Stablecoin Handbook: How a Trillion-Dollar Market Was Formed?

Original Title: Stablecoin Playbook: Flipping Billions to Trillions

Author: Rui Shang, SevenX Ventures

Compiled by: Mensh, ChainCatcher

Overview: 8 Key Opportunities Related to Stablecoins------

The younger generation is digital natives, and stablecoins are their natural currency. As artificial intelligence and the Internet of Things drive billions of automated microtransactions, global finance needs flexible monetary solutions. Stablecoins, as "currency APIs," transfer seamlessly like internet data, reaching a transaction volume of $4.5 trillion in 2024, a figure expected to grow as more institutions realize that stablecoins represent an unparalleled business model------Tether made $5.2 billion in profits in the first half of 2024 by investing its dollar reserves.

In the competition for stablecoins, complex crypto mechanisms are not key; distribution and real adoption are crucial. Their adoption is primarily reflected in three key areas: crypto-native, fully banked, and unbanked worlds.

In the $29 trillion crypto-native world, stablecoins serve as the gateway to DeFi, essential for trading, lending, derivatives, liquidity farming, and RWA. Crypto-native stablecoins compete through liquidity incentives and DeFi integration.

In the fully banked world of over $400 trillion, stablecoins enhance financial efficiency, primarily used for B2B, P2P, and B2C payments. Stablecoins focus on regulation, licensing, and leveraging banks, card networks, payments, and merchants for distribution.

In the unbanked world, stablecoins provide access to dollars, promoting financial inclusion. Stablecoins are used for savings, payments, foreign exchange, and yield generation. Grassroots marketing is crucial.

Natives of the Crypto World

In the second quarter of 2024, stablecoins accounted for 8.2% of the total crypto market capitalization. Maintaining exchange rate stability remains challenging, and unique incentives are key to expanding on-chain distribution, with the core issue being the limited applicability of on-chain applications.

The Battle for Fixed Exchange Rates

• Fiat-backed stablecoins rely on banking relationships:

93.33% are fiat-backed stablecoins. They offer greater stability and capital efficiency, with banks having the final say through control of redemptions. Regulated issuers like Paxos have become PayPal's dollar issuer due to their successful redemption of billions in BUSD.

• CDP stablecoins improve collateral and liquidation to enhance exchange rate stability:

3.89% are collateralized debt position (CDP) stablecoins. They use cryptocurrencies as collateral but face challenges in scaling and volatility. By 2024, CDPs have improved their risk resistance by accepting broader liquidity and stable collateral, with Aave's GHO accepting any asset in Aave v3, and Curve's crvUSD recently adding USDM (real assets). Partial liquidations are improving, especially with crvUSD's soft liquidation, providing a buffer for further bad debts through its customized automated market maker (AMM). However, the ve-token incentive model faces issues as the valuation of CRV declines after large-scale liquidations, leading to a decrease in crvUSD's market cap.

• Synthetic dollars use hedging to maintain stability:

Ethena USDe alone captured 1.67% of the stablecoin market share within a year, with a market cap of $3 billion. It is a delta-neutral synthetic dollar that hedges volatility by opening short positions in derivatives. It is expected to perform well in the upcoming bull market, even after seasonal fluctuations. However, its long-term viability largely depends on centralized exchanges (CEX), which raises questions. As similar products proliferate, the impact of small funds on Ethereum may diminish. These synthetic dollars may be vulnerable to black swan events and can only maintain low funding rates during bear markets.

• Algorithmic stablecoins have dropped to 0.56%.

Liquidity Guidance Challenges

Crypto stablecoins attract liquidity through yields. Fundamentally, their liquidity costs include the risk-free rate plus a risk premium. To remain competitive, stablecoin yields must at least match Treasury bill (T-bill) rates------we have seen stablecoin borrowing costs decrease as T-bill rates reach 5.5%. sFrax and DAI lead in T-bill exposure. By 2024, multiple RWA projects have enhanced the composability of on-chain T-bills: CrvUSD uses Mountain's USDM as collateral, while Ondo's USDY and Ethena's USDtb are backed by BlackRock's BUIDL.

Based on T-bill rates, stablecoins adopt various strategies to increase risk premiums, including fixed budget incentives (such as distributions from decentralized exchanges, which may lead to constraints and death spirals); user fees (linked to lending and perpetual contract trading volumes); volatility arbitrage (falling when volatility decreases); and reserve utilization, such as staking or re-staking (which is insufficiently attractive).

In 2024, innovative liquidity strategies are emerging:

• Maximizing on-chain yields: While many yields currently stem from self-consuming DeFi inflation as incentives, more innovative strategies are emerging. By treating reserves as banks, projects like CAP aim to direct MEV and arbitrage profits directly to stablecoin holders, providing a sustainable and richer potential yield source.
• Compounding with T-bill yields: Utilizing the new composability of RWA projects, initiatives like Usual Money (USD0) offer "theoretically" unlimited yields, benchmarked against T-bill yields------attracting $350 million in liquidity providers and entering Binance's launch pool. Agora (AUSD) is also an offshore stablecoin with T-bill yields.
• Balancing high yields against volatility: Newer stablecoins adopt diversified basket approaches to avoid single yield and volatility risks, providing balanced high yields. For example, Fortunafi's Reservoir allocates T-bills, Hilbert, Morpho, PSM, and dynamically adjusts portions, incorporating other high-yield assets as needed.
• Is Total Value Locked (TVL) ephemeral? Stablecoin yields often face scalability challenges. While fixed budget yields can drive initial growth, as total value locked increases, yields become diluted, leading to diminishing yield effects over time. Without sustainable yields or real utility in trading pairs and derivatives post-incentives, their total value locked is unlikely to remain stable.

The DeFi Gateway Dilemma

On-chain visibility allows us to examine the true nature of stablecoins: Are stablecoins a genuine representation of currency as a medium of exchange, or merely financial products for yield?

• Only the best-yielding stablecoins are used as trading pairs on CEX:

Nearly 80% of trades still occur on centralized exchanges, with top CEXs supporting their "preferred" stablecoins (e.g., Binance's FDUSD, Coinbase's USDC). Other CEXs rely on the overflow liquidity of USDT and USDC. Additionally, stablecoins are struggling to become margin deposits on CEXs.

• Few stablecoins are used as trading pairs on DEX:

Currently, only USDT, USDC, and a small amount of DAI are used as trading pairs. Other stablecoins, such as Ethena, with 57% of its USDe staked in its own protocol, are held purely as financial products for yield, far from being mediums of exchange.

• Makerdao + Curve + Morpho + Pendle, composite allocation:

Markets like Jupiter, GMX, and DYDX tend to use USDC for deposits, as the mint-redemption process of USDT is more suspect. Lending platforms like Morpho and AAVE prefer USDC due to better liquidity on Ethereum. On the other hand, PYUSD is primarily used for lending on Solana's Kamino, especially when incentivized by the Solana Foundation. Ethena's USDe is mainly used for yield activities on Pendle.

• RWA is undervalued:

Most RWA platforms, like BlackRock, use USDC as a minting asset for compliance reasons, and BlackRock is also a shareholder of Circle. DAI has achieved success in its RWA products.

• Expanding markets or exploring new territories:

While stablecoins can attract major liquidity providers through incentives, they face bottlenecks------DeFi usage is declining. Stablecoins now face a dilemma: they must wait for the expansion of crypto-native activities or seek new utilities beyond this realm.

Outliers in the Fully Banked World

Key Players Are Taking Action

• Global regulation is gradually clarifying:

99% of stablecoins are dollar-backed, with the federal government having the final influence. Following a crypto-friendly Trump presidency, the U.S. regulatory framework is expected to become clearer, as he promised to lower interest rates and ban CBDCs, which could benefit stablecoins. A U.S. Treasury report noted the impact of stablecoins on the demand for short-term government debt, with Tether holding $90 billion in U.S. debt. Preventing crypto crime and maintaining the dollar's dominance are also motivating factors. By 2024, multiple countries have established regulatory frameworks under common principles, including approvals for stablecoin issuance, reserve liquidity and stability requirements, restrictions on foreign currency stablecoin usage, and generally prohibiting interest generation. Key examples include: MiCA (EU), PTSR (UAE), Sandbox (Hong Kong), MAS (Singapore), PSA (Japan). Notably, Bermuda became the first country to accept stablecoin tax payments and license interest-bearing stablecoin issuance.

• Licensed issuers gain trust:

Issuing stablecoins requires technical capability, cross-regional compliance, and strong governance. Key players include Paxos (PYUSD, BUSD), Brale (USC), and Bridge (B2B API). Reserve management is handled by trusted institutions like BNY Mellon, safely generating yields through investments in funds managed by BlackRock. BUIDL now allows a broader range of on-chain projects to earn yields.

• Banks are the gatekeepers for withdrawals:

While deposits (fiat to stablecoin) have become easier, withdrawals (stablecoin to fiat) remain challenging, as banks struggle to verify the source of funds. Banks prefer to use licensed exchanges like Coinbase and Kraken, which conduct KYC/KYB and have similar anti-money laundering frameworks. While reputable banks like Standard Chartered have begun accepting withdrawals, smaller banks like Singapore's DBS are acting swiftly. B2B services like Bridge aggregate withdrawal channels and manage billions in transaction volumes for high-end clients, including SpaceX and the U.S. government.

• Issuers have the final say:

As a leader in compliant stablecoins, Circle relies on Coinbase and is seeking global licenses and partnerships. However, as institutions issue their own stablecoins, this strategy may be impacted, as their business model is unparalleled------Tether, a company with 100 employees, made $5.2 billion in profits in the first half of 2024 from investing its reserves. Banks like JPMorgan have launched JPM Coin for institutional trading. Payment app Stripe's acquisition of Bridge shows interest in owning a stablecoin stack, not just integrating USDC. PayPal has also issued PYUSD to capture reserve yields. Card networks like Visa and Mastercard are tentatively accepting stablecoins.

Factors Behind Efficiency Gains

With trusted issuers, healthy banking relationships, and distributors as foundational support, stablecoins can enhance the efficiency of large-scale financial systems, particularly in payments.

Traditional systems face efficiency and cost constraints. In-app or intra-bank transfers provide instant settlement but are limited to their ecosystems. Interbank payment fees average around 2.6% (70% to the issuing bank, 20% to the receiving bank, 10% to the card network), and settlement times exceed a day. Cross-border transaction costs are even higher, averaging about 6.25%, with settlement times reaching up to five days.

Stablecoin payments eliminate intermediaries, providing point-to-point instant settlement. This accelerates the flow of funds, reduces capital costs, and offers programmable features like conditional automatic payments.

• B2B (annual transaction volume of $120-150 trillion): Banks are well-positioned to drive stablecoin adoption. JPMorgan has developed JPM Coin on its Quorum chain, with approximately $1 billion in transactions per day as of October 2023.
• P2P (annual transaction volume of $1.8-2 trillion): E-wallets and mobile payment apps are well-positioned, with PayPal launching PYUSD, currently valued at $604 million on Ethereum and Solana. PayPal allows end-users to register for free and send PYUSD.
• B2C commerce (annual transaction volume of $5.5-6 trillion): Stablecoins need to collaborate with POS, banking APIs, and card networks, with Visa becoming the first payment network to settle transactions using USDC in 2021.

Innovators in the Underbanked World

Shadow Dollar Economy

Due to severe currency devaluation and economic instability, emerging markets urgently need stablecoins. In Turkey, stablecoin purchases account for 3.7% of its GDP. People and businesses are willing to pay a premium for stablecoins above the official dollar rate, with Argentina's stablecoin premium reaching 30.5% and Nigeria's at 22.1%. Stablecoins provide access to dollars and promote financial inclusion.

Tether dominates this space with a reliable 10-year track record. Even amid complex banking relationships and redemption crises------Tether admitted in April 2019 that USDT was only 70% backed by reserves------its peg remains stable. This is because Tether has established a robust shadow dollar economy: in emerging markets, people rarely convert USDT to fiat; they view it as dollars, particularly evident in regions like Africa and Latin America for paying employees, invoices, etc. Tether achieved this without incentives, relying solely on its long-standing presence and continued utility, enhancing its credibility and acceptance. This should be the ultimate goal for every stablecoin.

