The Future of Money/metamorworks.
Stablecoins: Crypto-natives vs TradFi
A three-tiered problem or a triple entente? Part three of a three-part series.
The first institution resembling a modern bank was established in the Republic of Venice in 1587. Not dissimilar to its present counterparts, the Banco Del Giro housed deposits, bankrolled the Republic through loans during the Ottoman wars and offered an annual interest of four per cent.
Half a millennium later, banking sits at the heart of finance and the global economy. In the US and EU alone, retail banks have lent over $3.5tn to consumers as of July 2022, with investment bank-led merger and acquisition deal values likely to reach $4.7tn this year.
Despite an integral part banks play within the economy, "they do stupid sh*t", Lucas Kiely, the chief investment officer at Yield App told AltFi.
Referring to UBS's $50bn subprime and mortgage loss incurred during the great financial crisis (GFC) of 2007, Kiely, a former executive director and senior trader at UBS during the crisis said: "It doesn't matter what banks are backed by or governments willingness to bail them out, are they safe?"
On 15 September 2008, the investment bank Lehman Brothers failed. Overwhelmed by mortgage-backed securities that were backed by default-risky collateralised debt obligation purchased on a 30.7x leverage ratio, Lehman's descent was responsible for an estimated $10tn in losses, or a sixth of the global economy.
Following the collapse of Lehman, the immune-to-disruption banking industry was now ready to be challenged. In 2009, the bitcoin blockchain went live, with anonymous founder Satoshi Nakamoto leaving a memento coded onto the genesis block: "The Times 03/Jan/2009 Chancellor on brink of second bailout for banks."
Thirteen years later, the hyper-disruptive crypto industry is in a fight with the old guard. Bitcoin and Ethereum have opened the door to an entirely new facet of finance, with decentralised lending pools, insurance solutions and information storage systems throwing the gauntlet down at traditional finance.
However, at the vanguard of the movement are stablecoins. Following Meta's Libra openly challenging monetary sovereignty, stablecoins – the stalwarts of stability in the turbulent crypto world. Their opponents: traditional financial firms, who are not ready to hand over the reins to the future of money without a fight.
This article is the second part of a three-article series on stablecoins and the future of money. The second article can be read here.
The case for stablecoins
Ushered into existence in 2012 by J.R. Willet, the founder of Mastercoin and the architect behind Initial Coin Offerings (ICOs). Stablecoins were conceived as a means to deal with the volatility of the early bitcoin market.
Willet suggested building a 'MasterCoin Protocol' that would sit upon bitcoin's blockchain that would allow users to "own stabilized currency tied to US dollars, Euros, ounces of gold, barrels of oil, etc."
Today, stablecoins are tokens whose value is tied to assets outside of the crypto space, generally in the form of a fiat currency like the US dollar. As Kiely explains: "Essentially a stablecoin is an IOU or a credit instrument. That means the quality of the issuer is paramount to create trust between the buyer and issuer."
For stablecoins, trust is derived from the collateral backing the stablecoin. The higher the quality of the stablecoin reserve backing the actual token, the more stable it is perceived.
"There are algorithmic stablecoins like Terra-Luna, then you have crypto-backed one's and then fiat stablecoins like Tether or Circle," Kiely said.
Algorithmic-backed stablecoins maintain their $1 peg through code that maintains the supply and demand of the token. DAI's reserve backing is made up of $10.5bn worth of cryptocurrencies and Circle's USDC is backed by fiat and short-term obligations.
The more liquid the assets backing the stablecoin are, the faster they can be redeemed by the user, making the stablecoin a safer bet than one backed by less liquid reserves.
Ultimately, stablecoins provide an outlet for traders to move away from the volatility of the crypto market. Another benefit is their use by the public, with cross-border payments a widely touted example of a stablecoin use case.
Currently, the global cost for sending is 6.3 per cent, and with over half a trillion sent by 250m migrant workers annually, the fees result in $45bn per year going to third-party intermediaries at the expense of small businesses and low-income households, the IMF finds.
"There are people who are underserved and unserved. A lot of that has to do with geography, your credit score and access to financial services," Teana Baker-Taylor, Circle's head of policy EMEA told AltFi.
According to the World Bank, 1.7bn people are unbanked. In inflation-ravished countries like Venezuela firms like Valiu use pesos to buy cryptocurrencies that it then transfers to sites like LocalBitcoins to trade into other fiat currencies or stablecoins.
Stablecoins offer a "high transactions speed, low cost and accessible solution for millions", Baker-Taylor adds, noting that the "infrastructure" behind stablecoins like USDC allows Circle service users "faster" and more "securely" than traditional finance alternatives.
The infrastructure provided by Circle (USDC), and Tether (USDT) Binance's BUSD or DAI are fundamental to their success. Data from CoinGecko suggests that the market capitalisation for the stablecoins sits at $149bn, with a 90-day trading volume of roughly $41bn.
USDC, BUSED and USDT account for upwards of 75 per cent of that volume.
Not only are they accessible to millions of unbanked citizens but a developing crypto infrastructure and growing comfort with fintech solutions are becoming ever more popular.
Research from the Bank of International Settlements (BIS) suggests that individuals with a proclivity for technology and the emergence of payment providers with PayPal have driven trial adoption.
This is backed by a study conducted by MasterCard in 2021 that over 9/10 of the 4,000 respondents used digital apps for simple financial tasks (paying bills, banking etc.) with a demand for more complex financial offerings "rising".
