fee is the stability fee, and it fluctuates between 0.5-2.5% per annum depending on the crypto market conditions.

Class II: Algorithmic Stablecoins

The algorithmic stablecoin is based on monetary policy and “game theory” to establish price stability. Monetary policy is a core function of central banks to control the money supply of fiat currencies.

The main idea behind Algorithmic Stablecoins is to achieve specific crypto-asset-monetary targets by adjusting the supply of tokens to match demand.

The idea behind a monetary policy is to increase the supply of money to cause inflation and hence depreciate the value of the fiat currency. Conversely, a decrease in the supply of money will lead to the appreciation of the value of the fiat currency.

Although there are many token economy models where algorithmic stablecoins can alter token supplied, there are no workable models available. To date, the only model that comes close to being implementable is seigniorage shares.

Seigniorage is the difference between the money value and the cost to produce it. If the seigniorage is positive, economic profit is realized.

There are three types of tokens in a typical seigniorage share stablecoin model: genesis tokens, stablecoins, and bond tokens.

Genesis tokens are complex securities that pay dividends in stablecoins whenever the price of the stablecoin is trading above the peg.

Genesis tokens are created at the initiation of the platform and are used as a fundraising vehicle for early investors. These tokens pay dividends in the form of a stablecoin whenever the stablecoin is trading higher than its peg. This should increase the supply of stablecoin, thus depreciating its value.
When the price of the stablecoin falls below its peg, the system will auction out bond tokens, which sell for less than one stablecoin; the system will pay bond token holders one stablecoin when the value of the stablecoin is back to its peg.
There is an expiry date on the bond, meaning that if the stablecoin doesn’t reach the peg before the bond tokens expire, the system will default on the debt.

Faults: The algorithmic stablecoin has been seen as a hedge against the crypto market and its ability to bear interest.

But, in December 2018, Basis, one of the most well-funded algorithmic stablecoin startups, confirmed shutting down due to regulatory pressures.

Furthermore, the price stability algorithm relies on issuing debt that matures when the stablecoin is traded at its peg. Therefore, when there are lots of bond tokens issued, there will be a price ceiling at the peg’s value, which will increase the supply of the stablecoin, thus putting downward price pressure on the stablecoin.

Speculators will want to take advantage of this price ceiling by immediately shorting the stablecoin at its peg, causing further downward price pressure and resulting in even more debt being issued.

Furthermore, once there is a significant movement below the peg, market players will en masse want to liquidate their stablecoins instead of purchasing bond tokens, which will lead to the failure of the stablecoin.

Sounds familiar? This is what happened with UST-Luna.

Value Creation: The first value flow commences during the ICO to raise the initial liquidity base, and the ICO investors get genesis tokens. Genesis tokens can be a weak hedge against the general cryptocurrency market. The reason for that is when the cryptocurrency market is bearish; there is an increase in demand for stablecoins, which results in the stablecoin trading above its peg. Base bonds are another complex security, essentially zero-coupon bonds without a fixed maturity date. The price of the base bond is correlated to the health of the stablecoin ecosystem. If a stablecoin ecosystem is “healthy”, the base bond price will be relatively higher than if the stablecoin ecosystem is “unhealthy”.

Below, I Visualize the Underlying Transaction Flow of a Mint/Burn on a Stablecoin Network.

Stablecoin issuance & redemption process diagram

The steps are as follows:

The user purchases a stablecoin from Crypto Exchange ‘A’ using USD fiat (using a bank, credit, or debit transfer) from their primary wallet.
Crypto Exchange ‘A’ as an authorized third-party to the stablecoin then receives fiat (usually USD) and transfers to the stablecoin issuer.
The stablecoin issuer then deposits USD fiat with its bank.
In exchange for USD fiat, the stablecoin issuer mints a stablecoin in the amount of the fiat transfer (this increases the total stablecoin in circulation).
Crypto Exchange ‘A’ then transfers the stablecoin to the primary wallet of the user.
While the user may continue to transact on Crypto Exchange ‘A’ frequently, secondary market transfers exist. The transfer from the stablecoin to another user does not involve the stablecoin issuer, nor would it involve a mint/burn activity – this is a secondary market transaction. In the event user then wanted to withdraw USD fiat on Crypto Exchange ‘B’, the user would transfer the stablecoin onto the exchange (effectively selling the stablecoin)
Crypto Exchange ‘B’ then transfers the stablecoin back to the stablecoin issuer.
The stablecoin issuer then withdraws fiat from its bank.
The fiat is then transferred to the Crypto Exchange ‘B’ in exchange for the stablecoins that are burned (this reduces the total stablecoins in circulation)
The fiat is transferred to the primary wallet of the user.

Please note that the visual above illustrates minting and burning – which are believed to be a primary market activity. Secondary market activities do not include the stablecoin issuer. An example of a secondary transaction would be the transfer of a stablecoin between two wallets (P2P) or most other transfers of stablecoins.

