When Will Stablecoins Break out of Crypto-Narnia?
So far, stablecoins have seen significant use within the cryptocurrency ecosystem, specifically as a volatility hedge, a tool for tax evasion and a vehicle for payments outside the banking system. Yet stablecoins have also been proposed as a payments solution for businesses. This post summarizes a recent R3 white paper, which explains why we have not seen corporates or financial institutions adopt stablecoins and proposes how these instruments may eventually fit into the existing financial system.
See the full paper here: Will Businesses Ever Use Stablecoins?
Getting Back to Basics
Blockchain was a technology built to facilitate payments. It’s stated right up there in the first sentence of Satoshi’s abstract. But Bitcoin payments have faltered, as merchants don’t want exposure to the directional risk of cryptocurrencies.
The volatility of cryptocurrency has created an opening for stablecoins, with Tether dominating payment volumes. And now the combined volume of a new breed of coins led by firms like Paxos and Gemini, which launched stablecoins in October, are comparable to Venmo.
But this use is currently confined to the closed loop ecosystem of cryptocurrency miners, speculators and exchanges. There are really three basic existing uses: locking in cryptocurrency profits, avoiding taxes, and niche payment scenarios outside the existing banking system.
A proliferation of diverse offerings is a fantastic step. However, the ambitious claims of many stablecoin white papers to obviate traditional payments systems, like ACH and wires, are a far cry from actual activity today.
What’s on the market now?
Right now, we see five different types of stablecoins. The vast majority of volumes occur with fiat-denominated stablecoins that are issued by third parties (trust-coin). However, coins issued directly by banks (bank-coin), such as Signature bank’s platform or JPMcoin, could potentially challenge these third parties by leveraging their own networks, not to mention their robust compliance departments.
The three remaining types of stablecoins (Figure 3) have seen less use. Commodity-coins can be backed by a wide range of assets, requiring a trusted custodian. Crypto-coins remove reliance on a centralized store of collateral, but ultimately are forced to overcollateralize to hedge against the risk of the underlying (basket of) cryptocurrency. Algo-coins don’t use any collateral and have yet to prove their legitimacy.
Most attention, particularly within the enterprise blockchain space, has gone towards CBDCs (Central Bank Digital Currency). They’re a great solution, but they are a few years out. And given current financial market infrastructure, startups are essentially locked out of innovating with central bank money in most countries.
This further shows why the bank-coin model may pick up momentum. Banks can leverage their existing responsibilities of onboarding customers to define the limits of the networks on which this cash would be otherwise free to move on top of.
Not every payment is created equal
It would be naïve to propose that there will be one stablecoin to rule them all. Rather, stablecoins will likely emerge to address specific types of payments.
Let’s briefly take a look at what sorts of payments firms make, and how they make them. The chart below starts with the five payment systems in the United States, who uses them, the direction of the payment flow (who is initiating the transaction — sender or receiver) and how this relates to what is or could be built on blockchain. (Note that the US payment system differs from others internationally and is used just as an example.)
ACH and wires handle the majority of enterprise payments. Specifically, the ACH system is commonly used by corporates for supplier payments and internal funds concentration. Wires, referred to as “large value systems”, are quick and often used for international or time sensitive payments. They are also used by financial institutions in the FX market or securities delivery.
A new R3 research paper, Will Businesses Ever Use Stablecoins?, explores these payment systems in greater detail, identifying where stablecoins may fulfil needs within the established financial system.
Stablecoins address a gap in the payments landscape
The stablecoins that will find the most success will facilitate payments across one or multiple blockchain use cases that involve significant value transfer. As a result, they will likely be designed to operate on blockchain systems that host the most credible applications and users.
This means stablecoins will have to be issued on blockchains that treat identity and privacy in a way that aligns with the requirements of regulated institutions, who must know their counterparty and cannot globally broadcast transaction details.
They will also most likely be issued by institutions that can command confidence in the instrument’s value and stability. However, even bank-coins in their current implementations are experimental and leave many open questions regarding future design. For example:
- Will future bank-coins continue to be siloed within the issuing commercial bank? (e.g. JPM Coin and Silvergate Network: coins can only be sent to account holders of the same bank.)
- If banks issue and transfer stablecoins between each other, how will they handle the resulting directional exposure to their competitors?
The timing couldn’t be better as enterprise blockchain applications are reaching production, and exchanges, such as SIX, move towards blockchain. Many of these applications are beginning to request the ability to settle payments in a suitable form of on-ledger money.
Central bank money may be out of the question for now. However, bank-coin and trust-coin issuers have a massive opportunity to serve as the settlement leg for corporates and financial institutions transacting on blockchain networks.