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Fighting to be STABLE: the Evolution of Stablecoins

This is a contributing article from Haseeb Qureshi, Investor at Dragonfly Capital. Formerly Metastable, @Airbnb, @earndotcom. Writer. Effective Altruist. Former poker pro. One always finds one’s burden again.

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The crypto industry has been in a tizzy lately over a the STABLE Act, a US bill that would require stablecoin issuers to obtain banking charters.

If adopted, the STABLE Act would force stablecoin reserves to be regulated like bank deposits. This would be a massive setback to stablecoins, which serve as the de facto money of the crypto ecosystem today.

The industry response was swift and furious. All at once, exchanges, entrepreneurs, and investors denounced the bill and its consequences.

For now we can rest easy, as the STABLE Act itself is unlikely to pass. But just recently, the Presidential Working Group made a statement suggesting that all stablecoin holders should be KYC’d.

This statement does not have the force of law. But it suggests the zeitgeist has changed.

Stablecoins have grown dramatically in the last couple of years, largely unperturbed by regulation. Is this sustainable? Is the STABLE Act a harbinger of what’s to come? And what will happen to Tether, or to decentralized stablecoins?

Here’s what I think: In the long term, regulation will be a one-way march. Centralized stablecoins will gradually become more and more restricted, pushing the crypto economy toward decentralized stablecoins.

It won’t happen overnight. But here’s how I expect that story to play out.

Let’s rewind.

The genesis of crypto money

In the beginning, Satoshi Nakamoto invented Bitcoin to create decentralized digital money. And in the early days, Bitcoin really was that.

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Before 2018, BTC was the numeraire of crypto. If you wanted to buy something with cryptocurrencies, you’d buy it with Bitcoin — there was nothing else as global or as liquid. BTC was the reserve currency for almost all trading. Even most ICO fundraising took place via BTC and ETH.

But Bitcoin isn’t exactly ideal money. Its infamous volatility, along with its 10-minute block time have made it a poor medium of exchange.

So after the ICO bubble collapsed in 2018, we entered into the second stage of crypto money: the era of Tether. This is the stage we’re living through now.

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Tether is a stablecoin: a “permissionless,” programmable digital dollar. The most common stablecoin is a fiat-collateralized stablecoin — basically, IOUs for dollars held in a bank account. Each USDT is technically an IOU issued by Tether Limited, which entitles you to a dollar deposit they hold at Deltec bank in the Bahamas.

I prefer to describe Tether as a cryptodollar rather than a stablecoin. The term “cryptodollar” makes clear that this is a fundamentally new monetary phenomenon.

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You can think of cryptodollars as a new rung in the hierarchy of money — they are dollars as abstract monetary assets. Via public blockchains, they are transmuted into apolitical permissionless tokens, effectively decoupled from the US banking system.

Tether is not the only cryptodollar. But today, it is the most dominant by a staggering margin.

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Stablecoin supply by issuer. Credit: Debank

And yet, Tether has a well-documented history of controversy. It is currently under investigation by the DOJ, CFTC, and the NY Attorney General. Tether admitted in 2019 that it was not fully backed by dollars, and yet its supply has only monotonically increased over time. Given that, you might wonder why Tether is preferred over USDC, which is regulated and backed by Circle and Coinbase.

The answer is straightforward: USDT is the most dominant stablecoin in the world because it got there first. It has been around so long that it has built up a moat as being the most liquid, most in-demand, and most credibly neutral stablecoin in the world. (In Asia, Tether’s nebulous regulatory status is often seen as a plus over the more buttoned-up USDC.)

The majority of crypto exchanges quote their most liquid pairs against USDT. USDT trades more volume than Bitcoin itself. Arguably, Tether is now the reserve currency of crypto.

How long will Tether’s dominance last?

Tether’s growth has been meteoric. As it gains traction, I expect more and more people around the world will realize that cryptodollars are a better way to get access to open access dollar flows from anywhere in the world. Cryptodollars are true global, digital cash. This makes them tremendously attractive internationally, especially in countries with strong currency controls.

In China, for example, each citizen is legally allowed to purchase only $50K of USD a year. Most of the BRICS countries face similar policies (not to mention countries facing heavy inflation like Argentina, Iran, or Lebanon).

Most cross-border transactions are conducted in USD, regardless of the countries involved. USD is, for better or worse, the de facto currency of international commerce. This gives the US government the enormous privilege of conducting foreign policy not just with its military, but with its chokehold over global financial infrastructure.

But countries are growing frustrated with the heavy-handed US financial hegemony. Today, Tether adoption is growing in cross-border commerce, especially across the Russia-China border. This lets businesses embrace the economic stability and neutrality of the USD, decoupled from the cudgel of US sanctions.

In the aftermath of COVID-19, it’s likely that the global burgeoning middle-class will increasingly seek monetary safety and diversification. For many, permissionless cryptodollars will be their onramp.

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Growth in active Ethereum stablecoin recipient addresses (mostly USDT). Credit: Joel John

The future is bright for cryptodollars. But will Tether survive long enough to see that future?

This is the grim question at the heart of the crypto industry.

