Author: Will Awang, Web3 Small Law

Despite the fact that millions of people are currently using stablecoins and trading trillions of dollars in value, the definition of stablecoins and people's understanding of them remain vague.

Stablecoins are a means of storing value and a medium of exchange, typically (but not necessarily) pegged to the US dollar. Although stablecoins have only been in development for a short five years, the evolutionary paths of their two dimensions are very instructive: 1. from under-collateralization to over-collateralization, 2. from centralized to decentralized. This is beneficial for helping us understand the technical structure of stablecoins and dispelling market misconceptions about them.

As a payment innovation, stablecoins simplify the way value is transferred. They have created a market parallel to traditional financial infrastructure, with annual trading volumes even surpassing major payment networks.

History is a guide to understanding the rise and fall of things. If we want to understand the design limitations and scalability of stablecoins, a useful perspective is the history of the banking industry, to see what works, what doesn't, and the reasons behind it. Like many products in cryptocurrency, stablecoins may replicate the historical development of banking, starting with simple bank deposits and notes, and then achieving increasingly complex credit to expand the money supply.

Thus, this article will provide a perspective on the future of stablecoin development by compiling a16z partner Sam Broner's article "A Useful Framework for Understanding Stablecoins: Banking History," drawing lessons from the history of the US banking industry.

The article will first introduce the development of stablecoins in recent years, then compare it with the history of the US banking industry, in order to make effective comparisons between stablecoins and banking. In this process, the article will explore three recently emerged forms of stablecoins: fiat-backed stablecoins, asset-backed stablecoins, and strategy-backed synthetic dollars, to look ahead to the future.

Key Takeaways

Through compilation, I have been deeply inspired, and at its core, it cannot escape the three axes of banking monetary theory.

• Although the payment innovation of stablecoins seems to disrupt traditional finance, the most important thing is to understand: the essential attributes of money (measure of value) and its core functions (medium of exchange) remain unchanged. Therefore, stablecoins can be said to be carriers or manifestations of money.
• Since the essence is money, the development patterns of modern monetary history over the past few hundred years are highly instructive. This is also the merit of Sam Broner's article, as he not only sees the issuance of money but also the subsequent use of credit as a tool for money creation by banks. This directly guides stablecoins, which are still in the money issuance phase.
• If fiat-backed stablecoins are currently the choice of the masses in the money issuance phase, then asset-backed stablecoins will be the choice in the subsequent credit creation phase. My personal view is that as more and more illiquid RWA tokenized assets come on-chain, their mission is not to circulate but to be collateralized, serving as underlying assets for credit creation.
• Looking at strategy-backed synthetic dollars, due to the design of their technical structure, they will inevitably face regulatory challenges and user experience barriers. Currently, they are more applicable in DeFi yield products, struggling to break through the impossible triangle of traditional finance: yield, liquidity, and risk. However, we see that some recent yield-bearing stablecoins based on US Treasury bonds, or innovative models like PayFi, are breaking through these limitations. PayFi integrates DeFi into payments, transforming every dollar into smart, autonomous funds.
• Finally, it is essential to return to the essence: the birth of stablecoins, synthetic dollars, or specialized currencies aims to further highlight the essential attributes of money through digital currencies and blockchain technology, strengthen its core functions, enhance the efficiency of monetary operations, reduce operational costs, strictly control risks, and fully leverage the positive role of money in promoting value exchange and economic and social development applications.

1. The Development History of Stablecoins

Since Circle launched USDC in 2018, there has been enough evidence over the years to show which paths stablecoins can successfully take and which they cannot.

Early adopters of stablecoins used fiat-backed stablecoins for transfers and savings. While stablecoins generated by decentralized over-collateralized lending protocols are useful and reliable, actual demand has been lackluster. So far, users seem to strongly prefer dollar-pegged stablecoins over other (fiat or novel) denominations.

Certain categories of stablecoins have completely failed. For example, decentralized, low-collateral stablecoins like Luna-Terra appeared to be more capital efficient than fiat-backed or over-collateralized stablecoins, but ultimately ended in disaster. Other categories of stablecoins remain to be observed: while yield-bearing stablecoins are intuitively exciting, they face user experience and regulatory barriers.

