The Evolution of Stablecoins: Insights from Banking History for Future Development

Stablecoins, as an innovative payment method, greatly simplify the process of value transfer. They have established a market that runs parallel to traditional financial infrastructure, with annual transaction volumes even surpassing major payment networks.

To gain a deeper understanding of the design limitations and scalability of stablecoins, reviewing the development history of the banking industry offers a valuable perspective. From this, we can learn which practices are feasible, which are not, and the reasons behind them. Similar to many products in the cryptocurrency space, stablecoins are likely to replicate the evolutionary path of banking, starting from simple deposits and notes and gradually evolving into more complex forms of credit to expand the money supply.

The Development History of Stablecoins

Since Circle launched USDC in 2018, the development trajectory of stablecoins has become clear. Early users primarily used fiat-backed stablecoins for transfers and savings. Although decentralized over-collateralized lending protocols have also produced some practical and reliable stablecoins, actual demand has not been strong. Currently, users clearly prefer dollar-pegged stablecoins over those pegged to other denominations.

Certain types of stablecoins have already failed, such as decentralized, low-collateral stablecoins like Luna-Terra, which ended in disaster. Other types, such as yield-bearing stablecoins, are still under observation and may face challenges in user experience and regulation.

As the application scenarios of stablecoins gradually become clearer, some new types of dollar-denominated tokens have also emerged. For example, strategic support synthetic dollars like Ethena represent a new product category that has not yet fully defined itself. It is similar to stablecoins but has not yet reached the safety standards and maturity of fiat-backed stablecoins, and is currently mainly adopted by DeFi users, taking on higher risks to achieve higher returns.

We also see that fiat-backed stablecoins such as USDT and USDC are being rapidly adopted, as they are popular due to their simplicity and security. In contrast, the adoption of asset-backed stablecoins is slower, even though these assets account for the largest share of deposit investments in the traditional banking system.

Insights on Stablecoins from the Development of the US Banking Industry

Reviewing the development history of the American banking industry helps us understand the current development model of stablecoins.

Before the enactment of the Federal Reserve Act in 1913, especially before the National Bank Act of 1863-1864, different forms of currency had varying levels of risk and actual value. The "actual" value of banknotes, deposits, and checks could differ significantly, depending on the issuer, the difficulty of redemption, and the issuer's creditworthiness. Especially before the establishment of the Federal Deposit Insurance Corporation in 1933, deposits had to be specially underwritten against bank risks.

During that period, one dollar did not equate to another dollar. This was because banks faced the contradiction between maintaining profitable deposit investments and ensuring the safety of deposits. To achieve profitable deposit investments, banks needed to issue loans and take on investment risks; but to ensure the safety of deposits, banks also needed to manage risks and hold sufficient positions.

It was not until the enactment of the Federal Reserve Act in 1913 that one dollar was basically equivalent to another dollar.

Today, banks use dollar deposits to purchase government bonds and stocks, issue loans, and engage in simple strategies such as market making or hedging under the Volcker Rule. The Volcker Rule was introduced after the 2008 financial crisis to limit banks from engaging in high-risk proprietary trading, reducing speculative activities in retail banking to lower the risk of bankruptcy.

Although retail banking customers may believe that their deposits are very safe, this is not the case. The collapse of Silicon Valley Bank in 2023 due to liquidity depletion caused by a mismatch in funding is a bloody lesson.

Banks earn profit by investing (lending) deposits to make a spread, balancing profit and risk behind the scenes. Most users do not understand how banks handle their deposits, although banks can essentially guarantee the safety of deposits during turbulent times.

Credit is an extremely important part of banking operations and is a way for banks to increase the money supply and the efficiency of economic capital. Although consumers can view deposits as a relatively risk-free uniform balance due to improvements in regulation, consumer protection, widespread adoption, and risk management.

Stablecoins provide users with many experiences similar to bank deposits and notes—convenient and reliable value storage, exchange medium, lending—but in a non-custodial "self-custodial" form. Stablecoins will mimic their fiat currency predecessors, starting with simple bank deposits and notes, and as on-chain decentralized lending protocols mature, asset-backed stablecoins will become increasingly popular.

Looking at Stablecoins from the Perspective of Bank Deposits

Against this background, we can evaluate three types of stablecoins from the perspective of retail banking: fiat-backed stablecoins, asset-backed stablecoins, and strategy-backed synthetic dollars.

fiat-backed stablecoin

Fiat-backed stablecoins are similar to banknotes from the era of the National Banking Act in the United States (1865-1913). At that time, banknotes were bearer instruments issued by banks, and federal regulations required that customers could redeem them for an equivalent amount of dollars or other fiat currencies. Although the value of banknotes may vary depending on the issuer's reputation, accessibility, and solvency, most people trusted banknotes.

Fiat-backed stablecoins follow the same principles. They are tokens that users can directly exchange for easy-to-understand, trusted fiat currency. Over time, people have increasingly believed that they can reliably find high-quality stablecoin issuers through various exchanges.

Currently, the combination of regulatory pressure and user preferences is attracting more and more users to turn to fiat-backed stablecoins, which account for over 94% of the total supply of stablecoins. The two companies, Circle and Tether, dominate the issuance of fiat-backed stablecoins, having issued over $150 billion of USD-dominated fiat-backed stablecoins.