"We're not a payment service provider, we're not a bank today, we are an issuer that is building the rails for a fully backed retail money solution," Baker-Taylor said.
TradFi flexing its muscles
Just as crypto-native stablecoin options make a strong case for their capabilities, so do the traditional financial options that have increasingly emerged since Meta's Libra project.
In June 2019, Meta, then Facebook announced it was launching Libra, claiming in its whitepaper that the tech firm wanted to make "moving money around globally, and in a compliant way, should be easy and cost-effective…"
According to Henri Arslanian, the author of The Book of Crypto the Libra announcement "singlehandedly catalysed the development of central bank digital currencies", while also spurring the private sector to turn their interest to stablecoins.
As it so happened, a few months earlier in February, JP Morgan announced that it has started to test digital asset coins representing fiat currency. Running on JP Morgan's Onyx blockchain platform, the JPM Coin is now used by the bank to facilitate quick cross-border money transfers.
Earlier this year, US banks joined forces to launch a bank-minted alternative non-bank-issued stablecoin. The USDF Consortium, organised by JAM Fintop and the Provenance Blockchain Foundation, is now backed by eight traditional banks.
In the UK, the Digital FMI Consortium is one of a few traditional financial options that are set to test the real-world use cases for stablecoins and central bank digital currencies (CBDCs).
The Digital FMI Consortium has been launched to test the real-world use cases for stablecoins and central bank digital currencies (CBDCs). 'Project New Era' is looking to test the UK's first privately-led digital Sterling stablecoin, backed by the Boston Consulting Group and pay with. glass, with IBM, Finastra, FinClusive, and Ibanera among others taking part.
"We can make a strong case for a traditional stablecoin alternative. I think the time is right," Brunello Rosa, founder and head of research at Rosa & Roubini Associates – the economic advisor behind Digital FMI – told AltFi.
However, where do traditional financial alternatives have a trump card? According to Kiely, this is very "straightforward".
"One, banks don't need full reserve backing, look at their liquidity ratio requirements. Two, do any stablecoins pay interest?", he said.
As discussed above, a stablecoins reserve composition is fundamental to building trust with customers. Yet, traditional banks do not necessarily have this restriction. According to the Basel III regulations, the leverage ratio – with tier 1 capital – must be at least 3 per cent of total assets, with consensus obligating a 6 per cent minimum tier 1 capital ratio.
Despite the US liquidity coverage ratio requirements calling for a "ratio requirement of 100%", the composition of liquidy does not need to be in cash, cash equivalents and short-term obligations as it does for crypto native stablecoin issuers.
"Here's a little secret of finance. Not even the current fiat money is fully backed. After the financial crisis we learned our money is the bank's money", Rosa explains.
"If it's going to stay in the vaults, it's going to stay in the vaults, and the government then needs to step in to ensure there is a deposit guarantee," he adds.
This brings us to the second major benefit traditional stablecoin issuers have over their crypto-native rivals. At present, federal deposit insurance is not granted to crypto-native stablecoin issuers. In the US, the Federal Deposit Insurance Commission (FDIC) has refused to insure crypto firms – the same holds for the EU and the UK.
Deposit insurance is critical during a bank run. Just as terraUSD collapsed in May, investors lost $18bn of their stablecoin investments. With no deposit insurance, they have no guarantee that their funds will be repaid.
Not only does deposit insurance secure investor funds, but it also allows FDIC-insured firms to access the Federal Reserve's lending facilities. By having access to central bank lending, firms could take loans to bolster their stablecoin reserves. This is available to banks but not to crypto-native solutions.
Lastly, as Kiely rightly points out: "Why even use a stablecoin? Ultimately, you get no yield or interest by holding them. It's a risk-on move since the [crypto-native] issuer holds your real cash, is not insured and doesn't pay you any interest."
In a report published last week, crypto lender MakerDao and the firm behind the DAI stablecoin enlisted crypto bank Sygnum and BlackRock to help boost the firm's balance sheet. DAI's $10.5bn collateral pool is composed of 18 cryptocurrencies including non-yield-bearing USDC. MakerDAO decided to transfer $250m of its assets into iShare fixed-income ETFs, to "boost" its balance sheet the report stated.
"I give you $100. Why am I giving you $100 for free? Why doesn't Circle or Tether pay me interest? I think banks have the advantage here," Kiely said.
A race to service central banks
Despite the regulatory hoops stablecoin issuers are facing, at the end of the day they are competing with traditional financial services to develop the framework for a retail central bank digital currency.
But so are traditional financial alternatives. As Rosa explains: "We are now building the infrastructure for our stablecoin solution. At the end of the day, the Bank of England will decide if it is good enough to use for retail."
According to data from CBDC Tracker, 66 countries are actively researching CBDCs with the Bahamas and Jamaica already launching central bank-backed virtual currencies.
A tokenised US dollar would be virtually void of the risks faced by any crypto-native or traditional bank offering. With 100 per cent reserve backing, unlimited high-quality like-for-like collateral and no exposure to the risks of traditional bank insolvency, CBDCs could defend their pegs and deliver on the promise of stability.
This week, the Biden administration called on Congress to begin to pass stablecoin laws, nothing that stablecoins were a "part" of the central bank digital currency debate. Although a central bank digital currency may not be on the cards for some time, the infrastructure, accessibility and vast amount of users will play a crucial role in the future of money.