With the current successful product-market fit of stablecoin adoption, other types of dollar-pegged tokens have also emerged. For example, strategy-backed synthetic dollars like Ethena represent a new product category that has not yet been fully defined. Although similar to stablecoins, they have not yet reached the safety standards and maturity required for fiat-backed stablecoins, and are currently more adopted by DeFi users, who take on higher risks for higher returns.

We have also witnessed the rapid adoption of fiat-backed stablecoins like Tether-USDT and Circle-USDC, which are attractive due to their simplicity and safety. The adoption of asset-backed stablecoins has lagged, as this asset class accounts for the largest share of deposit investments in the traditional banking system.

Analyzing stablecoins from the perspective of the traditional banking system helps explain these trends.

2. The History of the US Banking Industry: Bank Deposits and US Currency

To understand how current stablecoins mimic the development of the banking system, it is particularly helpful to understand the history of the US banking industry.

Before the Federal Reserve Act of 1913, especially before the National Bank Act of 1863-1864, different forms of currency had different risk levels, and thus different actual values.

The "actual" value of bank notes (cash), deposits, and checks could vary significantly, depending on three factors: the issuer, the ease of redemption, and the issuer's credibility. Especially before the establishment 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 is that? Because banks face (and still face) the contradiction between maintaining profitability from deposit investments and ensuring the safety of deposits. To achieve profitability from deposit investments, banks need to release loans and take on investment risks, but to ensure deposit safety, banks need to manage risks and hold positions.

It wasn't until the Federal Reserve Act of 1913 that, in most cases, one dollar = one dollar.

Today, banks use dollar deposits to purchase government bonds and stocks, issue loans, and engage in simple strategies like market making or hedging under the Volcker Rule. The Volcker Rule was introduced in the context of the 2008 financial crisis to limit banks' engagement in high-risk proprietary trading activities, reducing speculative activities in retail banking to lower bankruptcy risks.

While retail banking customers may think that all their money is in deposit accounts and very safe, the reality is different. Looking back at the 2023 collapse of Silicon Valley Bank due to a mismatch of funds leading to liquidity exhaustion serves as a bloody lesson for our market.

Banks earn profits by investing (lending) deposits to earn interest rate spreads, balancing profit-making and risk behind the scenes, while users mostly do not know how banks handle their deposits, even though in turbulent times, banks can generally guarantee the safety of deposits.

Credit is a particularly important part of banking operations and a way for banks to increase the money supply and economic capital efficiency. Although due to federal oversight, consumer protection, widespread adoption, and improved risk management, consumers can view deposits as a relatively low-risk unified balance.

Returning to stablecoins, they provide users with many experiences similar to bank deposits and notes—convenient and reliable value storage, medium of exchange, lending—but in a non-custodial "self-custody" form. Stablecoins will emulate their fiat currency predecessors, starting from simple bank deposits and notes, but as on-chain decentralized lending protocols mature, asset-backed stablecoins will become increasingly popular.

3. Evaluating Stablecoins from the Perspective of Bank Deposits

Based on this background, we can evaluate three types of stablecoins—fiat-backed stablecoins, asset-backed stablecoins, and strategy-backed synthetic dollars—from the perspective of retail banking.

3.1 Fiat-backed Stablecoins

Fiat-backed stablecoins are similar to US banknotes during the National Banking Era (1865-1913). During this period, banknotes were bearer instruments issued by banks; federal regulations required customers to be able to redeem them for an equivalent amount of dollars (e.g., special US Treasury bonds) or other fiat currencies ("coins"). Therefore, while the value of banknotes might vary based on the issuer's reputation, accessibility, and solvency, most people trusted banknotes.

Fiat-backed stablecoins follow the same principle. They are tokens that users can directly redeem for easily understood, trustworthy fiat currency—but there are similar warnings: while paper currency is a bearer instrument that anyone can redeem, holders may not live near the issuing bank, making redemption difficult. Over time, people accepted the fact that they could find someone to trade with and then redeem their paper currency for dollars or coins. Similarly, users of fiat-backed stablecoins are increasingly confident that they can reliably find high-quality stablecoin redeeming merchants using Uniswap, Coinbase, or other exchanges.

