CHAPTER FIVE

Stablecoins

Rising dominance

Approximately US$145B in stablecoins are currently in circulation, representing about 17-18% of the total crypto market capitalization. That’s more than 5x higher than the 3.4% stablecoin ratio at the beginning of 2021 against a similarly sized market cap. While the rise in that ratio coincides with the broader crypto market drop, the increasing dominance of stablecoins affirms that there has been a shift in the composition of cryptocurrencies towards higher-quality assets. Indeed, bitcoin, ether, and stablecoins together make up nearly 78% of the digital asset class at publication.

We believe that having a higher proportion of crypto's market cap parked in stablecoins is a supportive technical factor for the digital asset class. Not only does it mean that market participants are willing to remain digitally native during a market downturn, but it also represents a significant amount of dry powder sitting on the sidelines that can be deployed when investor confidence returns. Transactions involving just the top four stablecoins by market cap (USDT, USDC, BUSD, and DAI) represent a 76% share of all trading volumes across centralized exchanges, according to CryptoCompare.

Chart 21. Stablecoin market capitalization vs % dominance

Fiat-backed stablecoins represent 91.7% of this crypto sector of which Tether (USDT at $67B) and USDCoin (USDC at $44B) comprise the majority, leaving crypto-backed and algorithmic stablecoins to make up the remainder. Both USDT and USDC are highly liquid and offer comparable convenience for trading purposes, though USDT tends to have greater geographic presence outside of the US for historical reasons.

Fundamentally, the composition of a fiat- backed stablecoin's reserve assets is the most important factor determining its ability to maintain its peg. According to self-reporting by Tether, the stablecoin issuer has reduced its commercial paper holdings to near zero (0.09%) in early 4Q22, compared to a 31% position at the end of 2021. Part of those holdings has been replaced by US Treasury Bills, which now make up the majority 58% of their reserves (~$39B), while cash and bank deposits comprise 9% of all assets (see chart 22). Tether says that they plan to produce an audited statement of their reserves in the near future, although as of end-August 2022, Chief Technology Officer PaoLo Ardoino has said that this is still months away.

Chart 22. Tether reserves backing USDT

Meanwhile, Circle (issuer of USDC) started backing its stablecoin exclusively with cash and short-term US Treasuries starting in September 2021 and began disclosing the full breakdown of its holdings starting with a June 30, 2022 statement.

Note that Circle and Coinbase together cofounded the CENTRE Consortium in 2018, a joint venture that technically oversees USDC and is aimed at providing the governance and standards for adopting fiat stablecoins.

Fundamentally, the composition of a fiat-backed stablecoin's reserve assets is the most important factor determining its ability to maintain its peg.

Chart 23. Circle reserves backing USDC

The killer app?

We believe stablecoins represent one of the largest opportunities in the crypto ecosystem, as they play a crucial role in enabling market participants to price assets in a common currency and retain assets on-chain during periods of higher market volatility. Indeed, paired-trading with other digital assets remains their heaviest use case, offering near-instantaneous transaction settlement. This results in greater market liquidity and depth for digital assets.

But stablecoins also have the potential for mainstream commercial uses such as merchant payments and cross-border remittances. Indeed, we are seeing more stablecoin payments being sent globally via public blockchain networks, suggesting these assets are not just a store of value relevant only to crypto market players but rather represent a genuine improvement over traditional pay ment rails.

Thus, we expect demand for stablecoins to grow over the long term, which is one reason more DeFi protocols have started to launch their own platform-native stablecoins as a way to source liquidity and integrate service offerings. For example, the team behind automated market maker Curve has released plans on Github for a new stablecoin design called a Lending-Liquidating AMM Algorithm or LLAMMA, where the collateral type is contingent on price performance. Decentralized Lender Aave has also released a technical paper for its upcoming overcollateralized GHO stablecoin, which could help it lower capital efficiency costs. Despite deflated crypto markets more broadly, we are seeing growth in the stablecoin sector, as many anticipate that over time, a greater proportion of transaction activity across networks could be associated with these assets.

As stablecoins achieve scale, this is likely to put more scrutiny on stablecoin regulation, although no jurisdiction has fully implemented a comprehensive regulatory framework for stablecoins as of yet. In the US, the House Financial Services Committee is expected to continue working on a bipartisan proposal from Representative Patrick McHenry (R- NC), who will become the Committee's Chair in January 2023, and outgoing Chair Rep. Maxine Waters, that would establish a federal regulatory framework for fiat-backed stablecoins. While the details are still being worked out, the bill is expected to provide a path for nonbanks (like Circle), as well as banks to become regulated stablecoin issuers. Approved firms would also need to fully back stablecoins with highly liquid assets like cash or short-term government debt.

We believe stablecoins represent one of the largest opportunities in the crypto ecosystem, as they play a crucial role in enabling market participants to price assets in a common currency and retain assets on-chain during periods of higher market volatility.