Liberty Reserve, Redux

At bottom, Tether is Liberty Reserve.

Recall that Tether is under investigation by multiple US agencies and prosecutors and has so far produced very little in defense. It has never produced a full audit of its reserves. Tether does KYC its onramps and offramps, but this thin veneer of compliance is unlikely to protect them from the US government. Note that Tether has blacklisted just north of 250 total addresses out of its millions of token holders.

Everyone knows this is unsustainable. And the bigger Tether gets, the bigger the target on its back grows.

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Banned Tether addresses over time (less than 0.1% of addresses). Credit: Dune Analytics

Of course, Tether knows all this. Right now they are playing a cat and mouse game with their banking relationships, bouncing from bank to bank (Wells Fargo, ING, Noble Bank, Deltec) until they find someone who will take their money. This won’t continue forever: eventually Tether will get shut down or regulated out of existence.

Make no mistake: the day that Tether gets taken down will be apocalyptic.

Crypto markets will seize, exchanges will be thrown into disarray, millions of crypto traders will likely have their assets frozen, and prices everywhere will plummet. (It will be pronounced yet another death for Bitcoin.)

But, as it always does, crypto will eventually recover. And when the dust settles, we’ll enter the third stage of crypto money.

Order books will reconstitute themselves around a new cryptodollar. International crypto markets will quickly acknowledge this new standard, eager to get back to business.

But which cryptodollar will succeed Tether?

The rise of RUSD

The current contenders behind Tether are regulated stablecoins like USDC, BUSD, and TUSD (soon to be joined by the Libra AKA Diem). Let’s not concern ourselves with guessing which one will win that battle — let’s call the winner RUSD, for Regulated USD.

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RUSD will have the same affordance as Tether, but will be more compliant and trustworthy. And with time, RUSD will supplant Tether’s role in the international market for digital, permissionless, apolitical dollars.

So will this be the final stage? The terminal form of cryptodollars in the world?

I don’t think so. It seems to me that this third stage, the RUSD era, must also eventually end.

The Curse of Digital Cash

Today, fiat-backed stablecoins are effectively treated like cash. Anyone anywhere is allowed to pay whomever they want, in whatever amounts they want. It is only when these tokens are redeemed for their underlying USD that one hits the legal checkpoint. Until then, there is no meaningful legal oversight enforced in the flows of these tokens.

Imagine these stablecoins were legally sanctioned to be treated as cash. As JP Koning points out, wouldn’t all banks start adopting them? Stablecoins would effectively allow you to route around the Bank Secrecy Act. In this version of the world, anyone is free to instantly transfer $50M to anyone else in the world, no questions asked, with no way to definitively identify either counterparty after the fact.

If this were to persist, stablecoins would become the most powerful banking hack ever invented. Bank deposits, once the locus of financial regulation, would become strictly inferior to digital cash. If this is endorsed by regulators, then it will only be a matter of time until stablecoins gobble up a significant portion of USD settlement in the world.

I do not say this is impossible! But I am skeptical.

The march of regulation over the last 50 years has been one way: increasingly heavy-handed financial regulation, coupling domestic and foreign policy with economic control over the global financial system. This trend only accelerated after 9/11 and the Great Financial Crisis.

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Credit: Mercatus Center

Of course, permissionless digital dollars will eventually exist whether or not the US government blesses them. But will regulators recognize their inevitability and have the US to sanction its own digital dollar?

I suspect they cannot resist the temptation to intercede in the ledger — to ban the addresses of their enemies, to reward their allies, and pursue policy goals directly via control of the monetary system. If they do, that version of a digital dollar will become no different than the current banking system.

The President’s Working Group statement on stablecoins makes this point clear. Beyond suggesting that all transactors of stablecoins must be KYC’d, they reiterated that stablecoin issuers must comply with all AML and financial stability regulations.

So why, you might ask, are RUSDs even allowed to exist?

Mostly, it’s thanks to the warm halo of “innovation.” When stablecoins become widespread and pedestrian, this aura will fade. And what then? Rohan Gray, the designer of the STABLE Act, gave us a preview of what regulators will say: aren’t these fiat stablecoins just full-reserve digital banks?

Should their liabilities really be permanently treated like cash, as opposed to bank deposits? Can the American regulatory machine resist clamping down on this?

The short history of America after the PATRIOT Act tells us: probably not.

Even the Financial Action Task Force (FATF), a global inter-governmental organization that sets global standards for AML regulation, recently wrote that stablecoins “should never be outside the scope of anti-money laundering controls.” Similarly, the Financial Stability Board (FSB) recently urged regulators to follow the principle of “same business — same risks — same rules, independent of the underlying technology” in regulating stablecoins. This was recently echoed by the president of the ECB.

These RUSDs are treated as digital cash today. But make no mistake: regulators don’t want any such thing to exist.

Cash, what, with all its anonymity and unaccountability? Cash decreases the legibility of the economy, and accordingly, it is the enemy of the state. If cash didn’t already exist, governments would never allow its reinvention. FinCEN’s recently proposed rules requiring exchanges to report name and home addresses for transfers to “unhosted wallets” all but confirms this.

