A Stablecoin Love Letter

ZK rollups, liquid staking derivatives, and app-chains might command the attention of most crypto users recently, however the most promising and successful technological evolution over this past bull run has been the widespread adoption of the humble stablecoin. Amidst the ponzis and other nefarious activities that plagued crypto markets over the past few years, the stablecoin has continued its ascendance to mainstream adoption and solidified a strong foothold for crypto’s long-term existence as viable financial plumbing, something Bitcoin has failed to achieve at scale.

In short, stablecoins are a better mousetrap. When it comes to digital payments and remittances, stablecoins improve upon almost every core characteristic needed for their success: they are cheaper, faster, more flexible in their design, and globally scalable.

Increased Trust Assurances Drive Global Scale

Economically, stablecoins can help scale digital financial services to the next billion+ users, something fintechs have failed to do without incurring the excessive costs of legacy payment infrastructure. According to Deloitte research, “the digital payments industry recorded high growth in capital expenditure and R&D between 2016 and 2021 (CAGR:13%), in line with the global increase in the value of digital transactions. Companies have to invest heavily in infrastructure such as data centers and server farms to secure the processing of large numbers of transactions and to maintain existing infrastructures at a state-of-the-art level”. Stablecoins remove most of these costs as security and auditing functionalities can be outsourced to a public blockchain.

Stablecoins also allow merchants significantly improved economics by removing intermediaries, such as Paypal and Square, who charge egregious take rates to process payments (For context, Paypal charges up to 3.49% + 49 cents per transaction for business accounts and Square charges up to 3.5% + 15 cents.). In a low margin business such as convenience stores, this can be the difference between profitability and bankruptcy. Global transfer and remittance fees are also eliminated with the use of stablecoins, as they allow transfers to happen at the same cost regardless of the end-location of the receiver. As such, it is clear to see that Web2 fintechs cannot compete in a stablecoin world. Stablecoins can leverage public blockchains to absorb costs for stablecoin providers, whereas fintechs must reinvest in Capex and R&D to ensure adequate security, user experience, and network scalability. Such savings are akin to our own business model that offloads most back- and middle-office activities by leveraging public blockchains and decentralized applications, as opposed to traditional asset managers who must invest heavily in their operational infrastructure. In short, credibly neutral public blockchains replace expensive operational controls needed for user trust.

Akin to a horse drawn carriage competing with the automobile, current financial infrastructure fails to keep pace with stablecoins in terms of speed and settlement finality. While modern digital payments via credit and debit cards allow for purchases to finalize in seconds, back-end settlement is far messier. Typically, it takes 48–72 hours for merchants to receive funds from payment providers, increasing working capital requirements for merchants and exposing issuer banks to counterparty risks. Further, as card-not-present payments increase, incentivizing merchants to reduce fraud by eliminating settlement risk is a huge and often overlooked benefit. International payments are far worse, with some providers taking up to five business days to process transactions while there is little accountability for where the money is during the processing period due to the opaque nature of correspondent banking. Remittances are even worse. In a world of instant messages, global high-speed internet and 24/7 markets, this is unacceptable.

Reducing Barriers, Driving Access to Capital Formation

Stablecoins are not hamstrung to certain regions or countries and operate separate from man-made borders. Ultimately, this improves international commerce and lowers the barrier to entry for disenfranchised groups who might not have access to financial products besides physical cash. Moreover, stablecoins allow any individual with an internet connection access to 24/7 FX markets. We have seen the importance of this recently in Argentina, Lebanon, and Turkey, where consumers rely on USDT to protect savings in countries without easy access to traditional US Dollar financial products and savers can then easily convert savings back into local currencies to purchase local goods. As a byproduct of their global reach, stablecoins also make global markets more efficient. Funds can be sourced globally and aggregated at scale to create deeper liquidity in markets compared to fragmented national banking networks. Further, the fungibility and interoperability capabilities of stablecoins across various applications and devices help stablecoins stand out from the crowd compared to the siloed and non-fungible Web2 alternatives.

