The Nature of Stablecoins

A Stablecoin is a Loan

Fundamentally, a stablecoin is a loan.

The issuer is receiving some sort of collateral, which may be $1 USD in the case of USDC/USDT centrally issued stablecoins, or $1.3 USD worth of Ethereum in the case of the DAI stablecoin, and then the issuer mints a stablecoin.

The coin’s stability depends on the reliability of the issuer to give you back that collateral when you return the stablecoin. That makes sense, right?

Let’s get a little more specific.

In the case of DAI, because of ETH’s large ecosystem and much higher collateralization requirements, it does not suffer the same pro-cyclical design issues that plague other stablecoins. (Like, say, LUNA.)

However, is it risk-free?

Nothing is risk-free. In the case of centralized issuers, there is counterparty risk. In the case of over-collateralization, there is a risk that the collateral value drops precipitously.

It is essential to frame the discussion around stablecoins and lending right now because there is a lot of misinformation floating around the web.

Most people don’t realize that when you put a dollar into a bank, you have a liability on the bank’s balance sheet. The number you see on your mobile is just the bank’s ledger.

The money is not sitting in a vault with your name. It’s pooled and available to use at the bank’s discretion.

The bank can lend and use your dollars to trade. It has risk limits and controls, but the bank doesn’t answer to you; it responds to bank regulators.

The system works well if bank regulators are the best agents to proactively find risks and craft policies that incentivize prudent risk management. But as we’ve seen over the last few financial crises, this arrangement is less than ideal.

Of course, that doesn’t mean regulators cannot reduce the risks of this arrangement. They can categorically outlaw classes of activities and dramatically reduce the flexibility of banks in deciding what they can do with depositors’ money.

But even more than a decade after the global financial crisis, we still see regular blowups, including:

• Archegos Capital’s collapse arising from prime brokerage services—an otherwise relatively conservative business focused on lending.
• Robinhood and the GameStop (GME) trading frenzy, which contributed to a massive short squeeze and trading halts.
• Money market fund failures, especially during the 2008 financial crisis, and again during periods of market stress in 2020.
• Most recently, major currencies such as the euro (EUR) and Japanese yen (JPY) have experienced significant declines relative to the U.S. dollar, reminding us that even sovereign currencies are not immune to substantial market fluctuations.

So, could we eventually envision a monetary system that isn’t controlled by any single nation but instead serves as a stable medium of exchange and unit of account for goods and services?

I think so—but we’re not there yet.

One thing is certain: the road ahead will be full of interesting surprises.