Stablecoins: the billions, the issuers’ battle and the SEC

An essential role for the digital asset ecosystem

Stablecoin 101

Stablecoins are digital assets designed to maintain a stable value relative to a specific asset or a basket of assets. The most common peg is with a fiat currency (e.g., USD).

Unlike most cryptocurrencies, stablecoins are not volatile and provide a stable store of value. They evolve on top of the main blockchain protocols (like Ethereum, Solana, or Avalanche) and keep the desired characteristics of digital assets like traceability, security, real-time settlement, and 24/7 access. Moreover, they are digital-native and programmable (e.g., they can be related to some apps and smart contracts).

Stablecoins act as a bridge between traditional finance and the crypto world. They have become essential for cryptocurrency traders who swap from one digital asset to another by using stablecoins. Given their pegged value, they can easily be used for transactions or cross-border remittances, at a fraction of the cost of traditional payment methods.

Finally, stablecoins are also widely used in decentralized finance (DeFi). They are used as collateral for borrowing and lending and to provide liquidity to decentralized exchanges and other DeFi protocols.

Not all stablecoins are created equal

Almost anyone can create a stablecoin. CoinMarketCap lists >100 active stablecoins on its website. While they all have the same idea (i.e., being pegged to an asset), their designs differ.

For example, USDT, the largest stablecoin by assets, is not considered as decentralized as users need to trust a central authority controlling the collateral. Similarly, Dai, the fourth largest stablecoin, is maintained by a decentralized autonomous organization is capital inefficient as it requires depositors to collateral >100%.

The characteristics of a stablecoin will have an impact on its tokenomics, affecting its supply and demand. The main blockchain protocols face a trilemma between security, scalability (number of transactions per second), and decentralization. A comparable trade-off exists for stablecoins between decentralization, stability, and capital efficiency.

The collateralization of the stablecoin must be carefully reviewed by the investors. We can classified stablecoins in three main categories:

• Asset-backed, full-reserve stablecoins: Such a stablecoin type has reserves that are usually based on fiat money. Reserves can be composed of cash, commercial papers, fixed-income securities, or commodities such as gold or silver. In theory, a token is issued (or “minted”) each time $1 is deposited with the issuer.

• Over-collateralized, crypto-backed stablecoins: These type of stablecoins usually hold within their reserves cryptocurrencies. But given the volatility of this asset class, the protocol requires a greater collateral (i.e., a buffer) than the issued stablecoin. For instance, when using Ether as collateral, Dai requires 150% of its value to be posted as collateral.
• Algorithmic stablecoins: Digital assets have their lot of experiments and Algo-based stablecoins are definitely one of them – for better or worse, if we look at the collapse of TerraUSD (UST). These stablecoins do not rely on 100% independent collateral but encourage arbitrageurs to maintain the peg. A simple mechanism would increase the supply of tokens when the stablecoin’s price is above the peg, and reduce it when it is below the peg.

Sizing the market

The stablecoin market has significantly grown during the last bull market. It went from a total size of ~$5bn at the end of 2019 to a peak of ~$190bn in April 2022, and it currently stands at ~$135bn.

It is interesting to note that the peak was reached after the beginning of the current crypto winter. It implies that even if some investors have sold their cryptocurrencies, they kept some ammunition in stablecoins rather than fully going back to the traditional financial system. Also, 2022 was an eventful year, starting with the collapse of TerraUSD in May that erased ~$30bn of stablecoin value ($18bn directly and $10bn in other stablecoins), but the current level of stablecoin assets proves the resilience of the ecosystem.

How big will stablecoins be in the future? As the world is going into more digitization and the tokenization of everything, the market for stablecoins will keep getting bigger. According to the International Monetary Fund, the broad money supply was ~140% of global GDP in 2020 (or ~$120tn). Assuming no changes in the broad money supply and global GDP, it would not be surprising that stablecoins may represent 1% of this supply by the end of the decade (i.e.,  $1.2tn).

For sure, central banks around the world are taking the long view and fear losing their monopoly over the money supply, thus proposing a trustworthy substitute, central bank digital currencies (CBDCs). But most developed countries are still only in pilot phases for CBDCs (at best); it will take years to have digital fiat currencies with all the characteristics of stablecoins. Moreover, crypto purists will never accept to use CBDCs, for privacy reasons.

A lucrative business activity

A concentrated market

Nowadays, four stablecoins control >90% of the market. Their issuers have a significant influence on the entire ecosystem.

