a16z: A look at the future of stablecoins from the history of banking in the US

Original text:A useful framework for understanding stablecoins: Banking history(a16zcrypto)

Author:Sam Broner

Despite the fact that millions of people have already used stablecoins and traded trillions of dollars in value, the definition of the stablecoin category and how it is understood remains vague.

Stablecoins are a store of value and a medium of exchange for value, usually (but not always) pegged to the U.S. dollar. Although stablecoin has only been in development for a short period of 5 years, its evolutionary path in two dimensions is very informative: 1. from undercollateralization to overcollateralization, and 2. from centralization to decentralization. This is very useful in helping us understand the technical structure of stablecoins, as well as dispelling market misconceptions about them.

Stablecoin, as a payment innovation, has simplified the way value is transferred. It has constructed a market parallel to traditional financial infrastructure and has surpassed even the major payment networks in terms of annual transaction volume.

By learning from history, we can know the rise and fall.If we want to understand stablecoin design limitations and scalability, a useful lens is the history of the banking industry to see what works, what doesn't, and the reasons behind it. Like many products in cryptocurrencies, stablecoins may replicate the history of the banking industry's development, starting with simple bank deposits and notes, and then implementing increasingly sophisticated credit to expand the money supply.

As a result, this article will provide a look at the future of stablecoin development through the lens of the history of the U.S. banking industry by compiling a16z Partner Sam Broner's article A Useful Framework for Understanding Stablecoins: Banking History.

The article will begin by describing the development of stablecoins in recent years and then compare the history of the U.S. banking industry to enable a valid comparison between stablecoins and banking. In doing so, the article will look ahead by exploring three recently emerging stablecoin currency forms: legally-backed stablecoins, asset-backed stablecoins, and strategically-backed synthetic dollars. 

Key Takeaways

The compilation has been very enlightening, and in its essence, escapes the three axes of bank monetarism.

• Although the payment innovation of stablecoins may seem to disrupt traditional finance, the most important thing to go by is to understand that the essential attributes of money (scale of value) and its core function (medium of exchange) are unchanged. As such, stablecoins can be described as the vehicle or manifestation of money.
• Since it is essentially money, the pattern of development over centuries of recent modern monetary history is extremely informative. This is the merit of Sam Broner's article, as he not only sees the issuance of money, but also the subsequent use of credit by banks as a tool for money creation. This directly points the way to stablecoins, which are still in the currency-issuing phase.
• If fiat currency-backed stablecoins are the popular choice for the current currency issuance phase, asset-backed stablecoins will be the choice for the subsequent credit creation currency phase. My personal view is that as more and more illiquid RWA tokenized assets come to the chain, their mission is not to circulate, but to be collateralized and serve as underlying assets for credit creation.
• Looking at strategy-backed synthetic dollars, due to the design of the technical structure, which is bound to be subject to regulatory challenges as well as user experience barriers, it is currently more often applied to DeFi yield products, making it difficult to break through the impossible triangle of investing in traditional finance: return, liquidity and risk. However, we have seen some recent breakthroughs in the use of interest-bearing stablecoins with U.S. debt as the underlying asset, as well as innovative model applications such as PayFi, which integrates DeFi into payments and transforms every dollar into smart, autonomous money.
• Finally, it is necessary to return to the essence: the birth of stable coins, synthetic dollars or special currencies is aimed at further highlighting the essential attributes of money through digital currency and blockchain technology, strengthening its core functions, enhancing the efficiency of currency operation, reducing operating costs, tightly controlling risks, and giving full play to the positive role of money in promoting the exchange of value and the application of economic and social development.

I. History of Stablecoin 

Since Circle launched USDC in 2018, there has been enough evidence over the years to show which paths stablecoins work on and which don't.

Early adopters of stablecoins used legally backed stablecoins to transfer and save money. While stablecoins generated by decentralized overcollateralized lending protocols have been both useful and reliable, actual demand has been lackluster. So far, users seem to strongly prefer USD-denominated stablecoins over other (fiat or new) denominations.

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

Other types of dollar-denominated tokens have emerged to capitalize on the successful product market fit adopted by current stablecoins. Strategy-Backed Synthetic Dollars like Ethena, for example, is a new product category that has yet to be fully defined. While similar to stablecoins, they have not yet reached the level of security standards and sophistication required for fiat-backed stablecoins, and are currently being adopted more by DeFi users to take on higher risk and earn 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. The adoption of Asset-Backed Stablecoins has lagged, with this asset class accounting for the largest share of deposit investments in the traditional banking system.

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

II. History of banking in the United States: bank deposits and United States currency

To understand how the current stablecoin mimics the banking system for development, it is especially helpful to understand the history of the U.S. banking industry.

Prior to the Federal Reserve Act of 1913, and especially prior to the enactment of the National Bank Acts of 1863-1864, different forms of money forms had different risk ratings and therefore different real values.

The "real" value of Bank notes (Cash), Deposits, and Checks can vary widely depending on three factors: the issuer, the ease of cashing, and the trustworthiness of the issuer. In particular, prior to the creation of the Federal Deposit Insurance Corporation (FDIC) in 1933, deposits had to be specifically insured against bank risk.

