Original article by: Sam Broner
Original translation: TechFlow
Millions of people have traded trillions of dollars in stablecoins, but the definition and understanding of the category remains murky.
Stablecoins are stores of value and mediums of exchange, usually pegged to the U.S. dollar, but not necessarily so. People classify them along two dimensions: from undercollateralized to overcollateralized, and from centralized to decentralized. This classification helps understand the relationship between technical structure and risk , and dispels misunderstandings about stablecoins. I will propose another helpful way of thinking based on this framework.
To understand the richness and limitations of stablecoin designs, it is useful to draw on the history of banking: what works, what doesn’t, and why. Like many products in cryptocurrencies, stablecoins may quickly repeat banking history, starting with simple paper money and gradually expanding the money supply through complex loan mechanisms.
First, I will discuss the recent history of stablecoins, then take you through the history of banking to draw a helpful comparison between stablecoins and bank structures. Stablecoins provide users with a similar experience to bank deposits and paper money—convenient and reliable store of value, medium of exchange, and lending—but in an unbundled, “self-custodial” form. In the process, I will evaluate three types of tokens: fiat-backed stablecoins, asset-backed stablecoins, and strategy-backed synthetic dollars.
Let’s dig a little deeper.
History of Some Recent Stablecoins
Since the launch of USDC in 2018, the most widely adopted US stablecoin has provided us with enough evidence to show which designs are successful and which are not. Therefore, it is time to clearly define this field. Early adopters use fiat-backed stablecoins for transfers and savings. Although decentralized overcollateralized collateral protocols have produced useful and reliable stablecoins, their demand has been relatively muted. So far, consumers seem to prefer USD-denominated stablecoins over other (fiat or novel) denominated options.
Some categories of stablecoins have failed outright. Decentralized undercollateralized stablecoins, while more capital efficient than fiat-backed or overcollateralized stablecoins, have ended in disaster in the most high-profile cases. Other categories have yet to take shape: Yield-bearing stablecoins are intuitively desirable—after all, who doesn’t like yield?—but they face UX and regulatory hurdles.
Other types of USD-denominated tokens have also emerged, riding on the successful product-market fit of stablecoins. Strategy-backed synthetic dollars (described in more detail below) are a new product category that, while similar to stablecoins, do not actually meet important standards of security and maturity, and whose higher risk returns are accepted by DeFi enthusiasts as investments.
We have also witnessed the rapid adoption of fiat-backed stablecoins, which are popular for their simplicity and perceived security, while asset-backed stablecoins have lagged in adoption, despite their traditionally holding the largest share of deposit investments. Analyzing stablecoins through the lens of traditional banking structures helps explain these trends.
Bank Deposits and U.S. Currency: A Little History
To understand how contemporary stablecoins mimic bank structures, it’s helpful to understand the history of U.S. banking. Before the Federal Reserve Act (1913), and especially before the National Bank Act (1863-1864), different types of dollars were not treated equally. (For those interested in learning more , the U.S. went through three central banking eras before establishing a national currency: the Central Bank Era [First Bank 1791-1811 and Second Bank 1816-1836], the Free Bank Era [1837-1863], and the National Bank Era [1863-1913]. We’ve tried almost everything.)
Deposits had to be insured specifically against bank risks until the Federal Deposit Insurance Corporation (FDIC) was established in 1933. The real value of bank notes (cash), deposits, and checks may vary depending on the issuer, the ease with which they can be exchanged, and the reliability of the issuer.
Why is this happening? Because banks face a conflict between making profits and ensuring the safety of deposits.
In order to make a profit, banks need to invest deposits and take risks, but in order to ensure the safety of deposits, they need to manage risks and maintain sufficient cash reserves. Before the mid-to-late 19th century, different forms of currency were considered to have different risk levels and therefore different actual values. After the implementation of the Federal Reserve Act in 1913, the US dollar gradually became regarded as equivalent (in most cases).
Today, banks use dollar deposits to buy Treasury bonds and stocks, make loans, and engage in simple strategies such as market making or hedging, all of which are permitted under the Volcker Rule, which was introduced in 2008 to reduce the risk of bankruptcies by reducing speculative activities by retail banks. Lending is particularly important in banking operations and is how banks increase the money supply and improve the efficiency of capital in the economy.
Although the average bank customer may think that all of their money is held in a deposit account, this is not the case. However, thanks 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 are doing with their deposits, but they can be confident in the safety of their deposits even in times of economic turmoil.
Stablecoins offer users many familiar experiences similar to bank deposits and paper money - convenient and reliable value storage, medium of exchange, and lending - but in an unbundled self-custody form. Stablecoins will follow the example of their fiat predecessors. Their applications will start with simple paper money, but as decentralized lending protocols mature, asset-backed stablecoins will grow in popularity.
Stablecoins from the perspective of bank deposits
Against this backdrop, we can evaluate three types of stablecoins from a retail banking perspective: fiat-backed stablecoins, asset-backed stablecoins, and strategy-backed synthetic dollars.
