Stablecoins: Explain Like I’m a Senator
🎶 I'm not a fiat...not yet a decentralized cryptocurrency
🎉 Happy new year everyone ! I’m picking things up after a short trip back to Texas for the holidays and some close calls with Covid exposures 😬. Thankfully, we made it home ok and the family is all testing negative.
Excited to dive deeper into crypto this year with ya’ll! Let’s dive into stablecoins - I’ll give an overview of them and what was discussed in the recent Senate Banking Committee hearing on stablecoins.
Note: with crypto quickly growing and evolving, there will always be an exception to the following statements.
Exhibit A: This dad joke highlights the need for stablecoins (and that BTC was 15k only 4 years ago!).
What are stablecoins? From Alexis Goldenstein’s testimony: Stablecoins are crypto assets that attempt to maintain a stable value, either through a basket of reserve assets acting as collateral (like fiat, gold, other cryptocurrencies), or through algorithms. Often, they focus on being “pegged” to the U.S. dollar or to another currency. For this post we will focus on centralized asset-backed stablecoins, aka ‘off chain’, as they are the most widely used at the moment (in future posts on Defi I’ll cover algorithmic stablecoins, aka ‘on chain’ like Terra). Nearly 75% of crypto asset trading involved a stablecoin, and they are the lifeblood of the recent decentralized finance (DeFI) explosion. The stablecoin industry is estimated to be worth $130B (larger than the market cap of Goldman Sachs) and has 5X’ed from Oct. 2020 to Oct. 2021. Asset-backed stablecoins are a hybrid of cryptocurrencies and fiat and inherit a mix of their strengths and weaknesses.
What are their potential advantages?
Today: When comparing to fiat and established banking systems, stablecoins currently have faster settlement, are borderless, and are less regulated (for now). A big innovation is they are a form of programmable money and can be used in smart contracts - if X happens, then pay $Y to Z wallet.
In the future: They promise to have lower transaction fees (this can be the case today, but YMMV) and are more transparent and trusted due to being on an open blockchain. They could combat money laundering and terrorist financing (more on this below). They could also make financing more accessible to those underbanked. Currently they aren’t widely accessible due to the requirement of internet, mobile phones, and majority of their use cases aren’t very user friendly.
What are their disadvantages?
For most stablecoins, they are centralized and rely on a single entity to issue IOUs redeemable at a 1:1 ratio for the underlying asset, with reliable convertibility of the IOU helping to maintain the 1:1 peg. That means participants must believe in the integrity of the entity and most importantly believe that the stablecoins are sufficiently backed by assets.
The biggest concern is the lack of transparency and standards. Its not a good look when one of the top stablecoins, Tether, has failed to provide a promised audit showing adequate reserves, is accused of manipulating the price of Bitcoin, and had $31 million of USDT tokens stolen in a 2017 hack. Not having a set of established rules and standards adds additional risk and can leave participants feeling unprotected.
Currently, stablecoins are somewhat fragmented due to the many blockchains out there. This isn’t as big of a disadvantage per se, but more so a new mindset for the layperson that one digital US Dollar has different flavors. For instance, USDC is on Ethereum (ETH) and Solana (SOL), so if you want to transfer from one wallet to another, you have to take some intermediate steps, just like if you wanted to swap ETH <> SOL tokens in general. While similar to transferring money from one bank to another, it is still way faster and less painful. This wasn’t apparent to me at first, as I naively thought 1 USDC was 1 USDC. Transferring USDC from different exchanges and converting between blockchains also incurs fees, which can add up.
Stablecoins that are pegged to fiat are still impacted by a government’s monetary policies. When the Federal Reserve’s money printer goes brrrrr, the stablecoin is likewise impacted by inflation which reached 6.8% over the last year. If inflation continues to rise and becomes uncontrollable, it could have huge implications for crypto industry. In particular, if the US dollar becomes unstable and drops significantly in value, it will also drag with it any stablecoins pegged to its price.
They could lose its pegged value and crash. This would be the worst case of a major hack/ embezzlement or if there is doubt that a stablecoin is sufficiently backed. This could cause a panic and a run to sell holdings.
How are they used? In general, money has 3 main functions: medium of exchange, store of value, and measure of value (a Costco chicken costs $4.99). The wild fluctuations of even the most established cryptocurrencies like BTC limit the application of these 3 functions. That’s where stablecoins come in. Since we are still early on, adoption is low for using stablecoins as a traditional medium of exchange as few businesses accept them for good or services. They are instead used as a way to hold money within the crypto ecosystem and to use them as a digital currency to buy and sell other cryptocurrencies. They can also be used as a store of value, but depends on what they are pegged to (see inflation point above).
What were the big takeaways from the Senate hearing? This hearing was an informative, but cynical discussion. Unlike the more open-minded congressional hearing on crypto, this had much more skepticism – some healthy and some FUD based (fear, uncertainty, doubt).
Stacking the deck: Out of the 4 guests, only one actually worked on stablecoins (Dante Disparte, Chief Strategy Officer of Circle), while the others were academics / lawyers and were pretty clear they did not support stablecoins.
Stablecoins are viewed by many as a threat: They have grown to the point where they could threaten the power of banks, governments, and the dominance of the US dollar. The sting of the 2007 recession is still fresh on everyone’s mind, especially since it was driven by a financial instrument not many understood: mortgage backed securities.
FUD: Elizabeth Warren labeled DeFi as “the shadiest parts of the crypto world” and stated how stablecoins are funding terrorism and illicit activity. She also raised some of the concerns about lack of regulation and liquidity:
How much is too much government? An interesting point brought up by the Breakdown podcast was on government reach. The hope brought up by senators was we should be able to monitor and block the use of stablecoins for terrorism and illicit activity. China been criticized for their digital Yuan because they will have full access to how people spend their money and with that, ultimate control of how people can use it. While I’m not arguing for funding terrorism and the likes, it begs the question of can we have it both ways – a currency that is both free and open while also being restricted in some use cases. Could DeFi one day be deemed illegal and completely banned by our government?
Same 💩 different color: Senator Brown raised other skepticism that “Stablecoins and crypto markets aren’t actually an alternative to our banking system. They’re a mirror of the same broken system––with even less accountability, and no rules at all.”
Proposed regulation: Earlier, the Democrat-led Presidential Working Group called for the introduction of comprehensive oversight as soon as possible and advocated for limiting stablecoin issuance to insured depository institutions. Consistent with the opinion of Treasury Secretary Janet Yellen, the group urged Congress to require stablecoin issuers be insured depository institutions. IMO, this would greatly limit innovation in the space as it would add a huge amount of red tape and would only leave banks to have control. Ironically, this is exactly what Senator Brown was skeptical of.
What’s in store for 2022: I think 2022 will be a big year for defining regulation of stablecoins, as well as the continued growth of DeFi. Regulation will boil down to the power struggle between those who want them to have a bank like identity vs those who do not. Principles and frameworks feel rushed and are still fuzzy. Ultimately they will take time to sharpen, nevertheless enforce. Get your popcorn ready, things will get interesting.
Here are some great youtube videos for reference if you want to learn more: