a16z investors deeply analyze the evolution of stablecoins: looking at the future of stablecoins from 250 years of banking history
Stablecoins may quickly recreate the history of the banking industry.Author: Sam Broner
Compiled by: Deep Tide TechFlow
Millions of people have traded trillions of dollars through stablecoins, yet the definition and understanding of this category remain vague.
Stablecoins serve as a medium of value storage and exchange, typically pegged to the US dollar, but not necessarily so. They can be categorized along two dimensions: from under-collateralized to over-collateralized, and from centralized to decentralized. This classification helps to understand the relationship between the technology structure and risks and dispel misconceptions about stablecoins. I will propose another useful way of thinking based on this framework.
To understand the richness and limitations of stablecoin design, we can draw lessons from the history of banking: what worked, what didn’t, and why. Like many products in cryptocurrency, stablecoins may quickly replicate the history of banking, starting from simple banknotes and gradually expanding the money supply through complex lending mechanisms.
First, I will discuss the recent history of stablecoins, then take you back to the history of banking to make a beneficial comparison between stablecoins and banking structures. Stablecoins provide users with an experience similar to bank deposits and banknotes—convenient and reliable value storage, exchange medium, and lending—but in a non-custodial "self-custody" form. In the process, I will evaluate three types of tokens: fiat-backed stablecoins, asset-backed stablecoins, and strategy-backed synthetic dollars.
Let’s dive in.
A Brief History of Recent Stablecoins
Since the launch of USDC in 2018, the most widely adopted US stablecoin has provided us with enough evidence to showcase which designs are successful and which are not. Therefore, it is now time to clearly define this space. Early users utilized fiat-backed stablecoins for transfers and savings. Although decentralized over-collateralized lending protocols produced useful and reliable stablecoins, their demand has remained relatively flat. So far, consumers seem to prefer dollar-pegged stablecoins over other (fiat or novel) pegged options.
Certain categories of stablecoins have completely failed. Decentralized under-collateralized stablecoins, while more capital-efficient than fiat-backed or over-collateralized stablecoins, have ended in disaster in the most well-known cases. Other categories have yet to take shape: yield-bearing stablecoins are intuitively appealing—after all, who doesn’t like yield?—but they face user experience and regulatory hurdles.
Other types of dollar-pegged tokens have also emerged, benefiting from the successful product-market fit of stablecoins. Strategy-backed synthetic dollars (to be described in more detail below) represent a new category of products that, while similar to stablecoins, do not actually meet the important standards of safety and maturity, with their higher-risk yields accepted by DeFi enthusiasts as investments.
We have also witnessed the rapid proliferation of fiat-backed stablecoins, which are favored for their simplicity and perceived safety; while the adoption of asset-backed stablecoins has lagged, despite traditionally holding the largest share in deposit investments. Analyzing stablecoins through the lens of traditional banking structures helps explain these trends.
Bank Deposits and US Currency: A Bit of History
To understand how contemporary stablecoins mimic banking structures, it is very helpful to know the history of the US banking system. Before the Federal Reserve Act (1913), especially before the National Banking Act (1863-1864), different types of dollars were not treated equally. (For those interested in learning more, the US experienced three central bank eras before establishing a national currency: the Central Bank Era [First Bank 1791-1811 and Second Bank 1816-1836], the Free Banking Era [1837-1863], and the National Banking Era [1863-1913]. We have tried almost every method.)
Before the establishment of the Federal Deposit Insurance Corporation (FDIC) in 1933, deposits had to be specifically underwritten against bank risks. The "real" value of banknotes (cash), deposits, and checks could vary based on the issuer, the convenience of redemption, and the issuer's reliability.
Why was this the case? Because banks face a conflict between profitability and ensuring the safety of deposits.
To be profitable, banks need to invest deposits and take risks, but to ensure the safety of deposits, they must manage risks and maintain sufficient cash reserves. Before the late 19th century, different forms of currency were thought to have different risk levels, and thus their actual values varied. After the implementation of the Federal Reserve Act in 1913, the dollar gradually came to be seen as equivalent (in most cases).