Fiat-backed stablecoins
Fiat-backed stablecoins are similar to U.S. bank notes from the national banking era (1865-1913). During this period, bank notes were bearer certificates issued by banks; federal regulations required that customers redeem these notes for greenbacks (such as certain U.S. Treasury bonds) or other legal tender (“ coins ”) of equal value. Therefore, most people trust bank notes, even though their value can vary depending on the reputation, distance, and perceived solvency of the issuer.
Fiat-backed stablecoins operate on the same principle. They are tokens that users can redeem directly for a well-known, trusted fiat currency, but with similar restrictions: while a bank note is a bearer’s certificate that anyone can redeem, the bearer may not live near the issuing bank. Over time, people have come to accept that they can find someone willing to exchange a bank note for a greenback or coin. Similarly, users of fiat-backed stablecoins have become increasingly confident that they can reliably find someone willing to exchange a dollar’s worth of value for a high-quality fiat-backed stablecoin through Uniswap, Coinbase, or other exchanges.
Driven by regulatory pressure and user preference, more and more users are turning to fiat-backed stablecoins, which account for more than 94% of the total stablecoin supply. Two companies, Circle and Tether, dominate the issuance of fiat-backed stablecoins, together issuing more than $150 billion in USD-denominated fiat-backed stablecoins.
So why should users trust the issuers of fiat-backed stablecoins? After all, fiat-backed stablecoins are centrally issued, and it’s easy to imagine a possible stablecoin redemption “run”. To counter these risks, fiat-backed stablecoins increase trust by being audited by reputable accounting firms. For example, Circle is regularly audited by Deloitte. The purpose of these audits is to ensure that the stablecoin issuer has sufficient fiat or short-term Treasury reserves to cover any near-term redemptions, and that the issuer has enough fiat collateral to back each stablecoin 1:1.
Both verifiable proof of reserves and decentralized issuance of fiat stablecoins are possible but not yet achieved. Verifiable proof of reserves would increase transparency for audits and is currently achieved through methods such as zkTLS (zero-knowledge transport layer security, also known as web proofs), although it still relies on a trusted centralized authority. Decentralized issuance of fiat-backed stablecoins may be feasible but faces significant regulatory challenges. For example, to achieve decentralized issuance of fiat-backed stablecoins, issuers would need to hold U.S. Treasuries on-chain that have similar risk characteristics to traditional Treasuries. This is not currently feasible, but if achieved, it would further enhance user trust in fiat-backed stablecoins.
Asset-backed stablecoins
Asset-backed stablecoins are derived from on-chain loans. They mimic the mechanism by which banks create new money through loans. New stablecoins issued by decentralized overcollateralized lending protocols like Sky Protocol (formerly MakerDAO) are backed by highly liquid collateral on-chain.
To understand how this works, think of a checking account. The funds in your checking account are part of a complex system of lending, regulation, and risk management that creates new money. In fact, the majority of money in circulation, the so-called M2 money supply , is created through bank lending. While banks create money through things like mortgages, auto loans, business loans, and inventory financing, lending protocols use on-chain tokens as collateral for loans, thereby creating asset-backed stablecoins.
This system of creating new money through lending is called fractional reserve banking, and it officially began with the Federal Reserve Act of 1913. Since then, fractional reserve banking has matured significantly, with major updates in 1933 (with the creation of the FDIC), 1971 (when President Nixon ended the gold standard), and 2020 (when reserve requirements were reduced to zero).
Each change has given consumers and regulators more trust in a system that creates new money through lending. Over the past 110 years, lending has created an increasing share of the U.S. money supply and now accounts for the majority.
There are reasons why consumers don’t think of these loans when using their dollars. First, funds deposited with banks are protected by federal deposit insurance. Second, despite major crises such as 1929 and 2008, banks and regulators have continually improved their practices and processes to reduce risk.
Traditional financial institutions use three methods to safely issue loans:
For assets with liquid markets and fast liquidation practices (margin lending)
Large-scale statistical analysis of a set of loans using bundles (mortgage loans)
Through thoughtful and customized underwriting (commercial loans)
Decentralized lending protocols still account for a small share of the stablecoin supply as they are in the early stages of development. The most representative decentralized over-collateralized lending protocols are transparent, well-tested, and conservative in style. For example, Sky is the most well-known collateralized lending protocol, which issues asset-backed stablecoins based on on-chain, exogenous, low-volatility, and highly liquid (easy to sell) assets. Sky also has strict rules on collateralization ratios and effective governance and auction protocols. These features ensure that collateral can be safely sold even when conditions change, thereby protecting the redemption value of asset-backed stablecoins.
Users can evaluate collateral lending protocols based on four criteria:
Transparency in governance
Ratio, quality, and volatility of assets backing stablecoins
Security of Smart Contracts
Ability to maintain loan-to-value ratio 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 easy to understand. Users can audit the collateral backing asset-backed stablecoins, but can only rely on trust in the investment decisions of bank executives.
