The Nature of Stablecoins

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Stablecoins offer an opportunity to fix a long term problem in traditional finance, to understand more we need to know what they are, and what they aren’t. Prepared by CEO and Co-Founder of PennyWorks, Ivan Zhang.

A Stablecoin is a Loan

Fundamentally, a stablecoin is a loan. The issuer is receiving some sort of collateral, which may be $1 USD in the case of USDC/USDT centrally issued stablecoins, or $1.3 USD worth of Ethereum in the case of the DAI stablecoin, and then the issuer mints a stablecoin.

The coin’s stability depends on the reliability of the issuer to give you back that collateral when you return the stablecoin. Makes sense, right?

Let’s get a little more specific:

In the case of DAI, because of ETH’s large ecosystem and much higher collateralization requirements, it does not suffer the same pro-cyclical design issues that plague other stablecoins. (Like, say, LUNA.)

However, is it risk-free?

Nothing is risk-free. In the case of centralized issuers, there is counterparty risk. In the case of over-collateralization, there is a risk that the collateral value drops precipitously.

It is essential to frame the discussion around stablecoins and lending right now because there is a lot of misinformation floating around the web.

Most people don’t realize that when you put a dollar into a bank, you have a liability on the bank’s balance sheet. The number you see on your mobile is just the bank’s ledger.

The money is not sitting in a vault with your name. It’s pooled and available to use at the bank’s discretion.

The bank can lend and use your dollars to trade. It has risk limits and controls, but the bank doesn’t answer to you; it responds to bank regulators.

The system works well if bank regulators are the best agents to proactively find risks and craft policies that incentivize prudent risk management. But as we’ve seen over the last few financial crises’, this arrangement is less than ideal.

Of course, that doesn’t mean the regulators cannot reduce the risks of this arrangement; it can categorically outlaw classes of activities and dramatically reduce the flexibility of banks in deciding what they can do with depositors’ money.

But even a decade after the financial crisis, we still see regular blow ups including:

  • Archegos capital loss from prime brokerage services, an otherwise sleepy business focused on lending.
  • Robinhood and GME trading, causing massive short squeeze and exchange halts.
  • Money market fund failures, especially in 2008.
  • And again in 2021.

Most recently, major currencies such as EUR and JPY have seen dramatic drops in value relative to the dollar in the last few weeks, meaning that even national currencies of developed countries are not immune to significant market fluctuations.

So would it be possible to envision a day where a system of currency would be not within the control of any particular nation but can serve as a medium of exchange and a unit of account for goods and services that would be deemed “more” stable than sovereign alternatives?

I sure think so, but we are not there yet. One thing’s for sure, the road ahead will be full of interesting surprises.