As it stands with current mainstream digital payments tech, most platforms operate in isolation from each other. Silos create unnecessary barriers to commerce, P2P payments, and general ease of use, and can entice providers to continue extractive and rent-seeking behaviors. Take for instance a situation wherein an eBay vendor with a PayPal account tries to pay a bill to someone with only a Cash App account. A simple direct transfer between these two different providers is currently not possible. Instead, the eBay vendor would need to transfer the funds from PayPal to an intermediary bank (with a 24–48 hour processing period), then set up a Cash App account hooked to the bank account for final payment, which could also cause additional delays if Cash App needs further information for KYC and funding information purposes. With stablecoins, this simply goes away as 1 USD is equal to 1 USD and personal accounts are self-custodied on-chain, regardless of what application or end-provider is used for payment wallets. DEX swaps can easily convert currencies in the case of users wanting to pay in different stablecoins. Additionally, sub-penny transactions are now possible with stablecoin designs that were simply untenable previously. This opens the door to new payment schemes such as perpetual payment protocols like Superfluid Finance and others. Now, artists can receive royalties on a per block basis rather than waiting months for payouts and uber rides can be structured to be paid out on a per-mile basis as the ride progresses.

Trends and Barriers to Adoption

And now you may be asking yourself, if stablecoins are a better mouse trap, what could drive adoption? How could the industry look as it matures past speculative ponzis and institutionalizes into the mainstream? At a high level, we believe the most obvious outcome is an oligopoly forming overtime that solidifies a handful of blue-chip providers commanding the majority of global liquidity. We see this as the most likely outcome due to regulatory pressure and the need to prevent liquidity fragmentation destroying the end user experience. Zooming in on the regulatory aspect, OFAC and FINCEN requirements will remain costly endeavors for incumbents and so only the best-funded entities will stand a chance at scaling regulatory costs and fulfilling all current (and prospective) legal requirements for continued operations. We have seen this recently with the SEC fight with Paxos. If Paxos did not have sufficient capital buffers, they would have folded to all demands made by the SEC and ultimately forced out of business. Being on the good side of regulators is also paramount to maintain access to capital markets. Without access to treasury bonds, the business model of stablecoins would become unprofitable and/or providers will be forced out the risk curve toward inappropriate sources of yield. In turn, stablecoins could lose their status as a truly stable asset fit for commerce and instead become fiat-based derivatives with excessive counterparty credit risks. Stablecoin business models must be myopically focused on minimizing risks.

Another trend to follow will be who wins the fight for stable coin denominations. US dollar-backed stablecoins currently dominate, but US dollar dominance could wane if regulatory uncertainty turns toward outright hostility. The lack of regulatory clarity leaves the door open to geopolitical rivals to the dollar, with our eyes increasingly focused on developments in Hong Kong and Europe. Hong Kong is in a unique position to capture incremental demand as recent legislation should open the door to licensed exchanges and more mainstream adoption. Combine regulatory clarity with a US Dollar-peg and a top-tier banking system, and once could foresee HKD stablecoin growth in coming years. By proxy, the USD could continue to be used, but with a new wrapper and little oversight from the West. In Europe, the passing of MiCA, which is set to come into effect in 2024, could also pose a strong challenge to dollar dominance. MiCA legitimizes stablecoins as an asset class and provides a pathway to their regulation and existence within financial markets. With the Euro the second most used currency in global trade, leadership on regulatory clarity cannot be taken lightly. In short, American legislators and regulators will need to take a balanced approach, promoting innovation while also protecting global US dollar dominancy. We believe legal clarity from US legislators and regulators could very well secure US dollar dominance for another generation and so what to do with stablecoins is not just a crypto-native problem, but a distinctively American geopolitical issue.

Regardless, markets for unregulated stablecoins are likely to remain. Providers such as Tether, operating with minimal oversight, are likely to continue to see success in underbanked regions of the world. While we believe unregulated stablecoins will not see true real world commerce volume or adoption given the uncertainties, P2P payments and local commerce are likely to remain large drivers of demand going forward. This will be particularly true in areas of the world that are financially handicapped by OFAC, such as Iran or Russia, as more legitimate providers such as Circle and Paxos are expected to block addresses deemed to be in connection with these regions. So, while compliant stablecoin providers take the lead on KYC/AML requirements, non-compliant stablecoin providers could see integration opportunities coalesce around fringe markets and use cases.

