2018 was the year of the stablecoin, or digital dollar. The Ethereum ecosystem now has a wide variety of digital assets that maintain a 1:1 peg with the U.S. dollar, enabling a host of new financial use cases like remittances, payroll, and ecommerce.
Stablecoins solve a pain point that has plagued crypto usability since the industry’s inception: volatility. Not only can crypto-asset holders now access a stable medium of exchange in the most common global unit of account, but they can also take advantage of the increased transparency, accessibility, and programmability offered by open networks like Ethereum. Similarly, the fact that users can now get access to the stability of a particular asset without having to open up a bank account is massively overlooked.
The growth in the market capitalization of stablecoins clearly signifies market demand for a blockchain-powered stable currency.
Data includes USDC, TUSD, PAX, GUSD, and DAI
In order to better understand the “digital dollar” market, I've divided existing assets into two camps: fiat tokens, which are assets backed 1:1 by fiat currency held in bank accounts, and stablecoins trust-minimized stable crypto-assets. While both types maintain their value relative to the U.S. dollar, it’s important to understand how each asset is minted, what avenues accept the asset as payment, and who, if anyone, has the ability to change the rules of the system.
The most widely used and audited collateralized digital dollars include USDC, TrueUSD, Paxos, and Gemini Dollar, all of which are fiat tokens. You’ll notice that three of these assets were launched and are currently maintained by some of the largest crypto exchanges, giving them easy access to a liquid marketplace. Each asset is controlled by a regulated institution that holds dollars in reserve for every digital dollar they issue.
The most advantageous feature of fiat tokens is their liquidity. Given the fact that these assets have become linchpins in the business models of crypto financial service providers, exchanges have a strong incentive to create liquidity moats around their specific fiat token. As such, we’ve already seen Coinbase list new assets with the only trading pair being USDC. Similarly, Poloniex has run incentive campaigns for traders who trade against USDC pairs. It’s no surprise that the USDC market cap, in particular, has gone parabolic recently.
Another reason fiat tokens can generate this type of liquidity is because they’re regulated. Exchanges have no problem listing assets so long as they’re able to comply with KYC/AML laws. While this regulation is attractive to many crypto funds that want off-chain recourse, this of course comes with a tradeoff: centralization. The institutions issuing fiat tokens have a lot of influence over how these assets are traded and who can send/receive them. For example, Centre reserves the right to blacklist certain ERC20 addresses, ensuring no USDC can be sent to and from an address.
On the other end of the stablecoin spectrum are trust-minimized stable assets, the main working example being DAI. In these systems, users can access a stable and decentralized crypto-asset by posting collateral in a different asset. In the case of DAI today, a user must supply 1.5x the value of their loan in ETH. There’s no central party that maintains this peg, rather the system is operated by a set of smart contracts and network keepers that perform key functions like monitoring collateral positions and voting on interest rates.
DAI, and MakerDAO more broadly, have undergone impressive growth amidst a 90%+ decline in the value of ETH. We can see that over the course of 2018, the total supply of Dai grew over 10x, from ~6m USD to ~70m USD.
The most advantageous features of trust-minimized stablecoins are the trustless design and censorship resistance guarantees. Unlike fiat tokens, there’s no central party that can deny a user service or seize their assets. This makes DAI particularly useful for citizens in developing countries that want access to a more stable store of value or for DeFi applications that leverage regulatory arbitrage like betting markets.
Of course, decentralization comes at a cost, the main trade offs being scalability and liquidity.
As has been pointed out by the community, creating a closed loop arbitrage cycle for Dai is extremely difficult given the fact that the only way to access the asset is by posting 1.5 times more collateral. This means that demand for Dai is primarily driven by demand for loans rather than the underlying asset. Decreased demand for loans, as dictated by market volatility or an increased stability fee, will tighten liquidity and make accessing Dai more difficult for those who actually need it to store value.
The main takeaway here is that while stablecoins are proving to be one of the most important primitives in decentralized finance, there won’t be a one-size fits all winner. Different needs beget different features, which always come with trade-offs.
At the end of the day, creating a parallel financial system is about optionality — it’s about driving competition so costs come down and users can move between financial services fluidly. Both fiat tokens and trust-minimized stablecoins solve existing problems today. Crypto companies can now easily offer their employees payroll directly in fiat tokens, and financial institutions can seamlessly move in and out of assets without taking on the burden created by today’s financial plumbing. Similarly, anyone in the world can now access a stable store of value without the permission of a centralized party — all they need is an internet connection.