Stablecoins: The Gateway to On-Chain Finance

Today, as the line between traditional finance (TradFi) and digital assets begins to blur, with high-profile institutions rolling out onto public blockchain networks like Hedera, stablecoins are the killer app for on-chain finance. Over the next five years, stablecoins will experience explosive growth, fueled by emerging markets.

Stablecoins 1.0: A Short History of Stablecoins

Stablecoins were envisioned early on in the history of Web3 as the first major digital asset use case after trading. Over the last 10 years, issuers and traders experimented along three key axes - reserve type, reserve mechanism, and network type. 

Reserve Type 

The reserve type refers to what the stablecoin is backed by to help it retain its value.  Fiat-backed stablecoins, such as USDC or USDT, are the most common type of stablecoin. Under this model, each stablecoin is backed by a traditional fiat reserve currency like the US Dollar (USD), Euro (EUR), and Singapore Dollar (SGD). The fiat typically sits in a bank or trust, while the digital asset is issued and used on-chain as a stablecoin. Fiat-backed stablecoins can be redeemed for fiat currencies. 

Crypto-backed stablecoins, such as DAI, are backed by other cryptocurrencies or digital assets. These stablecoins aim to maintain correlation with the fiat currency they represent through over-collateralization. DAI, for example, is collateralized by a combination of other cryptocurrencies, including USD-backed stablecoins, Ethereum, and Ethereum derivatives.

Reserve Mechanism

Algorithmic stablecoins, like the infamous Terra (UST), are stablecoins that use algorithms and smart contracts to control supply and demand and maintain a stable price to the fiat they represent. Algorithms adjust the stablecoin's supply based on market dynamics and user demand.

Network Type: Permissioned vs Permissionless 

Stablecoins for retail use are typically built on public chains. To date, private coins structured as tokenized deposits have mainly been limited to serving interbank settlement use cases, with JPM Coin as a prime example. 

A mix of public and private solutions are being piloted by Central Bank Digital Currencies  (CBDCs), and we see public solutions such as EMTECH gain traction among more traditional private/permissioned offerings. 

‍Current State of the Stablecoin Market

Decentralized Finance (DeFi)

To date, stablecoins have mostly been used in crypto trading and DeFi. Here, stablecoins have served as a reliable medium of exchange, collateral, and liquidity in various DeFi protocols, facilitating decentralized lending, borrowing, and yield farming

Over the past couple of years, a number stablecoins, typically crypto-collateralized and algorithmic, have failed. This shakeout has largely been due to a mismatch in the asset’s architecture and the real needs of today's dominant use cases. Because algorithmic and crypto-backed stablecoins rely on underlying assets that are sensitive to the market, they more often run the risk of de-pegging, thereby bringing down the use cases built on top of them.

Fiat-backed stablecoins bypass this volatility through their 1:1 peg. USDC and USDT currently hold the vast percentage of stablecoin market share as they underpin the current DeFi ecosystem and have found their right product market fit.

A look at the market cap of stablecoins shows a current dominance of USD (or equivalent)-backed stablecoins, representing 95% of the aggregate market cap for the top 10 stablecoins. 

Regulations

The emergence of stablecoins has not been without its challenges, particularly concerning regulatory oversight. 

In 2020, the G7 group of nations tasked the Financial Action Task Force (FATF) to assess the potential risks posed by stablecoins and issued a report outlining the importance of regulatory oversight and consumer protection.

The European Union (EU) has notably been at the forefront of regulatory frameworks for stablecoins. The "Regulation on Markets in Crypto-Assets" (MiCA) approved earlier this year aims to establish a harmonized regime for crypto-assets, including stablecoins, within the EU. MiCA outlines requirements for issuer authorization, capital and investor protection, and ongoing supervision.

Singapore has also adopted a progressive approach to regulating stablecoins. The Payment Services Act (PSA) requires certain stablecoin issuers to obtain a license and comply with AML/CFT obligations. Recently, the Monetary Authority of Singapore (MAS) finalized the regulatory framework for stablecoins. 