The saving grace today is only that RUSDs today are too small to warrant meaningful intervention. Today, they are mostly used for speculating on cryptocurrencies — an innocuous pastime. In the context of the US dollar, they are barely a blip on the map (in total, all RUSD-type stablecoins add up to less than $20B in issuance, about a tenth of one percent of USD commercial bank deposits).

So what would actually trigger regulators coming in and stopping the party?

I can imagine two scenarios. One might be that RUSD issuance balloons in response to growing global demand. A fear of exponential growth might cause regulators or Congress to swoop in and turn the screws.

A second scenario might be triggered by a black swan: imagine a headline about terrorists funded with stablecoins, or an authoritarian country using stablecoins to evade US sanctions. There would be immediate calls to regulate cryptodollars.

I don’t think RUSDs would go away, mind you. Most likely they would allow small balances without KYC, but above that size an account has to get KYC’d to receive more funds. Or they could get regulated all the way like banks and enforce KYC on all cryptodollar holders, as was implied by the statement by the Presidential Working Group. RUSDs would have to start enforcing more terms of use and actively policing accounts for fraud (today it’s not very rigorous).

Once this happens, RUSDs will no longer be satisfactory solutions to the global demand for cryptodollars. They will serve institutional uses in the US, but they will be too regulated and out of reach for non-US individuals or the financially excluded. RUSDs will essentially become feature-enhanced bank deposits.

It is then, and only then, that we will enter the fourth stage — the stage when decentralized cryptodollars will take the mantle.

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The final form of cryptodollars

I haven’t mentioned any decentralized stablecoins until now. This is intentional: it is not until this point that decentralized stablecoins have a chance of real adoption.

Why do I claim that it will take so long? Why do all the other avenues have to be exhausted before a decentralized stablecoin has a chance of winning?

The primary distinguishing feature of a stablecoin is, of course, that it is worth $1. But decentralized stablecoins always have weaker price pegs. This makes them disadvantaged compared to their centralized counterparts.

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The Tether peg (green) vs the Dai peg (red) over 2020. Credit: Coinmetrics

Fiat-backed stablecoins maintain their price pegs through create-redeem loops, much like ETFs. If the price is too high, an arbitrageur can mint new stablecoins by wiring USD and selling the stablecoins on the open market for a profit. If the price is too low, they can buy stablecoins and redeem them for the underlying USD at a profit. This is all fast and low-risk, which allows arbitrageurs and market makers to ensure a tight peg on the stablecoin.

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An illustration of ETF create-redeem arbitrage. Credit: Michael Kitces

Crypto-native stablecoins are different. They have weaker price pegs because there is no true arbitrage in their price pegs — they operate more like central banks targeting a pricing band. Monetary policy moves slowly, and when the currency depegs, the central bank tries its best to react in real-time. Speculators may bet on the peg soon reverting, but this is not arbitrage; it’s better described as short-term speculation on the future effectiveness of monetary policy.

But this works! It does create a decentralized stablecoin. Dai today has proven it, having survived and maintained its peg over 2018, when its ETH collateral drew down in price ~95%, and it even survived Black Thursday, when ETH collateral crashed 50%+ in a single day. We know the mechanics behind decentralized pegs can work amidst highly volatile markets. But we also know they are not as robust as centralized stablecoins — and no wonder, given how much more complex their mechanisms have to be.

Decentralized stablecoins cannot compete head-to-head on price pegs. But decentralized stablecoins have one advantage: decentralized stablecoins are truly censorship-resistant.

Unfortunately, the market doesn’t care. Because today, nobody is doing any large-scale censorship of stablecoins.

If no censorship is actually happening in these centralized stablecoins, then Tether is providing the same thing that Dai purports to give you, except more liquid and with a tighter price peg. Right now, Dai is a worse stablecoin than Tether for all practical purposes.

But eventually, that will change.

Censorship will come, because regulators will have no stomach for truly unregulated digital cash. Once they impose regulations on fiat-backed stablecoins, only then will censorship-resistance be valued in a stablecoin, and only then will assets like Dai, Celo, or ESD become a suitable numeraire for the crypto industry.

That is my long-term thesis on why I believe decentralized cryptodollars will be the future money of crypto. I believe they will fundamentally change the global financial landscape.

This is why I titled this piece “the evolution of stablecoins.” Evolution is not a goal, but a process: one driven by selection pressures and extinction events. Bitcoin had to be decentralized only because all previous attempts to create digitally-native money failed. The same will eventually be true of permissionless cryptodollars.

But it won’t happen soon. It’s hard to be too confident on timelines here, but this likely takes more than 3 years to fully play out. And any projection that looks that far out is inevitably fuzzy given how many other aspects of the world will change by then.

The STABLE Act is, for now, an overture. Not itself the ending, but an omen of what that ending might look like.

In the meantime, as an investor, I am bullish on decentralized cryptodollars. They are, in the long run, the only truly long-term way to give people decentralized access to dollars anywhere in the world.

Disclosure: Dragonfly is an investor in MKR, CELO, and ESD.

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