Decentralised Finance (DeFi) is witnessing a spate of new stablecoins, led by a renaissance in yield-bearing products and an uptick in activity from traditional finance (TradFi) players.
This burst in activity is being matched by regulators, who are starting to get to grips with DeFi and finally appear convinced that the technology is here to stay.
The confluence of innovation and regulation will likely go some way to determine the scope and limitations of the latest evolution of stablecoins. With new regulations such as MiCA, FINMA’s new guidance on stablecoin issuance, and the Securities and Exchange Commission (SEC) quietly closing its investigation into Paxos regarding its issuance of Binance USD (once the third most popular stablecoin by market cap), we are witnessing a gradual shift towards greater credibility and trust in the crypto market.
The growing usage of stablecoins
Stablecoins have come a long way in the decade since Tether launched USDT. They were originally designed as a stable means of on-chain payment for volatile assets across multiple exchanges. Stablecoins have evolved to play a crucial role in DeFi, act as reliable collateral against loans, offer safe anchorage during crypto winters and can help companies manage their treasuries.
The raw data reflects the value of stablecoins in the crypto ecosystem. The market cap of stablecoins fluctuates according to demand and is currently hovering around the USD 170 billion mark. This is dwarfed by the current market cap of all cryptocurrencies, which stands at around USD 2.2 trillion.
But the numbers are reversed when measuring transaction volume. Monthly stablecoin transactions often surpass the USD 1 trillion mark during bull markets. According to Chainanalysis, stablecoin transactions weighed in at USD 10 trillion in 2023, making up 60 percent of all crypto assets trading volumes.
The latest theme is yield, which is in part inspired by Tether’s enormous profits. Tether has been hailed as one of the world’s most successful yet controversial businesses after generating profits of USD 6.2 billion last year and USD 4.5 billion in the first quarter of 2024 from its reserves of US Treasury bills and other investments.
These gains were boosted by favourable economic conditions, including rising interest rates, which could change in the future. But the basic premise holds that stablecoins could – and perhaps should – share profits derived from their underlying assets.
Drivers of innovation
A noteworthy feature of stablecoin activity in recent months is that innovation has arrived from both DeFi and TradFi, bringing the two worlds closer together.
DeFi protocols have for years offered passive income streams through stablecoin lending, staking and yield farming. Some new entrants have developed different strategies for milking passive yield simply by holding stablecoins. Here’s a few to consider:
- The most notable yield bearing offering from the TradFi space is the BUIDL token representing the BlackRock tokenised money market fund, which has attracted investments of over USD 500 million to date. Circle has stepped in to offer conversion from BUIDL to its USDC stablecoin, allowing investors to off-ramp into a more liquid on-chain representation of the US dollar.
- While many yield-bearing stablecoins share reserve profits with token holders, Agora’s AUSD rewards exchanges, market makers and FinTech’s for listing the token, providing liquidity and accepting AUSD for payments.
- Ethena’s “synthetic dollar” ENA token maintains stability with a “delta hedging” strategy of staking assets in one direction and taking the opposite derivatives position. This strategy aims to generate yield via “funding rate” payments made to traders that hedge against the current direction of the market.
Recent arrivals have injected a dose of disruption by blurring the lines between on-chain cash, securities, savings accounts and tokenised hedge funds or money market funds. However, there is much debate about whether a hedge fund strategy, such as ENA, can be properly classified as a stablecoin, if at all.
Regulatory intervention
While the DeFi world debates the nomenclature of digital assets, regulators are starting to offer their own take on what constitutes a palatable stablecoin.
The urgency of regulators has only been increased by the likes of Blackrock, PayPal and Société Générale bank issuing stablecoins. Given the sheer scale of real-world assets that could be tokenised in the future, the stablecoin market cap could potentially rise from around USD 170 billion today to trillions of dollars.
And as mentioned earlier, TradFi is increasingly overlapping with DeFi. Here’s why:
- The EU’s Markets in Cryptoassets (MiCA) regulation has defined two sets of stablecoins: those pegged to a single fiat currency (e-money tokens) and those whose value is referenced to a number of currencies or other assets, such as gold or other crypto-assets (asset-referenced tokens). MiCA also concludes that there is no place for decentralised or yield-bearing stablecoins under the EU regulatory regime.
- A US bill, currently going through Congress, takes a dim view of algorithmic varieties that maintain price stability by coding and smart contracts. The 2022 failure of the Terra/Luna project will have made regulators in many countries wary of algorithmic stablecoins.
- The Swiss Financial Market Supervisory Authority (FINMA) insists that every stablecoin issuer has either a banking license or bank guarantee for the underlying assets. In addition, FINMA wants issuers to identify every stablecoin holder to comply anti-money laundering rules.
- Other countries, such as Singapore, Japan, the UK and Hong Kong are ready to introduce new legislation to regulate stablecoins. It will be interesting to see how they treat yield-bearing variations, which can look a lot like savings accounts or fixed income securities products.
The developing global regulations are aimed squarely at the intersection of digital assets and traditional finance. Circle’s USDC, which is based in the United States and fully discloses its collateral backing, fits nicely into this space, which is why it has won MiCA approval.
USDT, on the other hand, appears to be playing coy with regulators’ demands for full transparency in the way it manages its underlying assets. This might imply that USDT will continue to lose market dominance to regulated stablecoins in future. Only time will tell whether Tether will continue to leak market share to rivals or continue to hold sway with cryptocurrency fans.
Investors are now faced with a growing array of yield-bearing stablecoin options with enticing prospects of increased yield opportunities (when conditions are set fair).
But institutional investors, in particular, will be taking a hard look, not only at yield potential versus their risk appetite, but also which type of investment will be tolerated in their region.
The SEC’s softening stance on crypto
Stablecoins and regulators have a chequered history. For instance, the SEC were quick to shut down the Libra (later re-named Diem) stablecoin project launched by Facebook (now Meta) in 2020, while the US regulator has long been rumoured to be unhappy with Tether’s opaque book-keeping.
However, its recent decision to close its case against Paxos might suggest a softening stance towards stablecoins and crypto assets in general. Perhaps this could turn the historically negative impact of US regulatory interventions into a positive force for the crypto market. And, as further regulatory clarity is established, we might also see the closing of other ongoing actions against crypto businesses in the near future.
It remains to be seen whether the Paxos vs SEC case will revive BUSD, but it is likely that the stablecoin providers who are already adhering to the developing regulatory standards will be the ones to establish a stronger foothold – like Circle’s USDC.
Concluding remarks
That being said, it’s worth noting that stablecoins which fall outside the scope of developing regulations, such as USDT, have not been banned outright, and there’s every reason to assume that they will continue to play a crucial role in DeFi – both among crypto natives and the increasing number of TradFi participants.
But it looks increasingly unlikely that unregulated stablecoins will be allowed to feature in TradFi blockchain projects, such as the tokenisation of securities. Regulators are sending a clear signal that they will only tolerate settlement using stablecoins issued by banks or other regulated financial entities.
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