#211—It’s the age of stablecoins

And why boring banks might be the solution.

May 09, 2022

Welcome to Yaka Stuff, our weekly newsletter that covers news, industry perspectives, and updates from the Hard Yaka ecosystem. Check out last week’s report here.

This week:

The crazy growth of stablecoins
Why the Fed is worried about stablecoins
It’s not just the Fed
The crypto maximalist approach
What about the boring approach?
This week in policy
Ecosystem updates
Stuff happens

1. The crazy growth of stablecoins

The attraction of stablecoins is pretty intuitive. You get the benefits of digitally native crypto without the volatility. You also get those benefits, today—rather than waiting for central banks to get their act together in releasing their own digital solutions.

And so, stablecoins are really popular.

Here’s Bankless:

While NFTs, DeFi, and DAOs have taken center stage in crypto over the past few years, stablecoins have been quietly growing in the background.
In the last year, the stablecoin market has grown by over 100%. 👀
In the last 2 years, it’s been 1,700%. 🤯

Also this chart from The Block Crypto:

Relevant:

2. Why the Fed is worried about stablecoins

It’s no surprise then that stablecoins are getting plenty of regulatory attention. Earlier this year, the Fed published a paper analyzing their impact on the banking sector.

Here’s Matt Levine’s take:

A less obvious risk of stablecoins is that they might be too stable. A stablecoin is, among other things, a substitute for putting money in a bank. Banks are generally very safe places to put money, but they are not perfectly safe. There can be runs on banks; banks can fail. For most U.S. retail bank accounts this is not a very salient problem, since they are backed by government deposit insurance, but many large institutional pools of money (corporate cash accounts, money-market funds, etc.) park their money in short-term bank instruments and are sensitive to risk. If a bank gets riskier, it will lose deposits. And if a stablecoin is so stable that it is safer than a bank, then banks generally will lose deposits.
Why is this a risk? Well, banks do useful stuff. Classically, they take people’s deposits and lend them out to other people to start businesses and buy homes. The provision of credit by banks helps the economy grow. More to the point, the withdrawal of credit by banks hurts the economy, and the risk here is wrong-way. If people get nervous about banks and pull out all their money to put it in safer stablecoins, then (1) that will probably happen at a time when the economy is shaky and (2) that will definitely make the economy shakier. The bulk of the response to the 2008 financial crisis involved preventing runs on banks, because those would have made all of the problems of the crisis much worse.

Relevant:

Matt Levine: The Fed v. Stablecoins
Stablecoins: Growth Potential and Impact on Banking

3. It’s not just the Fed

Biden’s top Treasury official Nellie Liang underscored the need to prioritize regulatory measures back in March.

Here’s Bloomberg:

There’s “broad agreement” that risks posed by stablecoins need to be addressed -- especially given the growth of the market, she said.
“I’m confident we’ll reach some consensus around some of these proposals,” Liang said Tuesday at a conference in Washington hosted by the

And last month, U.S. Sen. Patrick Toomey unveiled his proposed "Stablecoin TRUST Act.”

Here’s Coindesk:

As written, the discussion draft of the bill would define a "payment stablecoin," authorize the Office of the Comptroller of the Currency (OCC) to create a new license specific to stablecoin issuers, allow insured depository banks to issue payment stablecoins and address state regulatory oversight of this segment of the crypto industry.
"Payment stablecoins" would include stablecoins issued by a centralized entity, are pegged to and can be converted to a fiat currency (or currencies), are "designed to be widely used as a medium of exchange," do not confer interest and where transactions are recorded on a "public distributed ledger."
Stablecoin issuers would have to choose between securing the OCC license, a state money transmitter or similar license or a traditional bank charter. These companies would be subject to a disclosure regime that would require them to secure regular attestations, detail redemption policies and specify what actually backs the stablecoins they issue.

Then there’s the IMF, which pointed out the role of stablecoins in DeFi in its latest Global Financial Stability Report two weeks ago.

Here’s Barron’s:

More broadly, the IMF sees growing risks to stability in decentralized finance. DeFi platforms consist of “smart contracts” that are essentially software code setting the conditions for a transaction. They are entirely automated and don’t rely on centralized entities for market making, liquidity, settlement, or custody services.
Typically, users borrow a stablecoin—a token designed to maintain a fixed value—and provide a volatile crypto like ether or Bitcoin as collateral for the loan. The stablecoins are then used for trading, often as collateral for a long or short bet on another crypto. Lenders get compensated with a yield on the tokens they provide to a “liquidity pool,” with rates set by supply and demand in the market.
…
The solution, in the IMF’s view, is to crack down on the enablers of DeFi: centralized exchanges, wallet providers, and stablecoin issuers. Authorities could also review and audit the software governing smart contracts; require disclosures from DeFi platforms; and establish more governance of the industry, potentially through a self-regulatory organization. Another option would be to restrict exposure to DeFi platforms by regulated entities such as crypto exchanges, aiming to “slow the pace of growth,” it said.

Relevant:

4. The crypto maximalist approach

This, of course, brings us to the latest generation of so-called “regulation-proof” stablecoins from Terra to TRON.

