Revolution—Not Evolution: A stable of stablecoins and a challenge to banking

This article was originally published by Sandy Kaul in the "Revolution—Not Evolution" LinkedIn Newsletter.

Described by many as the first “killer app” of the Web3 space, stablecoins have become a rapidly growing tool used to facilitate liquidity in the crypto domain, transform cross-border trade and collateralize wallet-based finance and derivatives trading. Such utility marks a significant expansion from the original intent of stablecoins to act as on- and off-ramps between fiat currencies and crypto.

Yet, the extension of stablecoin use cases is just getting started, and the ultimate winner in the race to be the leading provider of stablecoins is far from decided.

Regulatory call: progress on legislation

Regulatory certainty is beginning to emerge. The US Securities and Exchange Commission (SEC) recently issued stablecoin guidance. Bills are working their way through the US Congress. The European Union has laid out its own requirements in their recently implemented Markets in Crypto Assets (MiCA) legislation. Global financial organizations such as the Bank of International Settlements (BIS) have been weighing in with their own views.

More issuers of stablecoins are emerging from crypto natives, payment processors and, increasingly, from regulated, traditional financial entities. As the implications of stablecoin growth and usage are becoming better understood, a growing set of firms is likely to join these ranks and issue their own stablecoins. 

Playing defense: an indefinite hold?

In part, new issuers from the traditional financial ecosystem are likely to enter the space as a defensive play. This is because the behavior of stablecoin holders is not following the path originally envisioned for the vehicle. Stablecoin users are proving to be “HODL’ers” in crypto-speak—holding on for dear life. Only a small portion of stablecoins in circulation are being burned to redeem the underlying fiat currency. Instead, holders are keeping their stablecoins in their wallet and treating them like an on-chain checking account, leaving balances in place to be ready for future transactions. Stablecoins are enabling the emergence of a parallel wallet-based ecosystem—one that is having the effect of removing fiat currencies from today’s dominant economies for extended periods of time.

Instead of a US dollar (or euro or any other fiat currency) being placed into the reserve pool of a stablecoin issuer for a single transaction and quickly being transitioned out of the collateral reserve via redemptions, it is becoming increasingly common for dollars placed in stablecoin reserves to remain in such pools indefinitely. Indeed, each stablecoin can pass from user to user an infinite number of times without ever being redeemed into fiat currency, so long as that exchange is being done with another wallet-enabled transactor.

Playing offense: collateral damage?

The semi-permanence of stablecoin balances is also allowing potential issuers to examine the space through an offensive lens. Though each dollar of stablecoin issuance is supposed to be backed 1:1 by a dollar of collateral, low stablecoin redemption rates are allowing issuers to extend the variety and duration of assets in their collateral pools beyond the fiat currency itself. A significant portion of the money that leaves the fiat banking system to back stablecoins is being invested rather than held in cash. This allows the stablecoin issuer to obtain yield on the collateral pool.

Paying out this yield directly or indirectly via rewards to holders of stablecoins risks having the stablecoin declared a security. Thus, the incentive is for the issuer to keep their reserves in yielding assets and collect that yield themselves. This dynamic results in further removal of fiat currencies from circulation. It also underscores the importance of having stablecoin regulation that mandates transparency into stablecoin collateral pools, requires issuers to attest to their “proof of reserves” and lays out strict guidelines about the required liquidity profile of such reserves.

Under pressure: increased temptation for potential issuers

Together, the low redemption rate from stablecoin holders and the ability to earn yield by investing the stablecoin collateral pose a significant challenge for commercial banks that rely on cash deposits to generate margin. If those cash deposits begin to disappear, pressures are likely to grow. The latest estimates put stablecoin assets at just over $200 billion, but Standard Chartered has forecast that market to grow 10x in the next three years following the passage of US stablecoin regulation.¹ Faced with such growth prospects, many banks are likely to amend their business models and become issuers of their own stablecoins.

This would allow them to replace lost earnings on deposits with collateral pool yields. Moreover, having their own stablecoin would offer a vehicle that banks could use to “trap” liquidity in their network by recirculating their own stablecoins continually across and between their clients. Indeed, banks are likely to quickly identify ways of incentivizing such behavior through cost savings or loyalty programs.

The deliberation at hand

On one hand, such a move would help accelerate the migration of today’s economy away from account-based, multi-ledger activities to a wallet-based, single ledger future on blockchain.

On the other hand, the potential complexity of having hundreds or even thousands of stablecoins could introduce unforeseen risks and frictions.

Central banks have been focused on digitizing their own currencies, but their ultimate role may end up being a sort of clearing house for stablecoins—acting as the buyer to every seller and the seller to every buyer to ensure the stability of their underlying currency.