Furthermore, the decentralized and transparent nature of blockchains can mitigate the risks that securities laws are designed to address. This is critical 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 digital native collateral (rather than “real-world assets”), as such collateral can be secured by autonomous protocols without relying on centralized intermediaries.
As more economic activity moves on-chain, we can expect two things: first, more assets will become candidates for collateral in lending protocols; second, asset-backed stablecoins will account for a larger share of on-chain currencies. Other types of loans may eventually be safely issued on-chain, further expanding the on-chain money supply. Nevertheless, users can evaluate asset-backed stablecoins, but this does not mean that every user will be willing to take on this responsibility.
Just as it took time for traditional bank lending to grow, for regulators to reduce reserve requirements, and for lending practices to mature, it will take time for on-chain lending protocols to mature. Therefore, it will take some time before asset-backed stablecoins can be used as easily as fiat-backed stablecoins.
Strategy-backed synthetic dollar
Recently, some projects have begun offering tokens with a par value of $1 that combine collateral and investment strategies. While these tokens are generally classified as stablecoins, the synthetic dollars backed by the strategies should not be considered stablecoins. Here’s why.
Strategy-backed synthetic dollars (SBSDs) give users direct exposure to actively managed trading risk. They are typically centralized, undercollateralized tokens combined with financial derivatives. More specifically, SBSDs are USD shares in open-ended hedge funds, a structure that is not only difficult to audit, but can also expose users to centralized exchange (CEX) risks and asset price volatility, especially during times of significant market volatility or sustained negative sentiment.
These characteristics make SBSDs unsuitable for the primary purpose of stablecoins—a reliable store of value or medium of exchange. Although SBSDs can be constructed in a variety of ways, with varying risks and stability, they all offer a dollar-denominated financial product that may be included in an investment portfolio.
SBSDs can be built on a variety of strategies , such as basis trading or participating in yield protocols, such as rehypothecation protocols that help secure active verification services ( AVSs ). These projects manage risk and reward, often allowing users to earn yield on cash positions. Through yield management risk, including assessing penalty risk of AVSs, looking for higher yield opportunities, or monitoring the reversal of basis trades, projects can generate yield-based 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 consequences of using SBSDs in DeFi strategies, as there could be serious knock-on effects in the event of a decoupling. Derivatives that rely on price stability and consistent returns can suddenly become unstable when an asset decouples or suddenly depreciates relative to its tracking asset. However, when a strategy contains centralized, closed-source, or unauditable components, it can be difficult or even impossible to assess and underwrite its risks. To underwrite risk, you must understand what you are underwriting.
While banks do run simple strategies with deposits, these strategies are actively managed and represent a small portion of overall capital allocation. These strategies are difficult to support stablecoins because they require active management, which makes them difficult to reliably decentralize or audit. SBSDs expose users to more concentrated risk than is permitted in bank deposits. Users have reason to be suspicious if their deposits are held in this manner.
In fact, users have been wary of SBSDs. Despite their popularity among risk-seeking users, not many people actually trade them. In addition, the U.S. Securities and Exchange Commission (SEC) has taken enforcement actions against issuers of “stablecoins” that are actually like shares in investment funds.
Stablecoins have become popular. The total amount of stablecoins used in global transactions has exceeded $160 billion. They fall into two main categories: fiat-backed stablecoins and asset-backed stablecoins. Other dollar-denominated tokens, such as strategy-backed synthetic dollars, do not meet the definition of stablecoins used for transactions or to store value, despite their increased awareness.
Banking history is a good reference for understanding this category - stablecoins must first be consolidated around a clear, well-understood, and easily redeemable bank note, just as the Federal Reserve Bank Notes gained recognition in the 19th and early 20th centuries. Over time, we can expect the number of asset-backed stablecoins issued by decentralized overcollateralized lending institutions to increase, just as banks increase 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.
But this analysis — useful as it may be — can only take us so far. Stablecoins have become the cheapest way to send dollars, which means that in the payments industry, stablecoins have the opportunity to reshape market structure, providing an opportunity for incumbent companies, especially startups, to build on a new platform for frictionless and costless payments.
Acknowledgements: Special thanks to Eddy Lazzarin, Tim Sullivan, Aiden Slavin, Robert Hackett, Michael Blau, Miles Jennings, and Scott Kominers for their thoughtful feedback and suggestions that made this article possible.
Sam Broner is a partner on the a16z crypto investment team. Prior to a16z, Sam was a software engineer at Microsoft, where he was a founding team member of Fluid Framework and Microsoft Loop. Sam also attended MIT Sloan School of Management, where he worked on Project Hamilton at the Federal Reserve Bank of Boston, led the Sloan Blockchain Club, directed Sloans first AI Summit, and received MITs Patrick J. McGovern Award for creating entrepreneurial communities. Follow him on the X platform @SamBroner .
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