Price volatility is often considered to be one the biggest barriers to mainstream adoption of cryptocurrencies as a medium of exchange. While this will become less of an issue over time as cryptocurrency prices stabilize, there are a number of different stablecoins that were created to address this issue. There are centralized stablecoins issued by an entity usually where fiat is held in a bank account (e.g. USDC). In this case I tend to use the term “fiat coin.” Then there are two types of decentralized stablecoins: crypto collateralized (e.g. DAI) and algorithmic (e.g. Basis model). Some coins also plan to have a combination of crypto collateralization and algorithmic. This post covers where I think stablecoins are headed based on their different attributes. For a more in-depth understanding of the different stablecoin models please refer to Cyrus Younessi’s post.
A fiat coin like USDC is stable because it is backed 1:1 by USD in a bank account. There is little risk to holding or using a fiat coin as long as you trust the issuing entity and underlying fiat (note that this is not always the case especially depending on which country you live in). There is also a centralized entity that is liable if something goes wrong which many individuals and businesses prefer. FDIC deposit insurance also covers up to at least $250,000 in the US while other countries have their own deposit insurance terms. These sound like ideal features for users of fiat coins. However, it is important to note that not everyone has access. For example, the user agreement for USDC states it is only available to individuals and institutions in supported jurisdictions. This list currently even excludes the US states of Hawaii, New York, and Minnesota. Users are also prohibited from transacting USDC for certain activities. In the digital world, it’s a lot easier to automatically restrict who can’t use the currency (e.g. blacklisted wallet). There are also less regulated centralized stablecoins like Tether, which has brought its own controversies including whether or not it is backed 1:1 with fiat. I believe over time the trusted, regulated stablecoins will dominate the centralized category.
Decentralized stablecoins like DAI don’t have a user agreement which means anyone can access it and there is no potential censorship. However there are tradeoffs to not having a coin backed 1:1 with fiat such as less stability and more complexity. For example, while DAI remained relatively stable during the bear market due to the overcollateralization requirement, we saw that it was actually more difficult to maintain the peg during a bull market due to the demand of borrowing from the Maker system for leverage (e.g. put up $200 ETH for collateral -> borrow $100 DAI -> sell $100 DAI for $100 ETH -> price of DAI goes down). With a number of stability fee adjustments (interest rate paid for borrowing DAI), DAI has been able to get back to a relatively stable value during a bull market. While the Maker system is significantly more complex than something like USDC, I don’t believe the end user needs to understand how this all works in the same way that most people don’t need to understand the intricacies of monetary policy in order to use USD. In addition, there is smart contract risk that comes with DAI and there is no centralized entity that is liable for any issues. Currently DAI requires a 150% collateralization ratio, which makes it more difficult to scale than fiat coins. However, this requirement will likely come down over time as the crypto collateral(s) becomes less volatile.
On the other hand, I have major concerns with purely decentralized algorithmic stablecoins as the lack of collateral and reliance solely on algorithms to get the price to be stable means a well funded, motivated individual or institution could attack the system and cause people to lose confidence in the stability of the model. This could then lead to a death spiral and the collapse of the stablecoin. Therefore, I don’t believe this type of stablecoin will exist at a large scale in the future or it will need to be paired with crypto collateralization.
As seen with Libra, there is an attempt to put together a group of organizations to create a coin that represents a basket of different fiat coins such as USD, EUR, and JPY. The idea is that a global coin shouldn’t be represented by only one fiat type. While this is an interesting concept, I’m skeptical that the hybrid approach is necessary. A fiat coin representing USD works well for many individuals and institutions that already use USD and same for EUR and JPY. Also if the coin were to become large enough, the weightings of the fiat coins in the basket and who can join the group of organizations can get political and possibly intervened by governments. In my opinion, a hybrid strategy loses the benefits of both centralized and decentralized coins without adding significant value. There is no single entity that is liable should something go wrong and you can still run into censorship among the participating organizations. Any coin where fiat is stored in a bank account is not censorship resistant as the assets can ultimately be seized. These types of new hybrid structures also face regulatory challenges as seen with the recent Congress hearings on Libra. I believe that we will still see more attempts at this model by different organizations and some could be successful if they get past the regulatory hurdles. In general, I’m actually excited about these efforts because it brings more awareness to cryptocurrencies.
There are also teams working on a tokenized basket of centralized and decentralized stablecoins to reduce the overall volatility. However, I still believe the hybrid strategy is not necessary. The appeal of decentralized stablecoins is that they are censorship resistant but tradeoffs include more volatility and smart contract risk. Having a basket of centralized and decentralized means that it is not censorship resistant due to the centralized coins but has increased risk due the decentralized coins.
Stablecoin adoption within decentralized finance
Another interesting aspect of both centralized and decentralized stablecoins is that people can lend them out on decentralized finance (“DeFi”). Over time I believe it will be standard for platforms like centralized exchanges, decentralized exchanges, wallets, and custodians to integrate the borrowing/lending of stablecoins and other cryptocurrencies using DeFi. I also believe that this could be a good business model for these types of platforms. For example, people will be depositing USD onto the platform to generate USDC where the USD earns some interest at a traditional bank and the USDC can be loaned out by the user on DeFi platforms for more interest. The entity could then take a small cut of the interest earned for facilitating this service. However, there is smart contract risk that comes with this. I cover more of my thoughts on DeFi in my prior post on the future of decentralized finance.
I’m excited about decentralized stablecoins but I’m not in the group that believes they will largely overtake and eventually replace fiat. I believe that centralized and decentralized stablecoins will coexist, with centralized stablecoins likely being the larger market size. However this does not mean there isn’t significant opportunity for the decentralized stablecoin market.
I also believe the issuer of the centralized stablecoins will change over time. At first it will be the crypto-native players who are comfortable issuing the token and that have relationships with banks to store the fiat (e.g. USDC). However over time, some banks will get more comfortable with this concept and start issuing this directly (e.g. JPMorgan coin). Then over a much longer period of time, some countries will start issuing the fiat coin directly. There are already countries looking into creating a digital coin given the improved efficiency (e.g. China). These coins will also be significantly easier for governments to monitor compared to cash which is an attractive feature to many governments. For these reasons, I envision most major governments will eventually be issuing their own fiat coin in the future.
There might also be a group of organizations that creates a popular coin that is out of a single government’s control although it is still subject to political pressure as the funds are still held in bank accounts. However, none of these options are censorship resistant. Decentralized stablecoins will serve a population that needs price stability but that do not have access to fiat coins and/or needs censorship resistance as a fundamental attribute.
Thanks Will Warren for reviewing this post.
Disclaimer: Linda Xie is a Managing Director of Scalar Capital Management, LLC, an investment manager focused on cryptoassets and has a position in MKR.