From Stablecoin Surge to Dollar Domination

In just three years, the total supply of stablecoins has grown 10x to more than $130B today. Stablecoins have emerged as a keystone of the crypto ecosystem, providing stability and a store of value in contrast to the volatility of much of the crypto world. We’ve seen a cambrian explosion of stablecoin issuance and designs and the ecosystem has expanded dramatically, accounting for a majority of crypto trading and capturing the attention of regulators and policymakers across the globe.

We’ve seen a newly passed regulatory framework in the EU, and plans to do the same in Singapore, Hong Kong and the US. Some of you may have missed a recent congressional hearing on stablecoins by the US House Committee on Financial Services which was overshadowed by Gensler’s frightening (and frankly embarrassing) testimony before the same committee on SEC oversight, where he expressed his views on the SEC’s overly broad role in regulating crypto assets. The hearing on stablecoins, however, held a more constructive and objective tone which highlighted — in this author’s opinion — a much more pivotal issue for both US and global capital markets.

In this article, we will explore how stablecoins work, some of the issues discussed in the recent stablecoin hearing, and why a properly regulated US stablecoin is a win-win across the globe.

HOW STABLECOINS WORK

How do stablecoins work? And more importantly, how do stablecoin issuers make money? To answer that, we’ll begin with a brief overview of the stablecoin market and a quick explanation of the main classifications of stablecoins.

Stablecoins can be taxonomized into three main categories: fiat-collateralized, crypto-collateralized, and algorithmic, i.e. non-collateralized. Fiat-collateralized stablecoins are the largest by far, and include stablecoins like Tether, USDC, and BUSD. They are backed by reserves of cash or cash equivalents, which are tokenized (minted) on-chain by an issuer who manages the cash reserves. You can think of them similar to a bridge between Ethereum and BNB Smart Chain, except in this case the bridge is between the traditional fiat network and a blockchain network. Crypto-collateralized stablecoins include stables like DAI and FRAX, which are completely on-chain and backed, and usually over-collateralized, by reserves of cryptocurrencies like ETH, BTC, and other stablecoins. Algorithmic stablecoins are a blanket term for an entire host of non-collateralized stablecoin designs that rely on mathematical relationships, often rebasing or seigniorage algorithms, to maintain price stability (beyond the scope of this article). Examples include the infamous TerraUSD, which was behind the catastrophic downfall of LUNA and Do Kwon.

In this article we will focus on the former (fiat-collateralized), as itaccounts for over 90% of the market and is the most likely to gain acceptance with regulatory frameworks around the world. It’s worth it to note that over 99.8% of the stablecoin market is denominated in US Dollars. This is an important and far-reaching dynamic that speaks to the sheer global demand of the US Dollar and of which we’ll explore in further detail.

HOW STABLECOIN ISSUERS MAKE MONEY

Stablecoin issuers take US Dollars from investors, exchanges, and businesses and issue them as dollar-pegged tokens on various blockchains which are redeemable at any time for their equivalent in USD. The issuers invest most of those US Dollars into short-term US treasuries, i.e. T-Bills. Holding T-bills provides yields to the holder at an implied interest rate that is in large part determined by the Federal Reserve. Currently that interest rate stands at around 4.5 to 5%. Despite what you may have heard in media echo chambers, treasuries are still considered some of the safest assets in the world, and “short-term” maturities ensure that the investment remains relatively liquid. It acts similar to a money-market fund (with key differences however), which lately has been the SECs angle for declaring stablecoins a security. In essence, stablecoin issuers take your dollars, put them on the blockchain, and get a risk-free return of around 4 to 5% by holding those dollars in treasuries.

THE BIG FOUR

Like the Big Four of accounting firms, there is also a Big Four of stablecoins. USDT, USDC, BUSD, and DAI dominate the market, representing 94.5% of all stablecoins in circulation. The market caps can be seen below.

Of the four, the three largest are collateralized by US Dollar cash and cash equivalents. DAI is the only one NOT fiat-backed, though a large part of its cryptocurrency collateral is in USDC, meaning even as a crypto-backed currency it still maintains significant, albeit indirect, exposure to US Dollar cash equivalents. Of the four largest stablecoins two are domiciled in the US, and explaining the history and dynamics of the different issuers will help us understand why the US should continue to tactfully foster the domiciling of stablecoin issuers.

US Tether (USDT) is the largest by both market cap ($80bn) and volume. Much of this can be attributed to its use as a collateral asset for leverage trading on Binance and has enjoyed first-mover advantage in the space - having been founded in 2014 by a trio that includes none other than Brock Pierce (you may remember him from The Mighty Ducks or his bizarre presidential run) but was quickly purchased in 2015 by Hong Kong-based iFinex, owner of the Bitfinex exchange, where it’s early integration with Tether helped catalyze its early dominance. Since then, usage of US Tether has exploded, but not without its share of continued controversy. According to Tether’s quarterly reserve reports, it holds $67 billion (as of Q4 2022) in 1:1 fiat collateral - though the reports are vague and do not include CUSIPs i.e. US Treasury IDs or granular breakdowns of asset categories (including a vague category labeled “Other Investments - Including Digital Tokens”). Its banking partners are mainly domiciled in the Bahamas and a major and understandable concern with Tether has been a lack of transparency and oversight which has led to multiple allegations of falsely stating reserves and market manipulation.

USD Coin (USDC) is the second largest by market cap ($30bn) and volume. USDC is issued by Circle in collaboration with Coinbase. Its reserves are much more transparent, holding 5.2bn in cash at reserve banks, and 25.5bn in short-dated US Treasuries. Balances are held and managed by US-domiciled institutions (BNY Mellon and BlackRock respectively), full audits are performed and publicly attested to monthly by Deloitte, and reserve composition is updated on their site daily. Circle was a recent victim of the Silicon Valley Bank ordeal, where they had held over $3bn of their reserves. Bankruptcy fears on those non-FDIC insured deposits caused over $1bn in redemptions and a temporary depeg from its $1 value that took social media by storm. USDC is mainly used in DeFi, as opposed to USDT which has most of its presence on centralized exchanges like Binance.

Binance USD (BUSD) is third largest ($6bn market cap), though quickly losing steam after their announcement to halt minting of new BUSD tokens. BUSD is issued by Paxos in conjunction with Binance, but have recently ended their relationship after a recent crackdown by the SEC and the New York Department of Financial services. BUSD is almost exclusively used on the Binance exchange with some volume on DEXs. Its drop in market cap from $20bn at the end of 2022 to $6bn today is a stark reminder of the influence our regulators have on the crypto ecosystem and highlights the need for retail awareness and a clear regulatory framework. Like USDT and USDC, Paxos collateralizes BUSD with cash equivalents like short term US treasury debt and reverse repo agreements.

DAI is an outlier in the Big 4, as it is the only stablecoin here that is purely on-chain and backed by cryptocurrencies rather than fiat. Essentially, users can create dollar-pegged DAI by depositing cryptocurrency collateral like Ethereum. A smart contract then generates an amount of DAI, usually less than the collateral’s market value in order to create a buffer against volatility in the collateral’s price. If the market value of the collateral drops below a certain point, it is publicly available to be sold to someone else in an action called “liquidation”, where the user’s collateral is transferred to the liquidator at a discount, in return for settling the user’s debts. It was created by MakerDAO with a full suite of on-chain governance mechanisms to move the different financial levers used to manage the ecosystem. It is a wonderful example of decentralized stablecoin issuance, but is worth noting again that much of its reserves are in USDC, which creates some exposure to a centralized entity (Circle in this case).

WHY A US DOMESTIC STABLECOIN ISSUER IS IN THE WORLD’S BEST INTEREST

We've seen a continued and unequivocal dollarization of crypto. Why? Because the dollar is STILL the most stable. Pundits and a frenzied media often misrepresent the idea of the US dollar losing value, but a cursory glance of the DXY (US Dollar Index) tells a different story *see below. Contrary to popular belief the dollar is actually in even HIGHER demand both domestically and globally, and doubly so in the world of crypto. Countries need dollars around the globe to transact and shore up capital positions to match growth in GDP and trade. Any dollars that are “printed” are inevitably absorbed, both domestically and globally. What recent media has been perpetuating is the idea of inflation, which is often misunderstood to be an inflation of the dollar - however the data actually shows the opposite. What’s “inflating” is actually the Consumer Price Index or CPI, a basket of goods meant to be a normalized representation of how expensive or inexpensive things are getting. The recent domestic (US) inflation scares have been caused in part by a large money injection during COVID but more so by supply chain shocks caused by a global shut down, of which we are still feeling the effects today. The large money injection was (wrongfully) expected by the Fed to flow into household savings based on previous data. However, what we did as a whole was ape into memecoins, stonks, and Amazon Prime - causing a huge spike in asset prices and driving an excess of demand into a shortage of supply.

This is all to say that the US dollar will continue to dominate crypto, and especially DeFi, for the foreseeable future. Ask anyone in the crypto space around the globe about the prices of Bitcoin, Ethereum, Lunr 😏, or god forbid Floki Inu - and the likely response will be denominated in dollars.

For regulators, this means that despite what consensus is on the Hill, the demand for the dollar within the crypto ecosystem will only continue to grow for the foreseeable future. If you’re one to believe that history is any indication of the future, all you need to do is look at the overall growth trends in the crypto and stablecoin ecosystems (market cap, active wallet addresses, stablecoin volumes, developer activity, media penetration). As this emerging ecosystem of decentralized capital and computation grows, the demand for dollars will grow right alongside it - and the US can either service this demand domestically, or leave it up to other jurisdictions that may not be as transparent or aligned with US ideals. Not to mention the US still needs net buyers of treasuries! You may have seen reports of “de-dollarization” or how Asia and Japan are slowly off-loading treasuries. Much of this has to do with the recent COVID-induced slowing of their economies, but much of these treasuries are being converted into dollar bonds, still another form of exposure to the US dollar but without the desired controls and issuance of US regulators (look up Eurodollars). If US regulators really want to maintain controls over dollar policy, more debt in the form of US Treasuries (held by stablecoin issuers) is in their best interest. US regulators like OFAC may also have concerns over AML/KYC controls. A domestically regulated stablecoin issuer will allow for the ability to regulate who and how those dollars are redeemed. The US would have no controls over dollar redemptions with for example, Tether, who is headquartered in CCP-controlled Hong Kong and banked in the Bahamas.

