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Everything Everywhere Daily: History, Science, Geography & More
Stablecoins: What They Are and How They Work
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One of the most talked about topics in finance today is stablecoins. Stablecoins have the potential to totally upend the world of banking and finance. Banks, governments and tech companies are all looking at stablecoins to determine how they might use them in the future. However, as important as they might be, most people have absolutely no clue what they are. Learn more about stablecoins, how they work, and what problems they might solve on this episode of Everything Everywhere Daily. This episode is sponsored by Mint Mobile. Most of you might have something that you're saving up for. Maybe it's the trip of a lifetime, your children, your retirement, or maybe even something nice for yourself. And if you're looking for some extra money, the easiest thing you can do is to cancel your current mobile plan and switch to Mint Mobile. With Mint Mobile, you can get high speed data and unlimited talk and text delivered on the nation's largest 5G network starting at only $15 a month. 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This is your chance to move past the generalities of war and find the specific local heartbeat of that era. Newspapers.com provides a vibrant, unfiltered view of the past, letting you see the nuance, the sacrifice, and the everyday lives that shape the world that we live in today. It's more than an archive, it's a way to ensure these stories are never forgotten. This Memorial Day, give a voice to the names in your family tree. Visit newspapers.com today and use promo code everything everywhere at checkout for 20% off your subscription. Newspapers.com honor the past by uncovering its stories. One of my least favorite terms is crypto. The reason is that the word is so vague and can encompass many things that are often quite different from one another. Bitcoin is technically a cryptocurrency, but it's completely decentralized and strictly limited in the number that can be created. Stablecoins also fall under the umbrella of cryptocurrencies, but they are totally different. Stablecoins are digital blockchain tokens priced in national currencies and backed by national currencies. While in theory, stablecoins can be priced in any currency, for the purpose of this episode, I'm going to be using US Dollars because that is where the vast majority of activity is happening right now. Before I get into the details of stablecoins, I want to cover some current long standing problems with the international banking system and global commerce. One problem is that sending money internationally is very slow and expensive. If you wanted to wire, say $500 from the United States to someone in the Philippines today, you're looking at fees of $15 to $40 and an exchange rate markup of 2 to 4%, as well as a wait between between one to five business days. The money passes through multiple corresponding banks and each takes a cut. You would think that with the advancement of computer and networking technology, we could send money instantly worldwide, but in reality, the time and cost of sending money internationally hasn't improved in decades. Another completely unrelated problem is that in countries like Argentina, Turkey or Venezuela, local currencies have lost 50 to 90% of their value in recent years. They're suffering from severe inflation, which can wipe out everyone's savings in an entire country. People in those countries want to hold dollars to protect their savings, but getting a US bank account isn't an option for the vast majority of them. Even when dollar denominated accounts are available at local banks, governments in the past have forcibly converted them to local currency. Another problem is the difficulty in conducting commerce online. There's no native payment system that came along with the Internet. Credit cards have been adapted for use online, but there are still issues with credit card fraud, merchant fees, and the fact that all commerce is controlled by just a few credit card companies. Finally, traditional finance is subject to a host of local restrictions. Bank transfers require business hours, credit, corresponding banking relationships, know your customer processes, and geographic restrictions. Every country has its own list of bank holidays and time zones means that banks often aren't open at the same time. Stablecoins are designed to solve or at least alleviate all of these problems. If you remember back to my episode on Blockchains, a blockchain is an immutable digital ledger, it can record transactions and wallets that are controlled by individual users. These are protected by advanced cryptographic algorithms, which is why they all fall under the broad umbrella of cryptocurrencies. What separates stablecoins from other types of cryptocurrencies is that each stablecoin is worth $1. They're not an investment. They're not designed to go up or down in price. A stablecoin keeps its peg through arbitrage and confidence. If a stablecoin is trading at $0.99, a qualified trader may buy it cheaply and then redeem it with the issuing company for $1, pocketing the difference. That buying pressure should push the price back towards $1. If it trades at $1.01, traders can then create new tokens for $1 and sell them for slightly more, pushing the price back down. This redemption can happen because most stablecoins, at least the ones I'm going to be covering in this episode, are backed one to one with US dollar denominated assets. This is usually in the form of short term treasury notes and some cash. In banks, that means that stablecoins have a 100% reserve. If they issue a billion dollars in stablecoin, then they have to have a billion dollars in assets. Cash can handle typical day to day redemptions and treasury notes can be sold if there are larger redemptions. And this is why they're called stablecoins. It's because the intent is for the price to be stable. This is one of the first major ways in which stablecoins differ from banks. Banks operate on fractional reserves. They do not keep all deposits sitting in cash or Treasuries. They lend much of the money as loans while maintaining sufficient liquidity to meet normal withdrawals and regulatory requirements. If you've ever seen It's a Wonderful Life, you may remember the speech that Jimmy Stewart gives during the bank run about how everyone's money is invested in the community. So in theory, everyone who owns a stablecoin with 100% reserves could get it redeemed in exchange for cash, which would then be sent to your bank. In a worst case scenario, there might be an issue with short term treasury note sales during a run. If you have a personal or corporate wallet, you have an encrypted claim to your stablecoin on the issuing company's blockchain. You can access it 24,7 from anywhere on Earth and send money to anyone that also has a wallet. Whereas bank or credit card transactions may take several days to clear and incur fees. A stablecoin transaction can take place