I normally don’t write about cryptocurrency in Bits about Money. It gets far too many column inches relative to its actual importance in the world, which is minimal compared to other financial infrastructure. I prefer writing about that extremely undercovered topic. But, much like Matt Levine feels professionally obligated to keep up with Elon Musk drama, I can’t avoid writing about stablecoins after the May 2022 collapse of Terra (UST).
As always, Bits about Money is my own opinion. My employer Stripe, which frequently has differences of opinion with me regarding cryptocurrency, has recently announced a product which uses a particular stablecoin (USDC). I have made de minimis usage of USDC personally partially out of technical interest and partially to use a prediction market. I find prediction markets intellectually interesting and have been an occasional user of them for almost 20 years. They have poker's thrill of intellectual ritualized combat and take advantage of my absolute incapacity to resist any textarea that could carry the message Someone Is Wrong On The Internet.
Stablecoins in a nutshell
A stablecoin is designed to be a deposit (i.e. money) recorded in a slow database which is negotiable among other actors who use the same slow database. This compares to deposits at e.g. banks, which are typically recorded in a faster database and are negotiable either at the bank or, through the banking system, at other users of money.
Stablecoins are typically contrasted with other cryptocurrencies, such as Bitcoin, because their unit of account is linked to a government-issued currency (overwhelmingly, the U.S. dollar) rather than more speculative assets one could record in a ledger maintained in a slow database.
Stablecoins are big business relative to most startups and miniscule relative to the money supply. There are currently a bit more than $150 billion issued, which (if they were consolidated) would be in the same weight class as a large regional bank like e.g. Fifth and Third.
Uses of stablecoins
In principle, you could use stablecoins as money, like how you use deposits as money. Stablecoins are not used like money; rather than facilitating almost the entire diversity of transactions in the economy, they are overwhelmingly used for a few niche use cases.
The cryptocurrency community often explains that the core use for stablecoins is for moving money between cryptocurrency exchanges to assist with arbitrage. This is not the dominant use of stablecoins. The dominant use is actually collateralizing investments in popular products with embedded leverage, such as Binance’s USDT/BTC perpetual futures contract. Perpetual futures are themselves a fun rabbit hole, which might have to wait for an essay of their own. Exchanges like them because they allow fat largely sub-rosa fees; institutions like them because they’re extremely capital-efficient; retail likes them because they allow high amounts of margin (which gamblers perceive as amping up their fun).
An emerging use case for stablecoins, which is not yet dominant, is that they’re programmable money that can be easily operated on by smart contracts in “decentralized finance” (DeFi). DeFi is something of a term of art; we’ll come back to how decentralized some popular offerings actually are in a minute. DeFi’s current raison d'etre is borrowing/lending cryptocurrency to allow increased leverage by traders, if one is charitable, or creating financial games which are Ponzi-adjacent (memorably described once as “boxes”) if one is less charitable.
In principle, stablecoins could be used to settle transactions. In principle, two crypto users could pull out their phones, share a QR code (to show the receiving wallet address), and send stablecoins over without their wallet providers needing to further coordinate. In practice, this is uncommon, because it is a higher-friction more-expensive slower Cash App which does not yet have the society-wide network effects of competing ways to settle transactions.
But the principle is interesting! It’s virtually impossible to find a tech investment fund which thinks that bank wires, for example, have the appropriate amount of friction and ceremony associated with them, and some tech investment funds use stablecoins to settle investments. Depending on the slow database used, this costs about the same as a bank wire (negligible relative to the investment) or less, is much faster, requires no coordination with a banker during bank hours, and may be substantially less likely to be disallowed if e.g. one of the counterparties is in another nation.
And slow expensive Cash App is a Cash App one can download without e.g. having sufficient legibility to the banking system to use fast cheap Cash App. Plausibly that is at least an intellectually interesting point in the multidimensional vector space of all possible Cash Apps.
You’re probably not here for a deep dive on slow database technology or fast database technology, and even if you were I'm not here to write it. Fast databases are complicated, impressive technical artifacts.
A more interesting question is how privately issued money gets and maintains parity with publicly issued money. There are a few different mechanisms for this.
Money market fund style stablecoins
A money market fund is a specialized form of investment vehicle designed to have the desirable characteristics of a deposit (liquidity on demand and virtually riskless) while having more yield than deposits do. This is typically achieved by having the money market fund invest in short-term high-quality commercial paper or government-backed securities. Money market funds had a rough go of it during the seize up of the treasury repo market during the global financial crisis, a story underappreciated but told in many other places, but be that as it may: fix the image of a money market fund in your mind.
Got it? OK. Now change the money market fund’s fast database to a slow database, make individual units of it movable without cashing out, and set the management fee to equal 100% of interest income.
The tickets are now diamonds. The money market fund is now a stablecoin.
USDC, issued by Circle, is the largest money market fund style stablecoin (and 2nd largest stablecoin overall). Their backing is held (currently) in cash and low-duration U.S. government issued securities.
