a16z: Looking at the future of stablecoins from the development history of U.S. banks

Author: Will Awang , Web3 Xiaolu

Although stablecoins are currently used by millions of people and trillions of dollars in value are traded, the definition of the stablecoin category and its understanding remains vague.

Stablecoins are a store of value and a medium of exchange for value, usually (but not necessarily) pegged to the U.S. dollar. Although the development time of stablecoins is only 5 years, its development and evolution path in two dimensions is very meaningful: 1. From under-collateralization to over-collateralization, 2. From centralization to decentralization. This is very beneficial to help us understand the technical structure of stablecoins and eliminate the market’s misunderstandings about stablecoins.

As a payment innovation, stablecoins simplify the way of value transfer. It has constructed a market parallel to traditional financial infrastructure, and its annual transaction volume has even exceeded that of major payment networks.

Taking history as a guide, we can see the rise and fall. If we want to understand the design limitations and scalability of stablecoins, a useful lens is the history of banking, looking at what works, what doesn’t, and why. Like many products in cryptocurrencies, stablecoins may replicate the history of banking, starting with simple bank deposits and notes and then enabling increasingly complex credit to expand the money supply.

Therefore, this article will compile a Useful Framework for Understanding Stablecoins: Banking History by a16z partner Sam Broner to provide a reference point of view on the development history of the U.S. banking industry and look at the future of stablecoin development.

The article will first introduce the development of stablecoins in recent years, and then compare the development history of the U.S. banking industry so that an effective comparison can be made between stablecoins and the banking industry. In the process, the article will explore the three stablecoin currency forms that have emerged in the recent past: fiat-backed stablecoins, asset-backed stablecoins, and strategy-backed synthetic dollars, with a view to the future.

Key Takeaways

Through the compilation, I was deeply inspired. Looking at its essence, there is no escape from the three pillars of banking and monetary science.

• Although the payment innovation of stablecoins seems to subvert traditional finance, the most important thing is to understand that the essential attributes of currency (value scale) and core functions (medium of exchange) remain unchanged. Therefore, stablecoins can be said to be the carrier or manifestation of currency.
• Since it is essentially currency, the development patterns of modern currency history over the past several hundred years are of great reference significance. This is also the redeeming feature of Sam Broner ’s article. He not only saw the issuance of money, but also saw subsequent banks using credit as a tool for money creation. This directly guides the direction for stablecoins that are still in the currency issuance stage.
• If stablecoins backed by legal currency are the public’s choice in the current currency issuance stage, then asset-backed stablecoins will be the choice in the subsequent credit creation money stage. My personal opinion is that as more and more illiquid RWA tokenized assets come to the chain, their mission is not to circulate, but to mortgage and create credit as underlying assets.
• Let’s look at the synthetic USD supported by the strategy. Due to the design of the technical structure, it will inevitably be subject to regulatory challenges and user experience obstacles. Currently, it is more applied to DeFi yield products, making it difficult to break through the impossibility of investment in traditional finance. Triangle: Return, Liquidity and Risk. However, we have recently seen that some interest-bearing stablecoins with U.S. debt as the underlying asset, or innovative model applications such as PayFi, are breaking through this limitation. PayFi integrates DeFi into payments, turning every dollar into smart, autonomous money.
• Finally, what needs to be returned to the essence is: the birth of stable coins, synthetic dollars or special currencies aims to further highlight the essential attributes of currency, strengthen its core functions, improve currency operation efficiency and reduce operating costs through digital currency and blockchain technology. , strictly control risks, and give full play to the positive role of currency pairs in promoting value exchange and economic and social development.

1. The Development History of Stablecoins

The years since Circle launched USDC in 2018 have provided ample evidence of where stablecoins work and where they don’t.

Early adopters of stablecoins use fiat-backed stablecoins to transfer money and save. While stablecoins generated by decentralized overcollateralized lending protocols are useful and reliable, actual demand is lackluster. So far, users appear to be strongly favoring USD-denominated stablecoins over other (fiat or new) denominations.

And certain categories of stablecoins have completely failed. Decentralized, low-collateral stablecoins like Luna-Terra, which appeared to be more capital efficient than fiat-backed or over-collateralized stablecoins, ultimately ended in disaster. Other categories of stablecoins remain to be seen: while interest-bearing stablecoins are intuitively exciting, they will face user experience and regulatory hurdles.

