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podcast transcript
One of the most talked about topics in finance today is stablecoins.
Stablecoins have the potential to completely transform the world of banking and finance.
Banks, governments, and technology companies are examining stablecoins to determine how they will be used in the future.
But most people have no idea what they are.
Learn more about how stablecoins work and the problems they can solve in this episode of Everything Everywhere Daily.
One of my least favorite terms is cryptocurrency. That’s because the word is so vague and can encompass many things that are often quite different from each other.
Although Bitcoin is technically a cryptocurrency, it is completely decentralized and the number that can be created is strictly limited.
Stablecoins are also a type of cryptocurrency, but they are completely different.
Stablecoins are digital blockchain tokens priced in and backed by a national currency. In theory, stablecoins can be priced in any currency, but for this episode we will use the US dollar, which is where most of the activity is currently taking place.
Before we dive deeper into stablecoins, I want to address a current, long-standing issue related to the international financial system and global commerce.
One problem is that sending money internationally is very slow and expensive. If you want to send $500 from the US to someone in the Philippines today, you’ll have to pay a fee of $15-$40, a 2-4% exchange rate hike, and wait 1-5 business days.
The money goes through several correspondent banks and gets a cut from each.
You’d think that advances in computer and networking technology would make it possible to send money around the world instantly, but the reality is that the time and cost of sending money internationally hasn’t improved in decades.
Another, completely unrelated problem is that in countries like Argentina, Turkey, and Venezuela, local currencies have lost 50-90% of their value in recent years. They are suffering from severe inflation, which could wipe out the savings of everyone in the country.
People in these countries like to hold dollars to protect their savings, but getting a U.S. bank account is not an option for most people. In the past, even if you had a dollar-denominated account at a local bank, the government forced you to convert it to the local currency.
Another problem is that online commerce is difficult. There is no basic payment system that comes with the Internet. Credit cards have become suitable for online use, but there are problems with credit card fraud, merchant fees, and the fact that all online commerce is controlled by a small number of credit card companies.
Finally, traditional finance is subject to various regional restrictions. Bank transfers require business hours, correspondent banking relationships, know-your-customer processes, and geographic restrictions. Every country has its own list of bank holidays, and depending on your time zone, banks often don’t open at the same time.
Stablecoins are designed to solve, or at least alleviate, all of these problems.
If you remember my episode about blockchain, blockchain is an immutable digital ledger. It can record transactions and wallets managed by individual users. It belongs to a wide range of cryptocurrencies as it is protected by advanced encryption algorithms.
What makes stablecoins different from other types of cryptocurrencies is that each stablecoin is worth one dollar. It’s not an investment. It is not designed to cause prices to rise or fall.
Stablecoins maintain pegs through arbitrage and trust. If a stablecoin is trading at $0.99, a qualified trader can buy it cheaply, exchange it for $1 at the issuing company, and cover the difference.
This buying pressure will push the price back to $1. If it’s trading at $1.01, a trader can create a new token at $1 and sell it at a slightly higher price, bringing the price back down.
This redemption can happen because most of the stablecoins I’m covering, at least in this episode, are backed one-to-one with US dollar-denominated assets. This is usually in the form of short-term Treasury bills and cash in the bank.
This means that stablecoins have 100% reserves. If you issue $1 billion in stablecoins, you must have $1 billion in assets. Cash can cover typical day-to-day repayments, and Treasury bonds can be sold for larger repayments.
This is why they are called stablecoins. This is because the goal is price stability.
This is one of the first major differences between stablecoins and banks. Banks operate on fractional reserves. We do not hold all deposits in cash or government bonds. They lend large amounts of money as loans while maintaining sufficient liquidity to meet normal withdrawals and regulatory requirements.
If you’ve ever seen it It’s a wonderful lifeYou may remember Jimmy Stweard’s speech during banking about how everyone’s money is invested in the community.
In theory, anyone who owns a 100% reserve stablecoin can exchange it for cash and send it to their bank. In a worst-case scenario, there could be problems selling short-term Treasury bonds during the run.
If you have a personal or corporate wallet, you have a cryptographic claim on your stablecoins on the issuing company’s blockchain. You can access it from anywhere 24/7 and send money to anyone.
While bank or credit card transactions can take days to settle and incur fees, stablecoin transactions are almost instantaneous and cost virtually nothing. This is very attractive to merchants who currently accept credit cards and often pay a fee of 1.5% to 3.5%.