The money market model is, relative to other ways to construct stablecoins, boring. Boring is a feature! Boring means that the stablecoin operator can’t get seigniorage income through digital alchemy. Boring also means that the stablecoin is unlikely to see its value vaporized under conditions of market stress.
Stablecoins are “pegged” to something, typically the USD. A peg is a story about why two things which are not the same are, in fact, similar enough to be treated interchangeably.
The story for money market fund style stablecoins is that, while in normal circumstances you would just hold the stablecoin or move it around, you could at any time return it to the operator and receive actual money at par. Like money market funds, these stablecoin operators have high confidence that their net asset value (NAV) is always almost exactly $1 per unit outstanding. Even under conditions of substantial market stress, one does not expect e.g. short-term Treasury bills or high-quality commercial paper to become illiquid or trade at a discount, even at large sizes.
That’s not an ironclad assumption! Again, it was false in 2008, when money market funds collateralized by Lehman Brothers commercial paper or Treasury repurchase agreements (repos) suddenly found their collateral impaired or illiquid. But it is what these boring stablecoins go with.
Another similar stablecoin is Paxos’ USDP, which is much smaller than USDC. Partisans between the two would probably say the main thing that differentiates them is the regulatory regime each operates under. As someone who is Switzerland here, I’d say “Meh, pretty much equivalent, and pretty low risk by the standards of cryptocurrency things.”
Part of that judgment for low risk is that these coins have enthusiastically courted engagement with U.S. regulators. Unwillingness or inability to bow to the demands of regulators, some of which make the coins worse qua products, is one reason why other stablecoin entrepreneurs went with the models discussed below.
One demand, for example, is that the stablecoin sponsors comply with Know Your Customer (KYC) and anti-moneylaundering (AML) regulations similar to the way other money services businesses have to. Enthusiasm for KYC and AML regulations is, to put it mildly, not universal in the cryptocurrency community. It will inevitably result in having to tell the user that the user can’t do the thing they want their money to do, at least some of the time, but current practice suggests that even enthusiastic compliance with these regulations results in an equilibrium far less frictionful than prevails for e.g. wire transfers.
Another demand was for more conservative collateralization than USDC previously used. That was unfortunate for USDC, since it costs them interest income, but regulators remember 2008.
Equity-backed stablecoins are sometimes called “algorithmic” stablecoins, to suggest they have the predictability of a well-operating computer program (on the way up) and blame the loss of billions of dollars on software rather than identifiable people (on the way down). I don’t think this is a particularly helpful frame. The interesting engineering is financial, not software.
Say you have a business. That business has equity value. If that business also plugs into many counterparties, keeps a ledger of money it owes to counterparties, and allows those debts to be transferred via any mechanism, that business could theoretically function as a payments rail. The business could choose to do this via letters carried by courier, via a slow database, or via many other methods.
How does the business maintain confidence among its counterparties that its debts are always worth face value, even if it doesn’t actually pay those debts back in any given period? By reference to its equity value.
If you continue to believe that e.g. Netflix has a large equity value, and equity takes impairments before debt does, then a Netflix bond (or Netflix Dollar) should maintain its value, all else being equal. Matt Levine has a great explanation of this.
Netflix is in the business of overpaying for mediocre content and distributing it really well, not in the business of facilitating payments, and so there is no convenient way to swap Netflix Dollars. People holding dollar-denominated liabilities from Netflix mostly just ask Netflix for their money, and charge Netflix an interest rate when Netflix desires not to repay those liabilities for a while.
But in principle, if Netflix invested engineering and partnership effort in making Netflix Dollars transferable on demand, Netflix could easily issue a stablecoin valuable only by remote reference to Netflix equity. Sophisticated marketplace participants would continue to believe that Netflix was good for its debts because we live in a society and because other sophisticated marketplace participants seem willing to believe that Netflix will eventually produce positive future cash flows meriting a generous current equity valuation. And, this is really really important, the size of the equity totally dwarfs the anticipated number of Netflix Dollars in existence.
What if you wanted to make Netflix Dollars but didn’t want to spend decades on a DVD business, streaming infrastructure, and content deals? Or if you wanted to issue a lot of Netflix Dollars, like billions of them, so many that short-term swings in the value of Netflix’s totally-real-all-must-acknowledge-some-people-do-pay-money-for-their-thing business might imperil the statement “There’s a whole lot more Netflix than there is Netflix Dollars”?
Well, you can conceivably make a Netflix Dollar out of any business. Even a fake or fraudulent one.
Let’s talk Terra USD, which was vaporized earlier this month.
Terra USD, which I’ll call Terra for convenience, was an equity-backed stablecoin. The equity was in the form of a sister token called Luna. (Cryptocurrency enthusiasts sometimes like to feign ignorance about tokens being equity claims, principally as a form of regulatory arbitrage. Luna is worse-is-better equity; worse in that it has far less protections than equity, better in that it could be sold to retail without getting one put in jail (yet).)