almost instantly and cost next to nothing. This is highly attractive to merchants who currently accept credit cards and often have to pay fees from 1.5 to 3.5%. Likewise, owning a stablecoin would require nothing more than Internet access or an app on your phone. There is tremendous demand for US Dollars in developing countries. People in foreign countries who want to own US Dollars don't now have to open up a bank account. They just need to set up a wallet and hold dollars as stablecoin. Another benefit of stablecoins is that in theory, they can handle extremely small payments. There's usually a minimum payment that comes with credit cards. Stablecoins can handle tiny payments much more easily and in some cases can handle as little as one millionth of a cent. This would be used for automated systems with programmatic training, something that can't really be done with the current banking or credit card system. There's another major reason why the government is especially interested in stablecoins. Stablecoin issuers are a potentially enormous new market for treasury bonds that gives the US Government another buyer for its debt, which can help lower borrowing costs at the margin and make it easier to finance deficits. Recent estimates suggest that stablecoin growth could add hundreds of billions and possibly up to $1 trillion in new treasury bill demand by 2028. And there's another reason why the federal government would like stablecoins. Dollar stablecoins spread dollar usage around the world, especially in places where people may not have easy access to US bank accounts. From Washington's perspective, that can reinforce the dollar's role as the dominant global currency while pull activity into a US regulated framework. So if a company has to have 100% reserves for their stablecoin, how do they make money? Stablecoin issuers mostly make money from the reserves backing the coins, which are mostly treasury notes. The issuer usually does not pay interest to holders of the stablecoin. So if the issuer has billions of dollars in reserves earning 4 or 5%, that interest income can be enormous. So if you're an issuer that has $100 billion in reserves earning 4%, that's $4 billion a year in gross interest income before expenses, partner payments, compliance costs, technology and taxes. They can also make money from fees, although these are usually less important than reserve income for the biggest issuers. Stablecoin issuers can also make money by offering related services. This can include business accounts, payment APIs, cross border payment tools, developer infrastructure, custody compliance services, and blockchain settlement products. In that sense, the stablecoin itself can be both a product and a way to pull customers into a broader financial system. So far I've been speaking in generalities. In reality, there are currently, as of the time of this recording, two major issuers of US dollar denominated stablecoins. Tether, which trades under the USDT ticker, is the largest stablecoin by a wide margin, with around 190 billion in circulation. As of today, it dominates global trading volume, particularly in Asia and emerging markets. Tether has been controversial for years because it was slow to provide clear audits of its reserves. Usdc, the other major Stablecoin, is run by Circle. It's the preferred stablecoin in US regulated environments and decentralized finance applications. Because Circle is even more transparent about its reserves and operates under US Money transmission licenses, USDC briefly lost its peg to the dollar in March of 2023 when news broke that circle had $3.3 billion sitting at Silicon Valley bank, which had just failed. It recovered quickly after FDIC backstopped bank depositors, but the episode was a reminder that bankruptcy backed by cash means something specific about where that cash is located. So if stablecoins can process transactions 24. 7 faster and cheaper than traditional banking, what exactly is the downside? Well, for starters, at least as of the time of this recording, stablecoin companies can't legally allow stablecoin holders to earn interest. This is actually a major point of contention between traditional banks and stablecoin companies right now. Banks are highly regulated and they feel that if stablecoin companies are going to compete with them, then they should just become banks. The other major problem is that this industry is so new that there is almost no regulation or case law surrounding stablecoins. Many investors are waiting for legislation to pass and for some guidance from the government so that they can reduce their risks. Another big issue will be transparency surrounding reserves. The trust people have in stablecoins will be tied directly to the company's ability to prove that it has reserves to cover all of its stablecoins. And yet another problem concerns the interoperability of coins from different companies. While all dollar stablecoins are priced in the same currency, you can't simply move a tether coin to the Circle network. This requires intermediaries and it might become a bigger issue going forward if more companies enter the field, which is highly likely. After hearing everything I've covered, you might still not be impressed or see why in the world you would bother to use stablecoins. And the truth is, if you live in the United States and use US Dollars as a consumer, there probably isn't much need to use stablecoins, at least not immediately. Many of the benefits of stablecoins will initially accrue to larger institutions that want faster, cheaper transaction clearing, and most of this will occur on the back end and might never even be seen by most consumers. Likewise, consumers with the greatest incentive to use stablecoin would be outside of the United States, where it's harder to obtain and retain dollars. Stablecoins are still brand new and have relatively low adoption, but they have enormous potential to upend the entire financial industry. Stablecoin transactions can bypass banks, rendering many of their functions totally irrelevant. Moreover, this might just be the opening act in the tokenization of both stocks and bonds as well, which would enable Global 24. 7 trading and near immediate clearance of all stock and bond trades. Just like with stablecoins, banks have been around for a very long time and it's a very conservative business, so it's too early to know when what exactly is going to happen. However, the potential for truly transforming the world of banking and finance might already be right in front of us. The executive producer of Everything Everywhere Daily is Charles Daniel. The associate producers are Austin Otkin and Cameron Kiefer. My big thanks go to everyone who supports the show over on Patreon. Your support helps make this podcast possible, and I also want to remind everyone about the community groups on Facebook and Discord. That's where everything happens that's outside the podcast, and links to those are available in the show notes. As always, if you leave a review on any major podcast app or in the above community groups, you too can have it read on the show.