Dollar Access

• Remittances: Inequality in remittances hinders economic growth. In Sub-Saharan Africa, individuals sending remittances to low- and middle-income countries and developed nations pay an average of 8.5% of the total remittance amount. For businesses, the situation is even more dire, with high fees, long processing times, bureaucracy, and exchange rate risks directly impacting growth and competitiveness in the region.
• Dollar access: From 1992 to 2022, currency fluctuations caused GDP losses of $1.2 trillion for 17 emerging market countries------an astonishing 9.4% of their total GDP. Access to dollars is crucial for local financial development. Many crypto projects are dedicated to entry, with ZAR focusing on grassroots "DePIN" approaches. These approaches leverage local agents to facilitate cash and stablecoin transactions in Africa, Latin America, and Pakistan.
• Foreign exchange: Today, the forex market has a daily trading volume exceeding $7.5 trillion. In the Global South, individuals often rely on black markets to exchange local fiat for dollars, primarily because black market rates are more favorable than official channels. Binance P2P is beginning to be adopted, but its order book approach lacks flexibility. Many projects like ViFi are building on-chain automated market maker forex solutions.
• Humanitarian aid distribution: Ukrainian war refugees can receive humanitarian aid in the form of USDC, which they can store in digital wallets or cash out locally. In Venezuela, amid deepening political and economic crises, frontline medical workers used USDC to pay for medical supplies during the COVID-19 pandemic.

Conclusion: Interwoven

Interoperability

• Foreign exchange:

Traditional forex systems are highly inefficient and face multiple challenges: counterparty settlement risk (CLS, while enhanced, is cumbersome), costs of multi-bank systems (involving six banks when purchasing yen at an Australian bank for the London dollar office), global settlement time zone differences (Canadian and Japanese bank systems overlap for less than five hours each day), and limited forex market access (retail users pay 100 times the fees of large institutions). On-chain forex offers significant advantages:

Cost, efficiency, and transparency: Oracles like Redstone and Chainlink provide real-time price quotes. Decentralized exchanges (DEX) offer cost efficiency and transparency, with Uniswap CLMM reducing trading costs to 0.15-0.25%------about 90% lower than traditional forex. Shifting from T+2 bank settlements to instant settlements allows arbitrageurs to adopt various strategies to correct mispricing.

Flexibility and accessibility: On-chain forex enables corporate treasurers and asset managers to access a wide range of products without needing multiple bank accounts for specific currencies. Retail users can access the best forex prices using crypto wallets with embedded DEX APIs.

Separation of currency and jurisdiction: Transactions no longer require domestic banks, detaching them from the underlying jurisdiction. This approach leverages the efficiency of digitization while maintaining monetary sovereignty, although drawbacks remain.

However, challenges persist, including the scarcity of non-dollar-denominated digital assets, oracle security, support for long-tail currencies, regulation, and unified interfaces with on- and off-ramps. Despite these hurdles, on-chain forex still presents enticing opportunities. For example, Citibank is developing blockchain forex solutions under the guidance of the Monetary Authority of Singapore.

• Stablecoin exchanges:

Imagine a world where most companies issue their own stablecoins. Stablecoin exchanges pose a challenge: paying merchants at JPMorgan using PayPal's PYUSD. While on- and off-ramp solutions can address this, they lose the efficiency promised by cryptocurrencies. On-chain automated market makers (AMM) offer optimal real-time low-cost stablecoin-to-stablecoin trading. For instance, Uniswap provides multiple such pools with fees as low as 0.01%. However, once billions enter the chain, trust in the security of smart contracts is essential, and sufficient liquidity and instant performance must support real-life activities.

• Cross-chain exchanges:

Major blockchains have diverse advantages and disadvantages, leading to stablecoins being deployed across multiple chains. This multi-chain approach introduces cross-chain challenges, with bridging posing significant security risks. In my view, the best solution is for stablecoins to launch their own layer 0, such as USDC's CCTP, PYUSD's layer 0 integration, and the actions we witness with USDT recalling bridged locked tokens, potentially launching similar layer 0 solutions.

Meanwhile, several unresolved questions remain:

Will compliant stablecoins hinder "open finance," as compliant stablecoins could potentially monitor, freeze, and withdraw funds?

Will compliant stablecoins still avoid providing yields that could be classified as securities products, thereby preventing on-chain decentralized finance (DeFi) from benefiting from its large-scale expansion?

Given Ethereum's slow speed and its L2 reliance on a single sequencer, Solana's imperfect track record, and other popular chains lacking long-term performance records, can any open blockchain truly handle massive funds?

Will the separation of currency and jurisdiction introduce more chaos or opportunity?

The financial revolution led by stablecoins is both exciting and unpredictable before us------a new chapter where freedom and regulation dance in delicate balance.