Building on the current successful product-market fit of stablecoin adoption , other types of USD-denominated tokens are emerging. Strategy-Backed Synthetic Dollars like Ethena are a new product category that is not yet fully defined. Although similar to stablecoins, they have not actually reached the security standards and maturity required for legal currency to support stablecoins. They are currently more adopted by DeFi users, taking higher risks and obtaining higher returns.

We have also witnessed the rapid adoption of fiat-backed stablecoins such as Tether-USDT, Circle-USDC, which are attractive due to their simplicity and security. Adoption of asset-backed stablecoins, an asset class that accounts for the largest share of deposit investments in the traditional banking system, lags.

Analyzing stablecoins through the lens of the traditional banking system helps explain these trends.

2. History of U.S. banking industry: bank deposits and U.S. currency

To understand how current stablecoins are evolving to mimic the banking system, it’s especially helpful to understand the history of U.S. banking.

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

The "actual" value of bank notes (Cash), deposits, and checks can vary greatly depending on three factors: the issuer, the ease of cashing, and The credibility of the issuer. Especially before the creation of the Federal Deposit Insurance Corporation (FDIC) in 1933, deposits had to be specially insured against bank risks.

In this period, one dollar ≠ one dollar.

Why? Because banks faced (and still face) the contradiction between maintaining profitability on deposit investments and ensuring the safety of deposits. In order to achieve profit from deposit investment, banks need to release loans and bear investment risks, but in order to ensure the safety of deposits, banks need to manage risks and hold positions.

Until the Federal Reserve Act of 1913, for the most part, one dollar = one dollar.

Today, banks use dollar deposits to buy Treasury bonds and stocks, make loans, and engage in simple strategies such as market making or hedging under the Volcker Rule. The Volcker Rule was introduced in the context of the 2008 financial crisis to limit banks from engaging in high-risk proprietary trading activities and reduce speculative activities in retail banks to reduce the risk of bankruptcy.

Although retail banking customers may think that all their money is perfectly safe in a deposit account. But this is not the case. Looking back at the collapse of Silicon Valley Bank in 2023 due to capital mismatches, which led to liquidity depletion, is a bloody lesson for our market.

Banks earn interest margins by investing (lending) deposits to make a profit. Banks balance making money and risk behind the scenes, and users mostly don 't know exactly how banks handle their deposits, although in turbulent times, banks can basically guarantee the safety of deposits .

Credit is a particularly important part of banking and is how banks improve the money supply and capital efficiency of the economy. Although due to improvements in federal oversight, consumer protections, widespread adoption, and risk management, consumers can treat deposits as relatively risk-free, unified balances.

Returning to stablecoins, they provide users with many of the same experiences as bank deposits and notes – a convenient and reliable store of value, a medium of exchange, lending and borrowing – but in an unbundled, “self-custodial” form. Stablecoins will follow the example of their fiat currency predecessors, and adoption will start with simple bank deposits and notes, but as on-chain decentralized lending protocols mature, asset-backed stablecoins will become increasingly popular.

3. Looking at stablecoins from the perspective of bank deposits

With this background, we can evaluate three types of stablecoins through the lens of a retail bank—fiat-backed stablecoins, asset-backed stablecoins, and strategy-backed synthetic dollars.

3.1 Stablecoins backed by fiat currency

Stablecoins backed by fiat currency are similar to US Bank Notes during the National Bank era (1865-1913). During this period, banknotes were bearer instruments issued by banks; federal regulations required that customers redeem them for equivalent amounts in U.S. dollars (e.g., special U.S. Treasury bills) or other legal tender (" coins "). So while the value of a bank note may vary depending on the issuer's reputation, accessibility, and solvency, most people trust bank notes.

Fiat-backed stablecoins follow the same principles. They are tokens that users can redeem directly for easy-to-understand, trustworthy fiat currencies—but with similar caveats: While banknotes are bearer instruments that can be redeemed by anyone, the holder may not live near the issuing bank , difficult to redeem. Over time, people accepted the fact that they could find someone to trade with and exchange their notes for dollars or coins. Likewise, users of fiat-backed stablecoins are increasingly confident that they can reliably find high-quality stablecoin acceptors using Uniswap, Coinbase, or other exchanges.