Here’s The Block:

There’s a new breed of stablecoin in crypto markets. They are pegged to the US dollar. They seek to maintain that peg “algorithmically” through a minting mechanism designed to tickle the fancy of arbitrageurs. Yet they are amassing colossal backing, à la older stablecoins, in case that mechanism fails.
In two of the most prominent cases — Terra’s UST and TRON’s USDD — the target size of these reserves is $10 billion. In sum, they are here to ensure that stablecoins — the lifeblood of crypto markets — cannot be interfered with by regulators.
“Regulatory pressure is going to hit the core protocol teams of decentralized stablecoins and centralized stablecoins alike,” says Do Kwon, founder of the blockchain Terra. “The key difference here is that the natural law is different. Even if I wanted to, let’s say, freeze accounts holding UST, I wouldn’t be able to do it.”
TRON founder Justin Sun’s thinking is similar. “We can’t make the most important part of crypto super centralized and vulnerable to basically everyone,” he says. “We need to make the stablecoin in the industry just as decentralized as bitcoin, so no one can touch it.”
The two share other similarities besides their views. Not only are they both trying to amass $10 billion in reserves for their stablecoins, but they have also both had run-ins with regulators.
Kwon is involved in an ongoing standoff with the Securities and Exchange Commission, the US watchdog, over its attempts to subpoena him. Sun’s TRON raised $70 million in 2017 through an initial coin offering just before a blanket ban was enforced by Chinese regulators.

Terra made news over the weekend after UST’s dollar peg came under mounting pressure.

Here’s Decrypt:

UST fell as low as $0.985 on Saturday, and it’s now trading for $0.99. Although a 1% depeg from $1 isn’t unusual for stablecoins at times of intense market pressure, the parity is often restored quickly. In the case of UST, it’s been more than 16 hours.
Some critics say this highlights UST as a liability for the wider cryptocurrency market as the Luna Foundation Guard, the organization that backs UST, has $3.5 billion in bitcoin ready to sell as a last resort should it need to defend UST’s stability. LFG reserves are in BTC (93%), LUNA (3.5%), and AVAX (3.5%).
The pressure on UST began to mount after the past few days saw high-volume withdrawals from Terra’s Anchor Protocol, where UST deposits currently earn investors 18.8% APY. Although it’s unclear what led to the withdrawals, it could be the bearish turn in the broader market.

Matt Levine wrote about Terra’s approach to maintaining its algorithmic peg a few weeks ago.

Relevant:

5. What about the boring approach?

What if we just let banks be boring banks?

Here’s the Fed (from that same research report referenced above):

Our research suggests the broad adoption of asset-backed stablecoins can potentially be supported within a two-tiered, fractional reserve banking system without a negative impact on credit intermediation. In such a framework, stablecoin reserves are held as commercial bank deposits, and commercial banks engage in fractional reserve lending and maturity transformation as they normally would with traditional bank deposits. We also find that the replacement of physical cash (banknotes) with stablecoins could result in more credit intermediation. In contrast, a narrow banking framework, in which stablecoin issuers are required to back their stablecoins with central bank reserves, minimizes the risk of ”runs” on stablecoins but can potentially reduce credit intermediation. …
While a narrow bank framework would guarantee the stability of a stablecoin’s peg as it is effectively a pass-through central bank digital currency (CBDC), this reserve framework poses the largest risk of credit disintermediation. Periods of financial stress or panic could lead to large migrations of regular commercial bank deposits into narrow bank stablecoins, which could disrupt credit provision. Though this credit disruption effect could be mitigated by limits on stablecoin holdings and differential reserve interest rates, the overall structure of the narrow bank approach to stablecoin reserves is potentially destabilizing for the banking system. Additionally, the narrow bank approach could lead to an expansion of the central bank’s balance sheet in order to accommodate the demand for reserve balances from stablecoin issuers.

Relevant:

Stablecoins: Growth Potential and Impact on Banking

6. This week in policy

7. Ecosystem updates

Hard Yaka invested in Line. Here’s TechCrunch:

There’s no shortage of fintechs claiming to build a more inclusive, mission-driven fintech platform for lower-income individuals. However, hurdles like required credit history or predatory interest rates and fees limits an entire cohort of people from engaging in our financial systems.
Akshay Krishnaiah, the founder and CEO of Line, thinks he can get users onboard for his vision of a more inclusive financial network. His startup doles out emergency lines of funds to people — as low as $10 — without charging interest or demanding proof of credit history and income. Over time, as trust grows from repayment, so does a customer’s ability to request larger checks.

Also, check out coverage of Origin Trail’s event with internet legend Bob Metcalfe in Brooklyn last week—here’s ZDNet:

OriginTrail's knowledge graph relies on multiple Layer 1 blockchains, but the company is soon going to introduce its own blockchain, running as a function of the Polkadot blockchain.
As co-founder and CTO Branimir Rakic explained Wednesday during a technical presentation, "blockchains are not good databases." Blockchains can be queried, but only in a limited fashion, said Rakic.
What's needed, maintains Rakic, is a "semantic network" on top of blockchains. That's what the company proposes with its distributed knowledge graph.
By combining Tim Berners-Lee's notion of "The Semantic Web" with Web3, said Rakic, you'll get "The Semantic Web3."
"I like where it's going," said Metcalfe of OriginTrail's approach. "All this stuff — DeFi, DOAs, crypto — all the decentralized stuff of Web3, it's all going in this direction of sharing value," said Metcalfe.

Relevant:

USBC

Discussion about this post

USBC

#211—It’s the age of stablecoins

And why boring banks might be the solution.

1. The crazy growth of stablecoins

2. Why the Fed is worried about stablecoins

3. It’s not just the Fed

4. The crypto maximalist approach

5. What about the boring approach?

6. This week in policy

7. Ecosystem updates

8. Stuff happens

Discussion about this post