Stablecoin Market Players’ Revenue Models

Currently, stablecoin revenue is primarily derived from

Stablecoin issuers: per transaction on issuance & redemption,
Exchanges: through trading fees, and
Banks: transaction/subscription fees and interest earned on fiat reserve deposits.

Some use cases concerning the stablecoin universe

Over time, I believe stablecoin development and adoption for use in commerce is perhaps the most significant revenue opportunity for the industry. Ultimately, I expect that stablecoin issuers may develop a revenue model similar to the current interchange/merchant discount model (albeit to a lesser degree). Also, given their unique role at the center of the network, they can extract the most significant value over time.

Revenue Model Possibilities for Stablecoin Market Players

What happened with Terra is a good thing for the community.

The way we can be sure about algorithmic stablecoins impact or business models is by studying the outcomes.

It took Terra four years to build the community and just a week to lose all its credibility.

There are decades where nothing happens, and there are days where decades happen.

Over the past week, TerraUSD (UST), an algorithmic stablecoin (which was the third-largest stablecoin with ~$19B market cap just one week ago) native to the Terra blockchain, fell below its intended peg of $1 (to as low as $0.23 at one point) and brought into question the sustainability of the algorithmic stablecoin.

UST is a part of a class of stablecoins known as algorithmic stablecoins (explained above), which are not fully backed by reserves and instead rely on an algorithm (or code) on the blockchain replicating central bank policy to keep the stablecoin pegged to $1.

This contrasts with fiat-backed stablecoins such as Tether (USDT) and USD Coin (USDC), backed by reserves including cash, treasuries, and other assets.

For example, if an institution wants to mint 1M USDC, it can send $1M to the stablecoin issuer to mint the stablecoins. In this case, the stablecoin issuer may deposit this $1 million at a bank.

Instead, UST (which is not fully reserved) utilizes a unique mint-and-burn mechanism that involves its native governance token (LUNA) instead of fiat currency.

To mint one UST, investors could exchange $1 worth of LUNA, and to burn (or destroy) a UST, the user can exchange the UST for $1 worth of LUNA (note that Luna is the native cryptocurrency of the Terra Blockchain).

This means that UST was, in essence, backed by its own token, which had no underlying reserves. At its core, this “stablecoin” was based on trust rather than underlying collateral.

“UST stablecoins were based on trust rather than underlying collateral.”

It makes you wonder, don’t the fiat currencies work in the same way? We trust the government & central banks not to default. (definitely not thinking about Argentina, Greece, or Sri Lanka. Should we?)

Backing UST with LUNA worked for a while to maintain Terra’s stability to its $1 peg (whenever the price fell below its $1 peg, arbitrageurs would purchase the discounted UST and swap them for $1 worth of LUNA and profit from the difference).

However, as the values of UST and LUNA coins decline, so does the incentive for arbitrageurs to participate.

The UST de-pegging highlighted that when an algorithmic stablecoin loses the trust of its community and users no longer find value in the LUNA and UST tokens underpinning the Terra ecosystem, the entire mechanism falls apart.

While this has brought fear, uncertainty, and doubt (FUD) to stablecoins overall, let me stipulate that not all stablecoins are made the same, and UST is not representative of the rest of the stablecoins industry.

The Terra-Luna situation has made me realize that regulation to protect investors is now overdue. In fact, with the DeFi product (called Anchor) that was looking to attract retail investors into UST by offering a ~20% yield, investor protections are needed from a disclosure perspective as well as from an investment preservation perspective (meaning that the underlying assets are being correctly managed).

Now could this event tip the scale toward stablecoin issuers needing to have a bank charter? This would require more regulations.

How would that look?

Should We Regulate Stablecoins like banks?

Stablecoins present significant run risks and financial stability risks to the degree they spill over to other parts of the financial markets. Furthermore, there are payment risks, custodial risks, money laundering risks, etc., that could arise and that are beyond the scope of this research and my experience.

In fact, in my view, for a stablecoin to meet the promise to its investors (of eventually receiving $1 back for every $1 invested), it must be secured by low-risk and high-quality liquid assets (HQLA) as is the case with USDC.

Now, regulating stablecoins has implications for the financial markets and the comprehensive banking system.

If stablecoins were regulated like banks, there are broader structural implications to consider.