In order to address the potential risk of a "bank run", fiat-backed stablecoins undergo audits by reputable accounting firms and obtain local licensing qualifications as well as comply with regulatory requirements. These audits aim to ensure that stablecoin issuers have sufficient fiat currency or short-term treasury bill reserves to cover any short-term redemptions, and that issuers have a total amount of sufficient legal collateral to support the redemption of each stablecoin at a 1:1 ratio.

Verifiable reserve proofs and decentralized issuance of fiat stablecoins are feasible paths, but they are not widely adopted at present. Verifiable reserve proofs can be implemented through methods like zkTLS, although they still rely on trusted centralized authorities. Decentralized issuance of fiat-backed stablecoins may be viable, but there are significant regulatory issues.

asset-backed stablecoin

Asset-backed stablecoins are the products of on-chain lending protocols, mimicking how banks create new money through credit. Decentralized over-collateralized lending protocols issue new stablecoins that are backed by highly liquid on-chain collateral.

This is similar to a demand deposit account, where the funds in the account are part of the creation of new funds facilitated by a complex system of lending, regulation, and risk management. In fact, most of the money in circulation, known as the M2 money supply, is created by banks through credit.

The system that allows credit to create new money is called the fractional reserve banking system, which originated from the Federal Reserve Act of 1913. Since then, the fractional reserve banking system has gradually matured and undergone significant updates in 1933, 1971, and 2020.

Traditional financial institutions use three methods to safely issue loans: against assets with liquid markets and rapid clearing practices (margin loans); conducting large-scale statistical analysis on a set of loans (mortgages); and providing thoughtful and tailored underwriting services (commercial loans).

On-chain decentralized lending protocols still only account for a small portion of stablecoin supply, as they are just getting started. The most well-known decentralized over-collateralized lending protocols are transparent, thoroughly tested, and conservative. They have strict regulations regarding collateralization ratios and effective governance and liquidation protocols to ensure that collateral can be safely sold, thereby protecting the redemption value of asset-backed stablecoins.

Users can evaluate mortgage loan agreements based on four criteria: governance transparency; the ratio, quality, and volatility of the assets supporting stablecoins; the security of the smart contracts; and the ability to maintain the loan-to-collateral ratio in real-time.

As more economic activities shift onto the blockchain, two things are expected to happen: first, more assets will be used as collateral in on-chain lending protocols; second, asset-backed stablecoins will account for a larger share of on-chain currency. Other types of loans may eventually be safely issued on-chain, further expanding the on-chain money supply.

strategy-supported synthetic dollar

Recently, some projects have launched tokens with a face value of 1 dollar, which represent a combination of collateral and investment strategies. These tokens are often confused with stablecoins, but strategy-supported synthetic dollars (SBSD) should not be regarded as stablecoins.

SBSD exposes users directly to the trading risks of active asset management. They are typically centralized, under-collateralized tokens with characteristics of financial derivatives. More accurately, SBSD represents dollar shares in an open-ended hedge fund, a structure that is both difficult to audit and potentially exposes users to risks associated with centralized exchanges and asset price volatility.

These attributes make SBSD unsuitable as a reliable store of value or medium of exchange. SBSD can be built on various strategies, such as basis trading or participating in yield generation protocols. These projects manage risks and returns, often allowing users to earn returns based on cash positions.

Users should thoroughly understand the risks and mechanisms before using any SBSD. DeFi users should also consider the consequences of using SBSD in DeFi strategies, as decoupling can lead to severe chain reactions.

Although banks do implement simple strategies for deposits and are actively managed, this only accounts for a small portion of the overall capital allocation. It is difficult to scale these strategies to support the overall stablecoin, as they must be actively managed, which makes these strategies hard to reliably decentralize or audit.

In fact, users have always been cautious about SBSD. Although they are popular among users with a higher risk appetite, very few users trade with them. Furthermore, regulators have taken enforcement actions against "stablecoins" that have features similar to investment fund stocks.

Conclusion

The era of stablecoins has arrived. There are over 160 billion USD worth of stablecoins used for trading globally, mainly divided into fiat-backed stablecoins and asset-backed stablecoins. Other dollar-denominated tokens, such as strategy-backed synthetic dollars, have seen increased recognition, but do not meet the definition of stablecoins as a store of value and medium of exchange.

The history of the banking industry provides a useful reference for us to understand the stablecoin asset class. Stablecoins must first be integrated around a clear, understandable, and easily exchangeable form of currency, similar to how Federal Reserve notes gained public recognition in the 19th and early 20th centuries.

As time goes by, we expect the number of asset-backed stablecoins issued by decentralized over-collateralized lending protocols to increase, just as banks have increased the M2 money supply through deposit credits. At the same time, we anticipate that DeFi will continue to grow, creating more SBSD for investors and enhancing the quality and quantity of asset-backed stablecoins.

Stablecoins have become the cheapest way to remit, which means they have the opportunity to restructure the payment industry and create opportunities for existing businesses and startups. Stablecoins are building a new payment platform that is frictionless and low-cost, which will bring vast development space for financial innovation.