Today, banks use dollar deposits to purchase government bonds and stocks, issue loans, and engage in simple strategies like market making or hedging, all permitted by the Volcker Rule. This rule, introduced in 2008, aims to reduce bankruptcy risk by limiting speculative activities in retail banking. Lending is particularly important in banking and is how banks increase the money supply and enhance capital efficiency in the economy.
While ordinary bank customers may think all their funds are held in deposit accounts, this is not the case. However, due to federal regulation, consumer protection, widespread adoption, and improved risk management, consumers can view deposits as relatively risk-free overall balances. Banks balance profitability and risk in the background, and users are mostly unaware of what banks do with their deposits, yet even during economic turmoil, they are confident in the safety of deposits.
Stablecoins provide users with many familiar experiences akin to bank deposits and banknotes—convenient and reliable value storage, exchange medium, and lending—but in a non-custodial "self-custody" form. Stablecoins will emulate their fiat predecessors. Their applications will start with simple banknotes, but as decentralized lending protocols mature, asset-backed stablecoins will become increasingly popular.
Evaluating Stablecoins from the Perspective of Bank Deposits
In this context, we can evaluate the three types of stablecoins from the perspective of retail banking: fiat-backed stablecoins, asset-backed stablecoins, and strategy-backed synthetic dollars.
Fiat-Backed Stablecoins
Fiat-backed stablecoins are similar to banknotes issued during the National Banking Era (1865-1913). During this period, banknotes were bearer instruments issued by banks; federal regulations required customers to be able to redeem these notes for an equivalent amount of greenbacks (such as specific US Treasury bonds) or other legal tender ("specie"). Thus, while the value of banknotes might vary based on the issuer's reputation, distance, and perceived solvency, most people trusted banknotes.
Fiat-backed stablecoins operate on the same principle. They are tokens that users can directly redeem for a well-known, trusted fiat currency, but with similar limitations: while banknotes are bearer instruments redeemable by anyone, holders may not live near the issuing bank. Over time, people gradually accepted that they could find someone willing to redeem banknotes for greenbacks or coins. Similarly, users of fiat-backed stablecoins are increasingly confident that they can reliably find someone willing to exchange high-quality fiat-backed stablecoins for a dollar value through Uniswap, Coinbase, or other exchanges.
Driven by regulatory pressure and user preferences, more and more users are turning to fiat-backed stablecoins, which account for over 94% of the total stablecoin supply. Circle and Tether dominate the issuance of fiat-backed stablecoins, jointly issuing over $150 billion in dollar-pegged fiat-backed stablecoins.
So why do users trust the issuers of fiat-backed stablecoins? After all, fiat-backed stablecoins are centrally issued, making it easy to imagine a potential "run" on stablecoin redemptions. To address these risks, fiat-backed stablecoins increase trust by undergoing audits by well-known accounting firms. For example, Circle regularly undergoes audits by Deloitte. The purpose of these audits is to ensure that stablecoin issuers have sufficient fiat or short-term Treasury reserves to meet any recent redemptions and that the issuers have enough fiat collateral to support each stablecoin on a 1:1 basis.
Verifiable reserve proof and decentralized issuance of fiat stablecoins are both possible but have not yet been realized. Verifiable reserve proof would enhance audit transparency and can currently be achieved through methods like zkTLS (zero-knowledge transport layer security, also known as web proofs), although it still relies on trusted centralized authorities. Decentralized issuance of fiat-backed stablecoins may be feasible, but faces significant regulatory challenges. For instance, to achieve decentralized issuance of fiat-backed stablecoins, issuers would need to hold on-chain US Treasuries with risk characteristics similar to traditional government bonds. This is currently unfeasible, but if realized, it would further enhance user trust in fiat-backed stablecoins.
