The UST fiasco showed the danger of algo-stablecoins, but in Europe, fiat stablecoins remain a losing business
Negative interest rates and strict regulations have stymied the rise of fiat-backed Euro stablecoins.
Introduction
The downfall of Terra’s UST stablecoin and its backing currency LUNA has the entire crypto space discussing the topic of stablecoins. They have played a central role in the crypto markets for several years and are increasingly drawing the attention of regulators around the globe.
While the conversation is largely focused on the topic of algorithmically-backed vs fiat-backed stablecoin reserves, in this article we’d like to examine a different cross section: the dominance of US-dollar based stablecoins and the reasons why a Euro-backed stablecoin has yet to reach popularity.
In case you missed it: UST’s demise demonstrates the danger of algorithmically backed stablecoins
The death-spiral of Terra’s UST wiped out crypto’s largest algorithmically-backed stablecoin, which at its peak commanded $18b of market capitalization. Algo-stablecoin like Terra seek to maintain the peg of a token’s value to that of a fiat currency, while holding only crypto currencies in reserve. Such stablecoins are the least reliant on any single party, but also the most delicate. It’s safest to rely on a third party to hold fiat currencies in a central account and issue stablecoins against that reserve, and as we pointed out in our recent Twitter thread, these fiat-backed currencies make up over 80% of the stablecoin market.
The rapid growth of stable coins has not included Euro-coins
The value that stablecoins provide to the market is obvious from the size of their ever-growing market capitalization. In 2021, while the rest of the crypto market chopped sideways, the market capitalization of stablecoins steadily rose from $36b to $168 billion, an increase of over 460%.
Taking a look at the top stablecoins reveals another fact: the market is totally dominated by USD-denominated stablecoins. Only $0.5b of the entire $162b stablecoin market is from Euro stablecoins — less than 0.3%. But why? It’s true that the Dollar is the world’s reserve currency, but the EU makes up about 20% of the world’s GDP, and 35% of the global SWIFT payments are made in Euros. We’d accordingly expect the size of the Euro stablecoin market to be roughly 100x bigger, so what’s the cause for such a massive discrepancy?
Negative interest rates: A massive hurdle for (fiat-backed) Euro-stablecoins
The business of fiat-stablecoin issuers is simple: receive money into a bank account and issue tokens representing that cash. Revenue comes from transaction fees (for minting or redeeming tokens) and interest earned on the cash. Of course, the interest rate in the US is not high by any means, and stablecoin issuer Tether infamously tried to earn more by holding at one point almost half its reserves in commercial debt. (That ratio is still at 30%, and is being moved into US Treasuries.) Since the beginning, Tether was notoriously bad at providing transparency around the reserve backing of their USDT stablecoin. Stablecoin issuer Circle (USDC) has upheld a better reputation, confirming that their reserves are backed by cash and short-duration treasuries.
Stablecoin issuers don’t need to cut corners and take risks — simply holding cash in a bank account is a sustainable business model in the United States, where the interest rate is positive, but in Europe it’s a different story. Already since 2014 the European Central Bank (ECB) has imposed a negative interest rate on reserves that banks hold at the ECB. By September of 2019 this number was -0.50%, which is where it remains today. This means that banks sitting on deposits have to pay for them, which is why banks began charging negative interest rates to their customers, or even telling customers to take deposits elsewhere. Holding short-duration bonds won’t help either, as they’d had negative yields since 2014 as well.
In Europe, there’s no way for a stablecoin issuer to make money on its deposits without going too far out on the risk curve. In a negative interest rate environment no one wants to hold Euros in reserve to back up a stablecoin.
Additional hurdles: strict regulations, being late to the party, and a lack of demand
On top of the burden of negative interest rates, stablecoin issuers in the EU face high regulatory and compliance requirements. The Markets in Crypto-Assets Regulation (MiCA) was introduced as a direct reaction to the announcement of Facebook’s Libra project in Summer 2019. EU policy stakeholders were outspoken in their attempt to stop Libra from launching in the EU, and about one-third of MiCA is taken up by stablecoin-related regulation requiring stablecoin issuers to be authorized as credit institutions or e-money institutions and adhere to bank-like compliance standards. These regulatory requirements scare away many potential Euro stablecoin issuers.
Another hurdle: the powerful first mover advantage of US Dollar stablecoins. Stablecoins like USDT and USDC are mainly for trading on centralized and decentralized exchanges, and its usefulness grows exponentially with the number of markets that it trades in. (A first mover advantage is likely also the reason that USDT was never overtaken by USDC, despite its murky origins.) These strong network effects will make it hard for a new Euro stablecoin to catch up with its well-established Dollar competitors.
Finally, every entrepreneur knows the danger of designing a product for which there is no demand, and today’s crypto investors and traders aren’t crying out for a Euro stablecoin. Fluctuations in the Euro-Dollar exchange rate are tiny compared to the volatility of the crypto markets, and simply not in the minds of crypto market participants. However, as more traditional European institutions and investors enter the space, the demand for EUR-stablecoins is likely to grow.
Is negative-interest-rate Europe the best place for algorithmic stablecoins?
Given the significant monetary and regulatory challenges of creating centralized fiat-backed stablecoins in Europe, it makes sense that Europe be the place where algorithmic stablecoins take market share. Currently three of the top six Euro stablecoins are algorithmic, corresponding to a 25% of the top six’s market cap. (US algo stablecoins also make up three of the top six, but only 6% of the market cap.)
The agEUR stablecoin from Angle is the largest Euro algorithmic stablecoin and the third largest Euro stablecoin overall, despite only having started six months ago. (Angle’s investor Fabric Ventures also backed us at Unstoppable Finance). So far, Angle’s protocol has managed to maintain well over 100% collateral backing — time will tell whether the team can scale demand, and whether the protocol remains robust as it grows.
Conclusion: Euro fiat-backed stablecoins will have to wait for rising interest rates, and until then the door is open to algorithmic competitors
While there’s no reason that algorithmically-backed stablecoins should be built to track dollars and not euros, the recent Terra UST debacle highlights the fact that the market has yet to choose a robust “winning” technology. Unfortunately, until the ECB raises interest rates, European fiat-backed stablecoin issuers will have no clear source of revenue on which to build their businesses. The additional lack of demand, high regulatory burden, and first-mover advantage of existing USD stablecoins present significant obstacles.
We believe that stablecoins will remain an important part of the DeFi ecosystem. We look forward to a future with widely used, reliable algorithmic stablecoins, but recognize that fiat backed stablecoins remain the most stable mechanism for now. We recognize that negative interest rates prevent the emergence of major Euro stablecoins, but also recognize that the continued dominance of USD in crypto undermines the ECB. We hope that rising interest rates in Europe will help boost the emergence of Euro stablecoins into the DeFi marketplace.
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