Today, a combination of regulatory pressure and user preferences seems to be attracting more and more users to fiat-backed stablecoins, which account for over 94% of the total supply of stablecoins. Circle and Tether dominate the issuance of fiat-backed stablecoins, having issued over $150 billion in dollar-dominated fiat-backed stablecoins.

But why should users trust the issuers of fiat-backed stablecoins?

After all, fiat-backed stablecoins are centrally issued, making it easy to imagine the risk of a "bank run" during stablecoin redemptions. To address these risks, fiat-backed stablecoins undergo audits by reputable accounting firms and obtain local licensing qualifications to meet compliance requirements. For example, Circle regularly undergoes audits by Deloitte. These audits aim to ensure that stablecoin issuers have sufficient fiat currency or short-term Treasury bill reserves to cover any short-term redemptions, and that the issuers have enough total fiat collateral to support the redemption of each stablecoin on a 1:1 basis.

Verifiable proof of reserves and decentralized issuance of fiat stablecoins is a feasible path, but it has not seen much adoption.

Verifiable proof of reserves would enhance auditability and can currently be achieved through zkTLS (Zero-Knowledge Transport Layer Security, also known as network proof) and similar methods, although it still relies on trusted centralized authorities.

Decentralized issuance of fiat-backed stablecoins may be feasible, but there are significant regulatory issues. For example, to issue decentralized fiat-backed stablecoins, issuers would need to hold on-chain US Treasury bonds that have a risk profile similar to traditional government bonds. This is not currently possible, but it would make it easier for users to trust fiat-backed stablecoins.

3.2 Asset-Backed Stablecoins

Asset-backed stablecoins are products of on-chain lending protocols that mimic how banks create new money through credit. Decentralized over-collateralized lending protocols like Sky Protocol (formerly MakerDAO) issue new stablecoins that are supported by highly liquid on-chain collateral.

To understand how this works, imagine a checking account where the funds in the account are part of the creation of new money, achieved through a complex system of lending, regulation, and risk management.

In fact, most of the money in circulation, known as the M2 money supply, is created by banks through credit. Banks create money using mortgages, auto loans, commercial loans, inventory financing, etc. Similarly, on-chain lending protocols use on-chain assets as collateral to create asset-backed stablecoins.

The system that allows credit to create new money is called fractional reserve banking, which originated with the Federal Reserve Act of 1913. Since then, fractional reserve banking has gradually matured and undergone significant updates in 1933 (the establishment of the Federal Deposit Insurance Corporation), 1971 (when President Nixon ended the gold standard), and 2020 (when the reserve requirement was reduced to zero).

With each reform, consumers and regulators have become increasingly confident in the system of creating new money through credit. First, bank deposits are protected by federal deposit insurance. Second, despite major crises like those in 1929 and 2008, banks and regulators have steadily improved their practices and processes to reduce risks. Over the past 110 years, the proportion of credit in the US money supply has grown significantly and now accounts for the vast majority.

Traditional financial institutions use three methods to safely issue loans:

1. Targeting assets with liquid markets and rapid settlement practices (margin loans);
2. Conducting large-scale statistical analysis on a group of loans (mortgages);
3. Providing thoughtful and tailored underwriting services (commercial loans).

On-chain decentralized lending protocols still account for only 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 protocol is transparent, well-tested, and conservative. For example, the most famous collateral lending protocol, Sky Protocol (formerly MakerDAO), issues asset-backed stablecoins against the following assets: on-chain, exogenous, low volatility, and high liquidity (easy to sell). Sky Protocol also has strict regulations regarding collateral ratios and effective governance and liquidation protocols. These attributes ensure that even if market conditions change, the collateral can be safely sold, thus protecting the redemption value of asset-backed stablecoins.

Users can evaluate collateral lending protocols based on four criteria:

1. Governance transparency;
2. The proportion, quality, and volatility of the assets supporting the stablecoin;
3. The security of the smart contracts;
4. The ability to maintain loan-to-collateral ratios in real-time.

Like the funds in a checking account, asset-backed stablecoins are new funds created through asset-backed loans, but their lending practices are more transparent, auditable, and easier to understand. Users can audit the collateral of asset-backed stablecoins, which distinguishes them from the traditional banking system where deposits are entrusted to bank executives for investment decisions.