Today, a combination of regulatory pressure and user preference appears to be attracting more and more users to fiat-backed stablecoins, which account for more than 94% of the total stablecoin supply. Circle and Tether dominate the issuance of fiat-backed stablecoins, with a combined total of more than $150 billion in U.S. dollar-dominated fiat-backed stablecoins issued.

But why should users trust fiat-backed stablecoin issuers?

After all, fiat-backed stablecoins are issued centrally, and it is easy to imagine the risk of a “bank run” when stablecoins are redeemed. In order to deal with these risks, stablecoins backed by legal currency are audited by well-known accounting firms, obtain local license qualifications, and meet compliance requirements. For example, Circle is regularly audited by Deloitte. These audits are designed to ensure that the stablecoin issuer has sufficient fiat currency or Treasury bill reserves to cover any short-term redemptions and that the issuer has sufficient total fiat collateral to support the acceptance of each stablecoin at a 1:1 ratio. .

Verifiable Proof of Reserve and Decentralized Issuance of Fiat Stablecoins is a feasible path, but it has not been adopted much.

Verifiable proof-of-reserves will improve auditability, currently possible through zkTLS (zero-knowledge transport layer security, also known as proof-of-network) and similar means, although it still relies on a trusted centralized authority.

Decentralized issuance of fiat-backed stablecoins may be feasible, but there are substantial regulatory issues. For example, to issue a decentralized fiat-backed stablecoin, the issuer would need to hold on-chain U.S. Treasury securities with a similar risk profile to traditional Treasury bonds. This isn’t possible today, but it would make it easier for users to trust fiat-backed stablecoins.

3.2 Asset-backed stablecoins

Asset-backed stablecoins are the result of on-chain lending protocols that mimic the way banks create new money through credit. Decentralized overcollateralized lending protocols like Sky Protocol (formerly MakerDAO) issue new stablecoins that are backed by highly liquid collateral on-chain.

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

In fact, most of the money in circulation, the so-called M2 money supply , is created by banks through credit. Just as banks use mortgages, car loans, business loans, inventory financing, etc. to create money, on-chain lending protocols use on-chain assets as collateral, creating asset-backed stablecoins.

The system that enables credit to create new money is called fractional reserve banking, which actually originated with the Federal Reserve Bank Act of 1913. Since then, the fractional-reserve banking system has matured, with major updates in 1933 (the creation of the Federal Deposit Insurance Corporation), 1971 (President Nixon ended the gold standard), and 2020 (the reserve ratio was dropped to zero).

With each change, consumers and regulators become increasingly confident in the system that creates new money through credit. First, bank deposits are protected by federal deposit insurance. Second, despite major crises such as 1929 and 2008, banks and regulators have been steadily improving their practices and processes to reduce risk. For 110 years, credit has made up an ever-increasing share of the U.S. money supply, now accounting for the vast majority.

Traditional financial institutions use three methods to safely issue loans:

1. Targeted at assets with liquid markets and quick liquidation practices (margin loans);

2. Conduct large-scale statistical analysis on a group of loans (mortgages);

3. Provide thoughtful and tailored underwriting services (commercial loans).

On-chain decentralized lending protocols still only account for a small portion of the stablecoin supply, as they are just getting started and have a long way to go.

The best-known decentralized over-collateralized lending protocol is transparent, well-tested, and conservative. For example, the most famous collateralized lending protocol, Sky Protocol (formerly MakerDAO), issues asset-backed stablecoins for assets that are: on-chain, off-chain, low-volatility, and highly liquid (easy to sell). Sky Protocol also has strict regulations regarding collateralization rates and effective governance and liquidation protocols. These properties ensure that the collateral can be sold safely even if market conditions change, thus protecting the redemption value of the asset-backed stablecoin.

Users can evaluate mortgage agreements based on four criteria:

1. Governance transparency;

2. The proportion, quality and volatility of assets supporting stablecoins;

3. Security of smart contracts;

4. The ability to maintain loan collateral ratio in real time.

Like funds in a checking account, asset-backed stablecoins are new funds created through asset-backed loans, but with lending practices that are more transparent, auditable, and easy to understand. Users can audit the collateral of asset-backed stablecoins, which is different from the traditional banking system where they can only entrust their deposits to bank executives for investment decisions.