While more countries such as Japan, Hong Kong, and the United Arab Emirates (UAE) have developed specific regulatory frameworks for digital assets, many others are still in the process of devising comprehensive guidelines. As the stablecoin industry continues to mature, the focus will shift to striking a balance between innovation and consumer protection, ensuring the stability and integrity of the global financial system.

A Maturing Landscape: Institutional Adoption

The recent release of PayPal’s PYUSD has thrown corporate and institutional adoption into the limelight. A number of financial institutions are actively researching the issuance and operation of tokenized deposits. One key use case is international remittances, a $190T market in 2023, which we see gaining traction on Hedera due to the network’s speed and cost-efficiency.

Swirlds Labs and The HBAR Foundation recently facilitated a Hedera-powered stablecoin remittance trial between Shinhan Bank, SCB TechX, and a major Taiwanese financial institution. The pilot demonstrated remittance transactions between South Korea and Taiwan that took on average 2.5 seconds and cost 5 cents in gas fees while being operational 24/7. In comparison,  traditional remittance would take between  1-10 days, only operate within traditional banking hours, without real-time traceability, and cost $25.88-$74.80 in transaction fees.

Our Thesis: Explosive Stablecoin Growth in Non-Majors

Over the next five years, we anticipate an explosive growth in stablecoins, driven primarily by fiat-backed stablecoins in non-USD currencies. 

At the time of writing, the combined market cap of the top 10 stablecoins is approximately $125 billion. This is 0.06% of just the United States’s monetary supply as of July 2023.

While early usage was historically limited to the crypto-native sphere, we expect stablecoins will become mainstream through institutional and corporate stablecoins, driving the modernization of traditional financial and payment infrastructure. 

The integration of stablecoins into payment rails will be crucial to their use in payments. A number of payment networks, from legacy players like Mastercard, now integrated with Hedera via FSCO, to emerging pure plays such as Six Clovers are racing to build multichain payment systems. With those rails in place, stablecoins will broaden their reach to become usable for everything from grocery shopping to paying your children’s overseas tuition. 

Currently, USD-backed stablecoins dominate the market. However, stablecoins are poised to bring even more efficiency to other global currencies. As stablecoins use cases expand beyond USD/EUR foreign exchange into more diverse pairs, and payment and settlement use cases mature, we anticipate growth to come from emerging markets like the Asia Pacific (APAC) and Latin America and Caribbean (LAC) regions. We see this already on Hedera. In addition to USDC, Hedera already supports XSGD, and has supported pilots for stablecoins backed by the Australian Dollar, South Korean Won, Thai Baht, South African Rand, and New Taiwanese Dollar.  

Fintechs will lead this charge in these regions. Already, we have seen WiPay, one of the largest financial institutions in the Caribbean, launch their WiCoin USD stablecoin on Hedera to unite the many islands and their largely unbanked populations under one frictionless currency. 

Our Vision: Stablecoins 2.0

The catalyst for the next wave of stablecoin adoption has begun. It’s now imperative for the issuance and management of stablecoins to become simpler and safer. Stablecoin Studio achieves this. The Stablecoin Studio implements a hybrid architecture, leveraging both the Hedera Token Service (HTS) and EVM-compatible Hedera Smart Contract Service (HSCS) to enable increased programmability for all stablecoins minted and managed through the Studio. 

This increased programmability ensures that all issuers can customize their stablecoin product suite to ensure compliance with multiple jurisdictions and product market fit with different target audiences. The programmability also broadens the pool of potential issuers, laying the groundwork for more corporate stablecoins like PYUSD.  

As the most efficient means of sending value, we believe that stablecoins will become ubiquitous as institutions and fintechs accelerate their on-chain innovation. As the adoption curve continues to accelerate and the product lifecycle matures to support a multi-tiered stablecoin ecosystem, we anticipate that stablecoins will usher in a new era of financial evolution, replicating and improving upon our existing relationship with money.