For users, a US domiciled stablecoin issuer will mean a more liquid, transparent, and regulated capital market in crypto. With fully regulated and transparent reserves held in highly regulated US institutions, users should have more confidence in the backing of the reserves, as well as the availability of the dollars to back those reserves (as dollars are issued domestically). Imagine if we found out that an opaque issuer domiciled in a jurisdiction free from enforcement had been misrepresenting deposit reserves and double printing, or you weren’t able to redeem for dollars (either out of mismanagement or outright refusal to do so). There would be no recourse for the average user, and cause a cascade of systemic failures in DeFi which would likely result in a negative feedback loop of dropping asset prices and trust in the ecosystem. Like traditional finance, most of crypto’s market value is predicated on confidence. US Regulators and the financial system haven’t always been perfect, but it is still among the best alternatives for financial systems with the ability to scale at a global level.

TAKING THE OTHER SIDE

You might argue that it’s pretentious to assume the US dollar should remain a reserve currency. I argue that until we have a neutral supranational currency (Bitcoin? Hint hint) that is widespread enough to facilitate global trade, we have no other choice. The merits of being a global reserve currency have costs and its pros and cons are widely debated. Arthur Hayes (founder of the BitMEX exchange), argues that countries like China, whom many have assumed want to provision the next reserve currency, actually do NOT want the responsibility and would rather have a more diversified currency dynamic.

As a regulator, you might argue that we can’t afford to have capital flowing to other assets and financial instruments that don’t have controls that are operated and overseen by the US. I argue that onshoring stablecoin market share actually brings MORE deposit flows into the very assets that the US has the most control over (Treasuries), given the dominance of the dollar-denominated stablecoin in the crypto world. Domestic stablecoin issuers would also allow thoughtful, regulated control systems to ensure that dollars are not redeemed by nefarious actors and criminals.

Regulators might also argue that stablecoins allow for a growth of unregulated credit and lending in a decentralized space. I argue that until we have robust markets for physical goods and digital necessities using crypto as a substrate, this expansion of credit is largely if not entirely limited to the crypto ecosystem - and worse comes to worst - the value of this credit creation, however large it might be, falls back to the reserves held (hopefully by vetted, US-domiciled institutions).

Crypto die-hards and libertarians may also point to the fact that in its current form, fiat-backed stablecoin issuance is not truly decentralized and represents another middleman (the very thing we set out to destroy!). I argue that while this is true, it is a necessary step for the continued development of crypto, and a necessary step towards a conducive regulatory environment (imagine regulation for crypto-backed stablecoins being passed before fiat-backed, yeah right). Regulation and development of bottom-up systems is not a linear process.

For those who ask why we should have any regulation at all, I would counter by asking for an example of any populous society or large financial system that works or has worked well without thoughtful regulation. It’s far from perfect, but the reason the US financial system is so robust is in large part due to the regulations that make it trusted and open for everyone.

TL;DR

The rise of stablecoins has been off the charts 📈 , regulation is taking a larger role on the political stage, and it is becoming increasingly clear that a properly regulated US stablecoin is a win-win for global capital markets.. The demand for the US dollar remains strong regardless of US policies and the US can either embrace this demand domestically or risk leaving it in the hands of less transparent and aligned jurisdictions. A US domestic stablecoin issuer would provide users with a more liquid and regulated capital market, ensuring confidence in the backing of reserves and the availability of dollars. Onshoring stablecoin market share brings more deposit flows into assets like US Treasuries, providing the US with greater control and aligning with current monetary directives. Thoughtful (looking at you Gensler!) regulation can address concerns of unregulated credit and lending and capital outflows, and while fiat-backed stablecoins may not be fully decentralized, they are a necessary step in the development of the crypto ecosystem and conducive regulatory environment.

Some people and agencies to follow moving forward for stablecoin regulatory developments:

• Patrick McHenry, Chairman of House Financial Services Committee (R-N.C.)
• Dante Disparte, Chief Strategy Officer and Head of Global Policy for Circle
• Cynthia Lummis U.S. Senator (R-WY) aka “Crypto Queen”
• Austin Campbell, Partner at Zero Knowledge Consulting and Adjunct Professor at Columbia
• Warren Davidson, House Rep (R-OH)
• New York Department of Financial Services (NYDFS)
• U.S. House Financial Services - Dems
• U.S. House Financial Services - GOP

Author:

Toby Fan, Web3 Strategist @ LunarCrush

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Toby Fan is Head Web3 Strategist at LunarCrush, which provides real-time social media data on crypto, NFT, and traditional equities. He is a graduate of UC Santa Cruz, where he double majored in Econometrics and Information Systems and helped lead departmental research on commodity market dynamics in China and the US. Toby is also an active contributor for Coinmonks (https://medium.com/@tobyornottoby) and a member of the BlockBrosDAO.