Likewise, owning a stablecoin requires only internet access or an app on your phone. There is a huge demand for dollars in developing countries. Foreign people who want to own US dollars do not need to open a bank account. All they need to do is set up a wallet and hold their dollars as stablecoins.
Another advantage of stablecoins is that they can theoretically handle very small payments. Credit cards usually have a minimum payment amount. Stablecoins make it much easier to handle micropayments, in some cases as small as a millionth of a cent.
It is used in automated systems with programmatic trading. This is something that current banking and credit card systems really can’t do.
There is another reason why the government is particularly interested in stablecoins. Stablecoin issuers represent a potentially huge new market for government bonds.
This gives the U.S. government another buyer for its debt, which could help lower borrowing costs and make it easier to finance deficits. Recent estimates suggest that the growth of stablecoins could increase demand for new Treasury bonds by hundreds of billions of dollars, up to $1 trillion, by 2028.
There is another reason why the federal government prefers stablecoins. Dollar stablecoins expand the use of the dollar globally, especially in places where people do not have easy access to U.S. bank accounts.
From Washington’s perspective, this could strengthen the dollar’s role as the dominant global currency while also bringing more digital financial activities into a U.S.-regulated framework.
So how do stablecoin companies make money?
Stablecoin issuers make money from reserves backing their coins, which are mostly Treasury bonds.
Issuers typically do not pay interest to stablecoin holders. So if an issuer has billions of dollars in reserves yielding 4-5%, that interest income can be huge.
So, if an issuer holds $100 billion in reserves yielding 4%, this would result in total interest income of $4 billion per year before expenses, partner payments, compliance costs, technology costs, and taxes.
They also make money from fees, but this is generally less important than reserve income for the largest issuers.
Stablecoin issuers can also generate revenue by providing related services. This may include business accounts, payment APIs, cross-border payment tools, developer infrastructure, custody, compliance services, and blockchain payment products. In that sense, stablecoins themselves can be a product and a way to attract customers to a broader financial platform.
So far, I’ve given you some general information. In fact, there are currently two major issuers of US dollar-denominated stablecoins.
Tether, traded under the USDT ticker, is currently the largest stablecoin with a circulating supply of approximately $190 billion. It dominates global trading volume, especially in Asia and emerging markets. Tether has been controversial for years because it has taken a long time to provide a clear audit of its reserves.
USDC is operated by Circle. Circle is the preferred stablecoin in the US regulatory environment and decentralized finance applications because it is more transparent about reserves and operates under a US remittance license.
USDC briefly lost its peg in March 2023 when news broke that Circle held $3.3 billion at Silicon Valley Bank. Although there was a quick recovery after the FDIC backstopped bank depositors, the episode was a reminder that “cash support” means specific things about where that cash lives.
So, if stablecoins can process transactions 24/7 faster and cheaper than traditional banks, what are the downsides?
First of all, at least as of this writing, stablecoin companies cannot legally allow stablecoin holders to earn interest. This is actually a major point of contention between traditional banks and stablecoin companies right now.
Banks are highly regulated, and I believe that for stablecoin companies to compete with banks, they have to become banks.
Another major problem is that because the industry is so new, there is little regulation or case law regarding stablecoins. Many investors are waiting for legislation to be passed and government guidance to help them reduce risk.
Another big issue is transparency surrounding reserves. People’s trust in stablecoins will be tied to the company’s ability to prove that it has reserves to cover all of its stablecoins.
Another issue concerns the interoperability of coins from different companies. Although all dollar stablecoins are priced in the same currency, you cannot simply move Tether coins to the Circle network. This requires intermediaries, which is likely to become a bigger problem in the future as more companies enter this field.
After hearing everything I’ve covered, you may still be unimpressed or not understand why stablecoins are used.
In fact, if you live in the US and use US dollars as a consumer, you probably won’t have much need to use stablecoins, at least not immediately.
Many of the benefits of stablecoins initially accrue to large institutions looking to clear transactions faster and cheaper. Most of this happens on the backend and may not be visible to most consumers.
Likewise, consumers with the greatest incentive to use stablecoins will likely be outside the United States, where dollars are more difficult to acquire and hold.
Although stablecoins are still new and have low adoption rates, they have enormous potential to disrupt the entire financial industry. Stablecoin transactions can bypass banks, rendering many of their functions inadequate.
Moreover, this could be the beginning of the tokenization of stocks and bonds, which, like stablecoins, would enable global 24/7 trading and near-instantaneous trade clearing.
Banking has been around for a very long time and is a very conservative industry, so it is still too early to know what will happen. But the potential to truly transform the world of finance may already be upon us.