1. USDT by Tether;
2. USDC by Circle and Coinbase;
3. BUSD by Paxos; and
4. DAI by a decentralized organization (over-collateralized stablecoin).

With a market share >50%, USDT is the clear market leader. Launched in 2014, it benefits from the status of early mover. The issuer quickly established a large network with all the major crypto exchanges. As a result, active traders have used USDT to easily transfer assets from one exchange to another.

But the market share of a stablecoin can quickly evolve. TerraUSD (UST) had a ~10% market share before its collapse in May 2022. Similarly, we expect BUSD to become insignificant following the restriction to stop issuing new coins (see below the section on the regulatory framework).

How issuers make money

When the issuers receive fiat currency to mint stablecoins, most of them put these reserves to work. With the surge in interest rates in 2022, issuers generated hefty profits last year.

How much? It is difficult to say precisely. We estimate the total revenue of the ecosystem in 2022 to have reached >$2.5bn.

Tether claimed to have increased its excess reserves by $700mn thanks to the higher rates. It does not say how much it kept in the accounts of the company.

As a publicly listed company, Coinbase must disclose more information. In the last quarter of 2022, it generated $146mn from its partnership with Circle on USDC. Coinbase will generate more revenue from this partnership if (1) it is able to increase the adoption of the token (distribution) and (2) keep the stablecoin on its platform (custody). A higher adoption of USDC is among our catalysts for a positive earnings surprise on Coinbase (a 2023 top pick for our strategy Blockchain & Digital Assets).

The holders of stablecoins do not receive any interests for having stablecoins. Custody platforms may provide incentives to bring stablecoins on the platforms, but these fees are not paid by the issuers of the stablecoins. For instance, Coinbase currently offers an average percentage yield of up to 1.5% for USDC custodied on its platform. This offered yield is obviously smaller than the revenue it can generate from its partnership with Circle.

If we exclude such incentives, the revenues generated from the reserves remain in the hands of the issuers. For 2023, with interest rates expected to remain high, the revenues from stablecoins will likely exceed those of 2022.

Tether: A colossus with feet of clay?

Issuers can generate more revenue if they take more risks on the invested reserves. We have warned multiple times (Blockchain outlook 2023, Fintech outlook 2023, Will fintech survive this market?, or Fintech outlook 2022) that we had concerns about USDT. Even leaving aside the current debate about whether stablecoins should be considered by the SEC as securities (see below), we cannot avoid a discussion about the quality of the reserves.

For years, Tether refused to provide sufficient transparency on its assets. With the market issues of 2022, this has changed, and the company is now working with renowned accounting firms. This is undoubtedly a positive, but it does not mean that everything is solved. We notice that as rates went up, Tether divested its holdings in commercial papers (and certificates of deposits) to invest in U.S. T-bills. But at the same time, it has always maintained an allocation of 15-20% into some risky and volatile assets, namely cryptocurrencies, loans, corporate bonds, mutual funds, and metals.

We expect more noise to come, specifically around the loans, as basically Tether mints USDT and lends them away. Like a bank, but without holding any banking license, it creates money. Should there be a bank run on Tether (and history proved that this can happen very fast in the crypto industry), it is difficult to see how the peg could be ensured.

The regulatory crackdown

Stablecoins and regulations

The regulatory framework for stablecoins is evolving quickly, like for the entire crypto space.

While the various agencies in the United States have been debating for years about how stablecoins should be treated, there seems to be a global consensus that the collateral impacts the classification (and the regulation) of a stablecoin. In simple words, if the reserves are not cash, then it is likely that the stablecoin falls into the category of a security (with multiple consequences). In this case, in addition to some anti-money laundering rules, stablecoin issuers have to comply with security trading/offering, banking, and financial infrastructure regulation.

The SEC is currently going after Paxos, the issuer of BUSD (and other smaller stablecoins). On a side note, this stablecoin with a market cap of ~$10bn uses the name of the leading exchange Binance only for branding purposes. The SEC is considering charging Paxos for selling unregistered securities. The reserves of BUSD are composed of cash, U.S. T-Bills, and repurchase agreements on long-term Treasury bonds. Paxos claims that these assets are not “securities”.

If taken to court by the SEC, issuers are likely to seek a settlement and avoid never-ending legal cases. Ripple Labs is a good example of this problem, as the judges are still struggling to determine if its XRP stablecoin is a security or not. At least, this legal case is helping define the characteristics of a security (identified via the Howey test or the Reves test).