First, mandating stablecoins to hold HQLA could significantly increase the demand for safe and liquid assets. This means that the stablecoin issuers would have to hold a significant amount of t-bills, cash, and other highly liquid assets as collateral. This could lead to shortages in t-bills and other HQLA, crowding out other buyers and intensifying the supply-and-demand imbalance in the money markets.
Second, it could encourage a high turnover of deposits into stablecoins, disrupting the funding markets and the broader economy. Growing acceptance of stablecoins as a form of payment among corporations could encourage money to rotate out of deposits and into stablecoins. The events of the past few months have already shown us that stablecoins are the cash of crypto, as crypto investors fled to stablecoins in a flight-to-quality. What if the traditional banking system also ran to stablecoins in a stressed scenario. Furthermore, to earn interest on stablecoins, stablecoins can also serve as an attractive cash investment alternative.
Third, If regulated, stablecoin deposits would need to be insured. If stablecoins were to be insured, banking institutions would lose retail deposits to stablecoins. The reserve assets that back stablecoins would not support credit creation, and the blended growth of stablecoins could increase borrowing costs and impact credit availability in the real economy. Sounds familiar??
Finally, regulating stablecoins would influence monetary policies worldwide. For example, central banks worldwide would have to restructure their balance sheets, and the short-term rates on central bank bonds would be much more volatile.

These are further explained in detail here.

In short, regulating stablecoins could decentralize or disintermediate the traditional financial system.

Isn’t that the whole point of blockchain and cryptocurrency—to eliminate intermediaries and decentralize strenuous activities?

What Caught My Eye?

A fantastic blog by Liberty Street Economics mentions tokenizing bank deposits.

They support this idea for the same three reasons which oppose the idea of regulating stablecoins (as mentioned in the section above):

First, commercial banks hold deposits for customers fractionally backed by reserves, avoiding locking up liquidity. These bank deposits support bank lending to the real economy and monetary policy transmission.
Second, customers can exchange these deposits for goods or services using well-functioning existing payment infrastructures.
Third, bank deposits have several other attractive features. First, they are issued by regulated institutions and protected by deposit insurance (up to $250,000), making them extremely safe. In addition, banks facilitate compliance with policies meant to reduce the risk of criminal activities, such as money laundering.

It’s possible, and I mentioned in my web3 thesis why I believe Tokenization is the next step to building and developing both developed & developing nations.

History is witness that every developed (& developing) economy initially progressed through:

Urbanization (of communities), then

Globalization (through products & services)

and, now the trend is apparent,

Tokenization (of both tangible & intangible assets and stores of value, i.e, digital assets)

The figure below accurately describes how technology mass adoption works and, subsequently, how I view an economy over time progress.

Economy Growth Phenomenon

Final Thoughts & Where to Look Next?

We are maybe five to six years too early to assess the impact of stablecoins on the vast multiverse of crypto commerce. Perhaps the widespread adoption of stablecoins can hedge against volatile fluctuations in the market.

In the short term, in all, I see three prominent use cases for stablecoin:

C2B payments, especially in Emerging Markets: Dollar-dominated stablecoin industry would provide an excellent hedge against weakening currencies in emerging markets and allow holders to access an international array of services.
International remittances: No conversion fees for cross-border payments.
International B2B payments: Being able to transact anytime with anyone.

My skepticism around algorithmic stablecoins persists.

The market should look at the quality and liquidity of the assets that back the stablecoin to assess the probability of the stablecoin returning to its pegged value.

So the market will need to evaluate if:

the assets are liquid enough to sell and
the assets themselves will hold value.

Should any larger stablecoins be unable to remain stable, this would become a more considerable risk for the broader cryptocurrency market.

Where to look next?

The most speculative and leveraged areas of the crypto markets are the focus as:

Global interest rates rise and
Most governments worldwide have removed liquidity it injected before.

The over 30x in stablecoin market capitalization since early 2020 influenced the crypto pricing, too, as stablecoins provided much liquidity and leverage.

So to answer the question, I first asked myself:

Does the significant fall in crypto prices and the possibility of de-pegging of stablecoins pose a more systemic risk for broader financial markets?

I believe that the systemic risk is limited due to the limited interaction between stablecoins and the broader banking system and is more dependent on the regulatory environment that is set for the long term. However, it should be concerning that some retail and institutional investors who bought bitcoin close to the peak may now be facing huge losses (BTC is down almost 60%).

In the 2017 crypto winter, many ICOs lost 70- 95% of their value, and some don’t trade today. Over recent months, hundreds of new crypto assets were listed on exchanges every week– there are now over 10,000. However, the market focus is still on the top few, as crypto correlations with bitcoin remain high.

As many market participants are likely making losses now, there could be further forced liquidations.

What does it mean for the crypto-financial ecosystem?

The stablecoin market could likely survive the regulations and criticisms. A critical impact of greater oversight would presumably be more straightforward access to the domestic and commercial banking system. That presumes, however, that large banks would be willing to hold the substantial and likely growing non-operational deposits associated with reserve funds.

The most likely result would be a new entrant to the already crowded market for short-term investments—a new entrant that is modest in size for now but with the documented potential to grow rapidly.

Thank you for reading through. I’d really appreciate it if you shared this with your friends who would enjoy reading this.

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