Paths to Scaling Real World Adoption

With $140bn in stablecoins outstanding, clearly the market is seeing impressive penetration already, but where has growth been most remarkable and what might catalyze further adoption? In a study from Mastercard in July 2022, the company found 36% of survey recipients were planning to use crypto as a means of payment over the next year. Meanwhile, in inflation-torn Latin America, 51% of consumers have already made a crypto transaction and 33% have used stablecoins for everyday transactions. Not too dissimilar from internet adoption, grey market activities are where “marginal” users see the most visible benefits to stablecoin usage. Adoption trends are most pronounced where predatory fees crowd low-income consumers into black markets, the lack of access to basic traditional financial products, and/or there is a preference to US dollars, but a scarcity of dollars. Pornography, which was instrumental in the early growth of Blu-Ray and VHS and spurred massive growth for early internet adoption, may catalyze additional demand as the industry struggles with banking access and a digitally native currency reduces frictions. Areas of the world with strict pornography laws and limited access to dollars are taking part.

Importantly for both merchants and consumers, the risks of credit card identity theft goes away. The FTC reported over 2.8 million credit card fraud cases in 2021 alone and a Nilson report estimated US and Global losses from card fraud to be $165 and $400bn over the next 10 years. Moreover, global travelers will likely see this as benefit given the disparate card networks throughout the world. Pools of money are now freely shareable within a defined group, globally, driving fees on international remittances rates (regularly 7–10% of transaction volume) to zero. Tipping to online creators to bypass platform take rates is another under-penetrated area where we’d expect strong growth given the ease and low cost of P2P stablecoin transfers. In sum, instead of the typical progression of technology adoption driven by the consumer, it seems as if stablecoin adoption could be driven by business and merchant adoption who will see the largest benefits from transitioning to the stablecoin economy. With the prospect of declining user incentives, such as cash back or purchase price deductions (as is common with cash payments), developed world consumers should become increasingly incentivized to make the jump. As for emerging market consumers, they already rely on it for daily usage and greater regulatory clarity could further entrench usage and US dollar dominancy.

Fractional Reserve Banking: Crypto’s Achilles Heal

While we originally wrote this paper before Silicon Valley Bank’s demise, there are clear implications for stablecoin issues in light of banking uncertainty in the United States and abroad. As is apparent with the collapse of Credit Suisse, SVB, Signature and potentially other large financial institutions in the coming weeks and months, stablecoins will need to reassess their on-off chain liquidity strategies and minimize counterparty risk with financial institutions to prevent any perception of less than 100% backing. This could be accomplished by holding no overnight balances with banking institutions and use bank accounts to disburse cash during the business day before draining deposits out at the end of the day similar to a sweep account. This will ultimately minimize counterparty risk with fractional reserve banking entities to intra-day and prevent non-FDIC insured balances being exposed for extended periods of time.

As the banking industry continues down its long path of consolidation, working directly with the FED and other central banks should become increasingly important in order to access the Reverse-Repo market and other comparable liquidity tools that will replace the need for bank accounts altogether. Utilizing the RRP market for short-term funds will in turn provide Circle and other stablecoin issuers an extremely liquid yield-bearing instrument to hold short term cash overnight as opposed to bank accounts. Withdrawal requests can then be queued on a daily basis with payouts on the next day, pulling needed liquidity from the RRP market that settles overnight. Overall, this will improve capital efficiency as funds will accrue interest, improve stablecoin provider margins, and potentially open the door for yield-bearing stablecoins by passing excess interest revenue on to end-holders. In effect, this strategy creates a safer and more profitable business strategy for all parties and can help bring stablecoins closer to their ultimate goal of becoming a true digital dollar equivalent and instill confidence that stablecoins are always 1:1 backed. At the end of the day, fully reserved stablecoins are little different than money market mutual funds (or fully reserved banks) that access the Fed’s RRP facility and we believe the Fed extending this privilege is geopolitically vital to preserving global dollar dominance longer term as cryptodollars proliferate globally. If the recent denial of Custodia Bank’s master account application to the Fed is any indication, Fed access by a stablecoin provider is unlikely to happen over the near term. As a result, other more friendly regulatory governments will take up the torch, leaving the Federal Reserve and the dollar at risk of being left behind.