In this period, one dollar ≠ one US dollar.

The reason? Because banks faced (and still face) a tension between keeping deposit investments profitable and keeping deposits safe. In order to realize deposit investment profitability, banks need to release loans and take on investment risk, but in order to keep deposits safe, banks need to manage risk and hold positions.

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

Today, banks use U.S. dollar deposits to buy Treasuries and stocks, make loans, and engage in simple strategies such as market making or hedging under the Volcker Rule, which was introduced in the context of the 2008 financial crisis to reduce the risk of insolvency by limiting banks from engaging in risky proprietary trading activities and by reducing the speculative activities of retail banks.

While retail banking customers may think all their money is safe in deposit accounts. But that's not the case, and looking back at the Silicon Valley bank failures that occurred in 2023 due to a mismatch of funds that led to a liquidity drain is a bloody lesson for our market.

Banks make a profit by investing their deposits (lending money) to earn a spread, banks balance making money and risk behind the scenes, and users are mostly unaware of what the banks actually do with their deposits, even though in times of turmoil banks can essentially guarantee that theDeposit securityThe

Credit is a particularly important part of banking and a way for banks to improve the efficiency of the money supply and the capitalization of the economy. This is despite the fact that, as a result of federal supervision, consumer protections, widespread adoption, and improved risk management, consumers can view deposits as relatively risk-free flat balances.

Returning to stablecoin, it offers users many similar experiences to bank deposits and notes - convenient and reliable storage of value, medium of exchange, lending and borrowing - but in an unbundled "self-custodable " form. Stablecoins will follow the lead of their fiat currency predecessors, and adoption will start with simple bank deposits and notes, but asset-backed stablecoins will grow in popularity as the chain matures with decentralized lending protocols.

III. Stabilized currency from the perspective of bank deposits

Against this backdrop, we can evaluate three types of stablecoins - legally backed stablecoins, asset-backed stablecoins and strategically backed synthetic dollars - through the lens of retail banking.

3.1 Fiat currency-backed stablecoins 

Stabilized coins backed by fiat currency are similar to U.S. Bank Notes from the U.S. National Bank era (1865-1913). During this period, bank notes were bearer instruments issued by banks; federal regulations required that customers could exchange them for the equivalent in U.S. dollars (e.g., special U.S. Treasuries) or other fiat currencies ("coins"). Thus, while the value of bank notes may vary depending on the reputation, reachability, and solvency of the issuer, most people trust bank notes. 

Fiat-backed stablecoins follow the same principle. They are tokens that users can exchange directly for easy-to-understand, trustworthy fiat currency - with a similar caveat: while paper money is a bearer instrument that can be exchanged by anyone, the holder may not live near the bank of issuance, making it difficult to exchange. Over time, people accepted the fact that they could find someone they could trade with and exchange their bills for dollars or coins. Similarly, fiat-backed stablecoin users are becoming more confident that they can use Uniswap, Coinbase, or other exchanges to reliably find high-quality stablecoin acceptors.

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.Two companies, Circle and Tether, dominate fiat-backed stablecoin issuance, together issuing more than $150 billion in US dollar-dominated fiat-backed stablecoins. 

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 address these risks, fiat-backed stablecoins are audited by reputable accounting firms and are subject to local licensing and compliance requirements. For example, Circle is regularly audited by Deloitte. These audits are designed to ensure that the issuer of the stablecoin has sufficient reserves of fiat currency or short-term treasury bills to cover any short-term redemptions, and that the issuer has sufficient total fiat collateral to support the acceptance of each stablecoin on a 1:1 basis.

Verifiable Proof of Reserve and Decentralized Issuance of Fiat Stablecoins are viable paths, but have not seen much adoption.

Verifiable proof of reserves will improve auditability and can currently be achieved through zkTLS (Zero Knowledge Transport Layer Security, also known as Proof of Network) and similar approaches, although it still relies on a trusted centralized authority.

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

3.2 Asset-Backed Stablecoins 

Asset-backed stablecoins are the product 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 the chain.

To understand how it works, try to think of a demand deposit account (Checking Account), where the funds in the account are part of the creation of new funds, through 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. Banks use mortgages, auto loans, business loans, inventory financing, etc. to create money, and similarly, on-chain lending agreements use on-chain assets as collateral, thus creating asset-backed stablecoins.

The system that enables credit to create new money is known as Fractional Reserve Banking (FRB), which really began with the Federal Reserve Bank Act of 1913. Since then, Fractional Reserve Banking has matured and was significantly updated in 1933 (with the creation of the Federal Deposit Insurance Corporation), 1971 (with the end of the gold standard by President Nixon), and 2020 (with the reduction of the reserve ratio to zero). 

With each change, consumers and regulators became more confident in the system of creating new money through credit. First, bank deposits are protected by federal deposit insurance. Second, despite major crises such as those of 1929 and 2008, banks and regulators have been steadily improving their practices and processes to reduce risk.110 Over the years, credit has become a larger and larger portion of the U.S. money supply, and now accounts for the vast majority.