Asset-Backed Stablecoins
Asset-backed stablecoins originate from on-chain lending. They mimic the mechanism by which banks create new money through loans. New stablecoins issued by decentralized over-collateralized lending protocols, such as Sky Protocol (formerly MakerDAO), are backed by highly liquid collateral on-chain.
To understand how they work, consider a checking account. Funds in a checking account are part of a complex system of loans, regulation, and risk management that creates new money. In fact, most of the money in circulation, known as the M2 money supply, is created through bank loans. While banks create money through mortgages, auto loans, commercial loans, and inventory financing, lending protocols use on-chain tokens as collateral for loans, thus creating asset-backed stablecoins.
This system of creating new money through loans is known as the fractional reserve banking system, which formally began with the Federal Reserve Act of 1913. Since then, the fractional reserve banking system has matured significantly and has undergone major updates in 1933 (with the establishment of the FDIC), 1971 (when President Nixon ended the gold standard), and 2020 (when the reserve requirement ratio was lowered to zero).
Each change has increased consumer and regulator trust in the system of creating new money through loans. Over the past 110 years, loans have created an increasingly large proportion of the US money supply, now accounting for the majority.
Consumers do not consider that these loans exist when using dollars for a reason. First, funds held in banks are protected by federal deposit insurance. Second, despite experiencing major crises like those in 1929 and 2008, banks and regulators continually improve their practices and processes to reduce risks.
Traditional financial institutions employ three methods to safely issue loans:
Targeting assets with liquid markets and rapid settlement practices (margin loans)
Using large-scale statistical analysis of a bundle of loans (mortgages)
Through thoughtful and customized underwriting (commercial loans)
Decentralized lending protocols still occupy a small share of the stablecoin supply as they are in their early stages of development. The most representative decentralized over-collateralized lending protocols are transparent, well-tested, and conservatively styled. For example, Sky is the most well-known collateral lending protocol, and the asset-backed stablecoins it issues are based on on-chain, external, low-volatility, and highly liquid (easily sellable) assets. Sky also has strict rules regarding collateral ratios and effective governance and auction protocols. These features ensure that even when conditions change, collateral can be safely sold, protecting the redemption value of asset-backed stablecoins.
Users can evaluate collateral lending protocols based on four criteria:
Transparency of governance
Ratio, quality, and volatility of the assets backing the stablecoins
Security of smart contracts
Ability to maintain loan collateral ratios in real-time
Like the example of funds in a checking account, asset-backed stablecoins are new money created through asset-backed loans, but their lending practices are more transparent, auditable, and easier to understand. Users can audit the collateral supporting asset-backed stablecoins, but must rely on trust for the investment decisions of bank executives.
Additionally, the decentralization and transparency of blockchain can mitigate the risks that securities laws aim to address. This is crucial for stablecoins, as it means that truly decentralized asset-backed stablecoins may not be subject to securities laws. This analysis may only apply to asset-backed stablecoins that rely on digitally native collateral (rather than "real-world assets"), as such collateral can be protected through autonomous protocols without relying on centralized intermediaries.
As more economic activity shifts on-chain, we can anticipate two things: first, more assets will become candidates for collateral in lending protocols; second, asset-backed stablecoins will occupy a larger share of on-chain currency. Other types of loans may eventually be safely issued on-chain, further expanding the on-chain money supply. Nevertheless, while users can evaluate asset-backed stablecoins, this does not mean that every user will be willing to take on this responsibility.
Just as the growth of traditional bank loans, the lowering of reserve requirements by regulators, and the maturation of lending practices all take time, the maturation of on-chain lending protocols will also take time. Therefore, it will take some time for asset-backed stablecoins to be as easy to use as fiat-backed stablecoins.
Strategy-Backed Synthetic Dollars
Recently, some projects have begun offering tokens with a face value of $1 that combine collateral and investment strategies. While these tokens are often classified as stablecoins, strategy-backed synthetic dollars should not be viewed as stablecoins for the following reasons.