Why is Luna equity valuable? The argument was that Luna was an equity interest (“Utility token!” Quiet, you.) in the business that was the operation of the Terra slow database. Terra Labs and other parties would make the slow database available to software developers in return for ongoing fees, which would make Luna valuable for the same reason “sell an underwhelming database subscription with a complicated pricing model over time to developers in exchange for money” makes Oracle equity valuable.
Terra Labs added a feature to the slow database which would allow one to use the slow database to exchange Luna (equity) for Terra (the stablecoin) at par. If Terra traded below the $1 peg, arbitrageurs could buy it, redeem for Luna, sell the Luna (somewhere), and profit from the difference. If it traded above the peg, you could run that trade in reverse: buy cheap Luna, redeem for dear Terra, sell the Terra, now you’ve got more money than you started with.
All pegs are stories. This story didn’t sound like a very good one, unless the Luna equity was valuable. Software company equity is more valuable when lots of people are doing interesting valuable things with the software.
So Terra Labs concocted the existence of an interesting valuable thing. They wrote a program using their slow database called Anchor. Anchor was an automated program to allow moneylending. There are many of these in DeFi land.
Many of them use an aggressive growth hacking strategy, which is saying “If you use my program, I will give you equity in my company.” This strategy is commonly called “yield farming.” Anchor was very aggressive about this, promising 19.5% APY yields on their stablecoin. To use their program to get 19.5% yields you needed to buy into their database software, which made their database software seem to be more valuable (“Look at all the users!”), which caused the value of their equity to go up, which allowed them to redeem their own equity for more money to throw at user acquisition, which…
… created a Ponzi scheme. With extra steps.
Was this a complicated bit of financial engineering? Was it conducted in secret by an elite priesthood who needed years of education to even understand the acronyms at play? Nope. It wore its I’m Going To Blow Up And Take You Down With Me heart on its sleeve. I looked at it about two minutes and then confidently tweeted about the mechanism and inevitable fate.
The cryptocurrency community did not cover itself in glory regarding Luna, because Luna made the right people an awful lot of money in 2021. As cryptocurrency venture capitalist Nic Carter has explained at length, it was apparently “the trade” of 2021. (His On The Brink is the best podcast in crypto, by miles.)
In early May, Terra Labs announced that it was going to stop subsidizing users of its computer program. Users stopped using it, never having had any reason to use it other than collecting Terra Lab’s subsidy. This caused the perceived value of Luna equity to decline, which put pressure on the peg, which caused people to exit the pegged stablecoin, which decreased the use of the slow database and further hurt the implicit equity value of owning the slow database, which…
The technical term for this is a “death spiral.”
On May 8th, Terra was the 3rd largest stablecoin in the world, with $18 billion in assets. Luna had recently been worth more than $30 billion.
It is, as of this writing, less than two weeks later. The shenanigans aren’t over, because Terra Labs thinks that it can trick people again, but many tens of billions of dollars were lost and will not be recovered.
All pegs are a story. This story will probably fill a book. The part of the book before the depegging is fiction; the rest is history.
I consider this effectively inevitable for the seigniorage model, because no business, not the most valuable business in the world, can continue having a high equity value relative to “all the money anywhere”, and to the extent a business incubates a non-neglible seniorage-backed stablecoin in it, increased adoption of that product will forever represent a (growing!) threat to the business. The better that product gets and the faster it grows, the worse the threat.
Choosing to subsidize the use of the product was an accelerant but probably wasn’t even necessary to cause the collapse, and indeed we have seen several similar schemes (Iron Finance, Basis, etc). This is a product unsafe at any size. (I really enjoyed Preston Byrne’s writeup of Basis Coin back in 2017 and, if you read it, Terra was visible a mile away.)
Don’t want to comply with pesky government regulations? Do want to award yourself a license to print money? Then pretend to be a money market style stablecoin, but just lie about it. Cover redemptions with other people’s money that you misappropriate. Spread the wealth around to co-conspirators both directly and by driving up the price of assets you mutually depend on.
You are ride-or-die on the lie.
As long as everyone is making money, no one will look at you too closely. Your detractors will sound like crazy people; your co-conspirators will hopefully be extremely skilled at regulatory capture. Buy a president or prime minister. Buy several. Buy an entire sovereign nation and use it like Saul Goodman would use a nail salon.
You can afford it.
Any reason for optimism?
Successful proofs-of-concept are one way that the world gets better. It isn’t a law of nature that the right amount of ceremony and cost for international money transfers is the amount it would take to do things between banks. Wise (nee TransferWise) experimentally disproved that, and brought an excellent product to market.
Money market style stablecoins don’t look to me like the obvious future of money movement. But they’re an argument with executable computer code attached. There is at least some possibility that that argument produces a user experience compelling enough, at risks society can stomach, that something which looks somewhat like them might end up a large, enduring part of the landscape.
I don’t buy it, but some smart people do.
I look at arguments like Wise or Cash App and think “Hmm, there is an excellent argument that these should interoperate and slow databases don’t necessarily need to be part of that interoperation. Plausibly it might even be so obviously true to society that they get mandated to do it.”
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I write about the intersection of tech and finance, approximately biweekly. It's free.