Over-collateralized stablecoins such as DAI have a different pathway to safe and effective management of counter-party risk. Specifically, DAI will need to diversify their underlying asset basket away from USDC and other fiat-backed stablecoins to prevent DAI (or others) from “going down with the ship”. On-chain collateralized stablecoins were made to be resistant to events such as a banking crisis but ended up in the crossfire due to too much exposure to USDC and other fiat backed stablecoins via collateralized UNI USDC LP positions and their Pegged Stability Modules. For context, stablecoins predominately from PSM’s accounted for ~$3Bn of collateral backing for DAI as of recently. As such, we believe it to be prudent that Maker and others use this as a learning opportunity going forward and consider limiting this basket of collateral to a more conservative percentage such as 10%. Maker has been working particularly hard to diversify assets via RWA initiatives, and we believe this to be the right move. Differentiating themselves as the true on-chain stablecoin juggernaut via RWA initiatives and staying true to their vaults for crypto-native collaterals should drive future, more stable growth.

The Infrastructure is Built, What Could the Market for Stablecoins Look Like?

Regarding the rate of adoption for stablecoins in coming years, we believe they could mimic internet and smartphones adoption trends. To gain a high-level understanding of the potential addressable market over the next 5- and 10-year periods, we utilized blended compound annual growth rates (“CAGRs”) for worldwide internet and smartphone adoption starting at 1995 for the internet and 2005 for smartphones. As such, we estimate stablecoin volumes outstanding could grow at a c. 70 and 44% CAGRs over the next five and ten years, respectively. Below, we estimate the total dollar value of stablecoins contributing to the global payments market as well as the total money supply.

Per Juniper research, the global B2B payments market is estimated to be $35Tn as of 2022. We also know that there are c. $140Bn in stablecoins outstanding as of early 2023. Using these two data points, we set out to estimate their current contribution to global payments. To do this, we conservatively estimate a stablecoin money velocity multiplier range for stablecoins to determine the impact each $1 of stablecoins outstanding could have on gross global payment volumes. From 1970 to pre-covid (after which the data becomes murky due to extraordinary monetary growth) M1 money velocity within the United States trended between 5–10 turns per year. As such, we use a 5x multiplier on the low end and a more conservative 8x multiplier on the high end. Ultimately, this resulted in a current contribution of 2–3.2% of total global payments or $690Bn-$1.1Tn annually. Looking forward, and using the long-term CAGR adoption rates, we arrived at a 23–36.7% contribution to global payment volume or $9.7Tn-$15.5Tn by 2028, and 53.6–85.8% or $27.2-$43.6Tn by 2033.

Separately, we incorporated our assumptions of stablecoin penetration growth into a money supply analysis. First, we combined the current total outstanding money stock for developed markets (US, Australia, Canada, EU, UK, and Japan) which totaled c. $56.1Tn and divided it by the current stablecoin supply previously referenced to arrive at 0.25% for the percentage of developed market currency currently denominated in stablecoins. We then utilized the growth rates previously described to calculate forward projections to this number resulting in an estimated $2.5 Tn in stablecoins outstanding by 2028 and $8.8Tn by 2033.

In sum, we believe stablecoins could see similar rates of adoption as the internet or mobile phones given their material improvements to financial transactions and limited technological barriers. There seems little doubt the stablecoin market could be huge, but there remain open questions regarding regulatory, KYC-AML frameworks impeding progress and steering the landscape toward new winners and losers. It should be mentioned that stablecoins are likely to grow regardless of what governments want. As such, regulators, legislators, and their constituencies will have to decide whether to allow stablecoins to be created and managed domestically or risk more shadow financial services like Terra or geopolitical rivals to fill the void. The future is bright and we are excited to play a responsible role in pushing toward a more open, frictionless financial system.

By: Christian Lantzsch and Sefton Kincaid, CFA