Strategy-backed synthetic dollars (SBSDs) allow users direct access to actively managed trading risks. They are typically centralized, under-collateralized tokens combined with financial derivatives. More precisely, SBSDs are dollar shares in open-ended hedge funds, a structure that is not only difficult to audit but may also expose users to risks associated with centralized exchanges (CEX) and asset price volatility, especially during significant market fluctuations or prolonged negative sentiment.
These characteristics make SBSDs unsuitable for the primary uses of stablecoins—reliable value storage or exchange medium. Although SBSDs can be constructed in various ways, with differing risks and stability, they all provide a dollar-denominated financial product that may be included in investment portfolios.
SBSDs can be built on various strategies, such as basis trading or participating in yield protocols, like helping to secure active validation services (AVSs) through re-staking protocols. These projects typically allow users to earn yield on cash positions by managing risks and returns. By managing yield risks, including assessing the penalty risks of AVSs, seeking higher yield opportunities, or monitoring reversals in basis trading, projects can generate yield-bearing SBSDs.
Before using any SBSD, users should thoroughly understand its risks and mechanisms, just as they would with any new tool. DeFi users should also consider the implications of using SBSDs in DeFi strategies, as decoupling could lead to severe cascading effects. When assets decouple or suddenly depreciate relative to their tracking assets, derivatives relying on price stability and continuous yield may suddenly become unstable. However, when strategies include centralized, closed-source, or unauditable components, it may be difficult or even impossible to assess and underwrite their risks. To underwrite risks, you must understand what you are underwriting.
While banks do run simple strategies through deposits, these strategies are actively managed and constitute a small portion of overall capital allocation. These strategies are difficult to support stablecoins because they require active management, making it challenging to achieve reliable decentralization or auditing. SBSDs concentrate risks more than those permitted in bank deposits. If users' deposits are held in this manner, they have reason to feel skeptical.
In fact, users have been cautious about SBSDs. Although SBSDs are popular among risk-preferring users, the actual number of traders is not large. Additionally, the US Securities and Exchange Commission (SEC) has taken enforcement action against issuers of "stablecoins" that effectively resemble shares in investment funds.
Stablecoins have become mainstream. The total amount of stablecoins used in global transactions has exceeded $160 billion. They are primarily divided into two categories: fiat-backed stablecoins and asset-backed stablecoins. Other dollar-pegged tokens, such as strategy-backed synthetic dollars, while gaining recognition, do not meet the definition of stablecoins for trading or value storage.
The history of banking is a good reference for understanding this category—stablecoins must first be integrated around a clear, easily understandable, and easily redeemable banknote, just as Federal Reserve banknotes gained recognition in the 19th and early 20th centuries. Over time, we can expect the number of asset-backed stablecoins issued by decentralized over-collateralized lending institutions to increase, just as banks increased the M2 money supply through deposit loans. Finally, we can expect DeFi to continue to grow, not only by creating more SBSDs for investors but also by improving the quality and quantity of asset-backed stablecoins.
However, this analysis—while potentially useful—can only take us so far. Stablecoins have become the cheapest way to send dollars, meaning that in the payments industry, stablecoins have the opportunity to reshape market structures, providing existing companies, especially startups, with opportunities to build on a frictionless and costless new payment platform.
Acknowledgments: Special thanks to Eddy Lazzarin, Tim Sullivan, Aiden Slavin, Robert Hackett, Michael Blau, Miles Jennings, and Scott Kominers, whose thoughtful feedback and suggestions made this article possible.
Sam Broner is a partner on the a16z crypto investment team. Before joining a16z, Sam was a software engineer at Microsoft, where he was one of the founding team members of Fluid Framework and Microsoft Loop. Sam also attended the MIT Sloan School of Management, where he participated in the Boston Federal Reserve's Project Hamilton, led the Sloan Blockchain Club, mentored the first Sloan AI Summit, and received the MIT Patrick J. McGovern Award for creating an entrepreneurial community. You can follow him on the X platform @SamBroner.
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