Additionally, the decentralization and transparency enabled by blockchain can mitigate the risks that securities laws are designed to address. This is important for stablecoins because it means that a truly decentralized asset-backed stablecoin may fall outside the scope of securities laws —an analysis that may be limited to relying solely on digitally native collateral (as opposed to “real-world assets”). ”) asset-backed stablecoin. This is because this collateral can be secured through autonomous protocols rather than centralized intermediaries.

As more and more economic activity is moving 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 greater share of the currency. Other types of loans may eventually be issued securely on-chain to further expand the on-chain money supply.

Just as it took time for traditional bank credit to grow, regulators to reduce reserve requirements and credit practices to mature, so too will on-chain lending protocols take time to mature. It stands to reason that in the near future we will see more people transacting with asset-backed stablecoins as easily as with fiat-backed stablecoins.

3.3 Strategy-backed Synthetic USD

Recently, several projects have launched $1 face value tokens that represent a combination of collateral and investment strategies. These tokens are often confused with stablecoins, but synthetic dollars backed by strategies should not be considered stablecoins . Here’s why:

Strategy-backed synthetic dollars (SBSD) allow users to directly face the trading risks of active asset management. They are typically centralized, undercollateralized tokens with financial derivative properties. More precisely, SBSD is a dollar share of an open-ended hedge fund—a structure that is both difficult to audit and can expose users to centralized exchange (CEX) risk and asset price volatility, for example, if there is a significant move in the market or Sentiment continues to decline.

These properties make SBSD unsuitable for use as a reliable store of value or medium of exchange, which are the primary uses of stablecoins. While SBSDs can be structured in a variety of ways, with varying levels of risk and stability, they all offer USD-denominated financial products that people may want to add to their portfolios.

SBSD can be built on a variety of strategies – for example, basis trading or participating in yield-generating protocols such as the Restaking protocol that helps secure Active Verification Services (AVSs). These programs manage risk and reward, often allowing users to earn returns on top of their cash positions. By using returns to manage risk, including evaluating AVSs to reduce risk, looking for higher yield opportunities, or monitoring basis trades for inversions, projects can generate a yield-generating strategy to back Synthetic USD (SBSD).

Before using any SBSD, users should have a thorough understanding of its risks and mechanisms (as with any new tool). DeFi users should also consider the consequences of using SBSD in DeFi strategies, as decoupling can have severe knock-on effects. Derivatives that rely on price stability and steady returns can become suddenly unstable when an asset decouples or suddenly loses value relative to the asset it tracks. However, underwriting the risks of any given strategy may be difficult or impossible when the strategy contains centralized, closed-source, or non-auditable components.

While we do see banks implementing simple strategies for deposits that are actively managed, this represents only a small portion of overall capital allocation. It is difficult to use these strategies at scale to support overall stablecoins because they must be actively managed, which makes these strategies difficult to reliably decentralize or audit. SBSD exposes users to greater risks than bank deposits. Users have reason to be skeptical if their deposits are held in such an instrument.

In fact, users have been wary of SBSD. Although they are popular among users with a higher risk appetite, few users trade with them. Additionally, the U.S. Securities and Exchange Commission has taken enforcement actions against people who issue “stablecoins,” which function like shares in investment funds.

4. Finally

The era of stablecoins has arrived. There are over $160 billion in stablecoins traded globally. They fall into two broad categories: fiat-backed stablecoins and asset-backed stablecoins. Other USD-denominated tokens, such as strategy-backed synthetic dollars, have grown in awareness but do not meet the definition of a stablecoin as a store of value and medium of exchange.

Banking history is a good indicator of understanding the stablecoin asset class – stablecoins must first coalesce around a clear, understandable, and easily convertible currency, similar to what the Federal Reserve notes did in the 19th and early 20th centuries. The way the public perceives it.

Over time, we should expect the number of asset-backed stablecoins issued by decentralized overcollateralized lending protocols to increase, just as banks increase the M2 money supply through deposit credit. Finally, we should expect DeFi to continue to grow, both by creating more SBSD for investors and by increasing 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 way to send money, which means stablecoins have a real opportunity to reshape the payments industry and create opportunities for existing businesses. More importantly, create opportunities for startups to build on a new payments platform that is frictionless and cost-free.