Moreover, the decentralization and transparency enabled by blockchain can mitigate the risks that securities laws aim to address. This is important for stablecoins because it means that truly decentralized asset-backed stablecoins may fall outside the scope of securities laws—this analysis 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 through autonomous protocols rather than centralized intermediaries.

As more economic activities shift 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 currency. Other types of loans may eventually be safely issued on-chain to further expand the on-chain money supply.

Just as the growth of traditional bank credit, regulatory reductions in reserve requirements, and the maturation of credit practices take time, the maturation of on-chain lending protocols will also require time. We have reason to expect that in the near future, more people will use asset-backed stablecoins for transactions as easily as they use fiat-backed stablecoins.

3.3 Strategy-Backed Synthetic Dollars

Recently, some projects have launched tokens pegged at $1 that represent a combination of collateral and investment strategies. These tokens are often confused with stablecoins, but strategy-backed synthetic dollars should not be viewed as stablecoins. The reasons are as follows:

Strategy-backed synthetic dollars (SBSD) expose users directly to the trading risks of actively managed assets. They are typically centralized, under-collateralized tokens with attributes of financial derivatives. More accurately, SBSD are dollar shares in open-ended hedge funds—this structure is both difficult to audit and may expose users to risks associated with centralized exchanges (CEX) and asset price volatility, for example, if there are significant market fluctuations or prolonged downturns in sentiment.

These attributes make SBSD unsuitable as reliable stores of value or mediums of exchange, which are the primary uses of stablecoins. Although SBSD can be constructed in various ways, with differing levels of risk and stability, they all provide financial products priced in dollars that people may wish to include in their portfolios.

SBSD can be built on various strategies—such as basis trading or participating in yield-generating protocols, like Restaking protocols that help secure Active Verification Services (AVSs). These projects manage risks and returns, often allowing users to earn yields based on cash positions. By using yields to manage risks, including assessing AVSs to reduce risks, seeking higher yield opportunities, or monitoring basis trading contango, projects can generate a yield-producing strategy-backed synthetic dollar (SBSD).

Users should thoroughly understand the risks and mechanisms of any SBSD before using them (as with any new tool). DeFi users should also consider the implications of using SBSD in DeFi strategies, as decoupling can have severe ripple effects. When an asset decouples or suddenly depreciates relative to its tracked asset, derivatives that rely on price stability and stable yields may suddenly become unstable. However, when a strategy includes centralized, closed-source, or unauditable components, it may be difficult or impossible to underwrite the risks of any given strategy.

While we see that banks do implement simple strategies for deposits and actively manage them, this only accounts for a small portion of overall capital allocation. It is challenging to scale these strategies to support the overall stablecoin ecosystem, as they must be actively managed, making it difficult to reliably decentralize or audit these strategies. SBSD exposes users to greater risks than bank deposits. If users' deposits are held in such tools, they have reason to be skeptical.

In fact, users have been cautious about SBSD. Although they are popular among users with higher risk appetites, very few users trade them. Additionally, the US Securities and Exchange Commission has taken enforcement actions against those issuing "stablecoins" that function similarly to shares in investment funds.

4. Conclusion

The era of stablecoins has arrived. There are over $160 billion in stablecoins used for trading globally. They are divided into two main categories: fiat-backed stablecoins and asset-backed stablecoins. Other dollar-pegged tokens, such as strategy-backed synthetic dollars, have gained recognition but do not meet the definition of stablecoins as stores of value and mediums of exchange.

The history of banking is a good indicator for understanding the asset class of stablecoins—stablecoins must first be integrated around a clear, understandable, and easily redeemable form of currency, similar to how Federal Reserve notes gained public recognition in the 19th and early 20th centuries.

Over time, we should expect the number of asset-backed stablecoins issued by decentralized over-collateralized lending protocols to increase, just as banks increased the M2 money supply through deposit credit. Finally, we should expect DeFi to continue to grow, creating more SBSD for investors while also improving the quality and quantity of asset-backed stablecoins.

While this analysis may be useful, we should focus more on the current situation. Stablecoins are already the cheapest remittance method, which means they have a real opportunity to reconstruct the payment industry, creating opportunities for existing businesses. More importantly, they create opportunities for startups to build on a new payment platform that is frictionless and cost-free.

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