In the meantime, the SEC asked Paxos to stop minting any new coins.

Will the SEC go after other stablecoins?

A stablecoin that goes out of business is usually good news for its competitors, as they can expect net inflows. However, if such a problem would arise on larger stablecoins, liquidity in the crypto market would suffer in the short term, as stablecoins are widely used for trading purposes.

The crypto industry closely monitors the developments on Paxos. But the problem is complex, and a decision on Paxos would not necessarily apply to all stablecoins as each stablecoin is differently designed. Moreover, it is unlikely that the SEC will devote major resources to go after all issuers. If we look at the two largest stablecoins, they follow two different strategies:

1. Circle and Coinbase are known for continuously discussing with regulators to ensure that they meet all regulatory requirements. With reserves only composed of cash and U.S. T-Bills, USDC is considered by its issuers as a “regulated dollar digital currency issued as a stored value under U.S. money transmission law”.
2. Tether keeps repeating that it does not operate in the United States and does not onboard any U.S. person, making it more difficult for the SEC to suspend all minting activities of Tether as it did for Paxos. One solution for the SEC to impose restrictions on USDT would probably be to go after the various banking institutions involved with Tether. But this would also come with challenges, as the banking network of Tether remains opaque, and most of the assets are likely in the custody of small banks in the Bahamas.

Finding the equilibrium

U.S. regulators must be careful. If they go too far in their requirements (e.g., imposing some sort of bans on stablecoins), it is likely that the crypto economy will move away from the United States. Other countries that have clear regulations on blockchain and stablecoins (like Switzerland) would greatly benefit from such a move.

The SEC seems to concentrate its efforts on stablecoins issued by centralized entities. Most of the issues in the crypto ecosystem in 2022, such as excess leverage, fraud, or interconnections, come from centralized entities. At the same time, the various protocols run as intended, especially all the DeFi protocols. Decentralized stablecoins like DAI could eventually benefit from the regulatory crackdown on the other stablecoins. It will be difficult for regulators to go after decentralized organizations since they have by nature no address, no real shareholders, and no directors. However, such stablecoins also come with some disadvantages, like their technical complexity, poor user experience, and the risk of hacks of the smart contract.

The financial innovation through blockchain is only starting. Whether centralized or decentralized, stablecoins are a key element of this ecosystem and are here to stay. Regulators should bring some clarifications and work with the developers of the crypto world. The alternative, i.e., the development of a crypto economy outside of the regulatory framework, will likely cause a bigger crisis down the road. Such a scenario would be in nobody’s interest.

Catalysts

• End of the crypto winter. With a change in the monetary policy, new regulations, and important developments on the various blockchain protocols, 2023 should be different from 2022. The end of this crypto winter could even materialize this year. This would bring new investors on this asset class, boosting at the same time the adoption of stablecoins.

• Partnerships. Stablecoins need to improve interoperability with the traditional financial infrastructure and increase partnerships with the incumbents. Visa is conducting pilots to enable payments through USDC. As a consequence, millions of merchants may allow payments with stablecoins. We bet Mastercard and other networks will not wait too long before announcing something similar.

• Improved user experience. As stablecoins operate on blockchains and smart contracts, they are programmable. However, the user experience to interact with these contracts is far from optimal, especially in DeFi. A new generation of apps is being developed, which will make interactions with the blockchain easier. Code can be written to automatically execute transactions without the need for any authority to validate it. Fiat currencies cannot do that. Programmability offers new solutions in lending, insurance, or payments that may simplify all financial processes and operations.

Risks

• Regulations. In the short term, stricter regulation is obviously a risk for the ecosystem – at least for the existing stablecoins. But in the long-term, regulation will act as a catalyst for broader adoption as the rules of the game will be clearer and better known.

• CBDC. Will institutional investors favor a stablecoin issued by a private company or a central bank digital currency issued by the Fed? Trust is a must in financial services. While developed countries are conducting various pilots, there is still no clear plan for an actual launch. The design of the CBDC will also matter. A wholesale CBDC would, for instance, have little impact on the existing stablecoins.  

• Fraud. A proper due diligence should be conducted on stablecoins. TerraUSD is not the only stablecoin that collapsed – Basis, OneCoin or SteadyCoin are other examples of mismanagement of investor’s resources. If a digital asset is too good to be true, it probably isn’t.