Traditional financial institutions use three methods to securely issue loans:

1. For assets with liquid markets and rapid liquidation practices (margin loans);

2. Large-scale statistical analysis of a group of loans (mortgages);

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

De-centralized lending protocols on the chain still make up only a small portion of the stablecoin supply, as they are just getting started and have a long way to go. 

The best-known decentralized overcollateralized lending protocols are transparent, well-tested and conservative. For example, the best-known collateralized lending protocol, Sky Protocol (formerly MakerDAO), issues asset-backed stablecoins for the following assets: on-chain, exogenous, low volatility, and high liquidity (easy to sell.) Sky Protocol also has strict rules on collateralization rates, as well as effective governance and liquidation protocols. These attributes ensure that collateral can be safely sold 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. Transparency in governance;

2. Proportion, quality and volatility of assets backing the stablecoin;

3. Smart contract security;

4. Ability to maintain loan-to-value ratios in real time.

Like funds in demand deposit accounts, asset-backed stablecoins are new funds created through asset-backed lending, but their lending practices are more transparent, auditable and easy to understand. Users can audit the collateral for asset-backed stablecoins, which distinguishes them from the traditional banking system where one can only entrust one's deposits to bank executives for investment decisions. 

In addition, the decentralization and transparency enabled by blockchain can mitigate the very risks that securities laws are designed to address. This is important for stablecoins because it means that truly decentralized asset-backed stablecoins may be beyond the scope of securities laws - an analysis that may be limited to assets that rely exclusively on digitally native collateral (as opposed to "real-world assets") backed stablecoins. This is because such collateral can be protected through autonomous agreements rather than centralized intermediaries.

As more and more economic activity is moving up the chain, two things are expected to happen:First, more assets will become collateral used in on-chain lending agreements; second, asset-backed stablecoins will account for a larger share of on-chain currency. Other types of loans may eventually be securely issued on-chain to further expand the on-chain money supply.

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

3.3 Synthetic Dollars for Strategy Support

Recently, a number of projects have launched tokens with a face value of $1. These tokens 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. The reasons are as follows:

Strategy-backed synthetic dollars (SBSD) expose users to direct trading risk in active management of assets. They are typically centralized, undercollateralized tokens with financial derivative properties. More accurately, SBSDs are dollar shares in open-ended hedge funds - 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 significant market volatility or a sustained drop in sentiment. 

These attributes make SBSDs unsuitable for use as a reliable store of value or medium of exchange, which are the most prominent uses of stablecoins.While SBSDs can be structured in a variety of ways, with varying levels of risk and stability, they all offer U.S. dollar-denominated financial products that people may wish to include in their portfolios.

SBSDs can be built on a variety of strategies - for example, basis trading or participation in revenue-generating protocols such as Restaking repledging protocols that help safeguard Active Verification Services (AVSs). These programs manage risk and reward and typically allow users to generate returns on top of their cash positions. By managing risk with return, including evaluating AVSs to reduce risk, looking for opportunities for higher returns, or monitoring basis trades for inversions, programs can generate a return-generating strategy to support synthetic dollars (SBSD).

Users should have an in-depth understanding of the risks and mechanics of any SBSD before using it (as with any new instrument.) DeFi users should also consider the ramifications of using SBSDs in a DeFi strategy, as decoupling can have serious knock-on effects. Derivatives that rely on price stability and stable returns can be suddenly destabilized when an asset decouples or suddenly depreciates relative to its tracking asset. However, underwriting the risk 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 a small fraction of the overall capital allocation. It is difficult to use these strategies at scale to support stablecoins as a whole because they must be actively managed, which makes them difficult to reliably decentralize or audit.SBSD exposes users to greater risk than bank deposits. Users are justifiably skeptical if their deposits are held in such an instrument. 

In fact, users have always been wary of SBSDs. Despite their popularity among users with a higher risk appetite, few users have traded with them. In addition, the SEC has taken enforcement action against those who issue "stablecoins," which function like shares in an investment fund.

IV. FINAL

Stablecoin's time has come. There are more than $160 billion in stablecoins being traded globally. They fall into two main categories: fiat-backed stablecoins and asset-backed stablecoins.Other dollar-denominated tokens, such as the strategy-backed Synthetic Dollar, have grown in recognition but do not meet the definition of a stablecoin as a store of value and medium of exchange. 

Banking history is a good indicator for understanding the stablecoin asset class - stablecoins must first be consolidated around a clear, understandable, and easily redeemable form of money, similar to the way Federal Reserve bills gained mass awareness in the 19th and early 20th centuries.

Over time, we should expect the number of asset-backed stablecoins issued by decentralized overcollateralized lending agreements to increase, just as banks have increased the M2 money supply through deposit credit. Finally, we should expect DeFi to continue to grow, both creating more SBSD for investors and increasing the quality and quantity of asset-backed stablecoins.

As useful as this analysis may be, it is more important that we look at the current situation. Stablecoin is already the cheapest way to send money, which means it has a real opportunity to reshape the payments industry and create opportunities for existing businesses. More importantly, creating opportunities for startups to build on a new frictionless, cost-free payments platform.