Stablecoins: What They Are and How They Work

Podcast Transcript

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 looking at stablecoins to determine how they might use them in the future.

However, 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.

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 is completely decentralized and strictly limited in the number that can be created.

Stablecoins also fall under the umbrella of cryptocurrencies, but 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 use 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 want to wire $500 from the US to someone in the Philippines today, you’re looking at fees of $15-40, an exchange rate markup of 2–4%, and a wait of 1-5 business days.

The money passes through multiple correspondent banks, each taking 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 haven’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 are suffering from severe inflation, which can wipe out everyone’s savings in the country.

People in those countries want to hold dollars to protect their savings, but getting a US bank account isn’t an option for most of them. Even when dollar-denominated accounts are available at local banks, governments have forcibly converted them to local currency in the past.

Another problem is the difficulty of conducting commerce online. There is no native payment system that came along with the internet. Credit cards have been adapted for online use, but there are issues with credit card fraud, merchant fees, and the fact that all online 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, correspondent banking relationships, Know Your Customer processes, and geographic restrictions. Every country has its own list of bank holidays, and time zones mean banks often aren’t open at the same times.

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 fall under the broad umbrella of cryptocurrencies.

What separates stablecoins from other types of cryptocurrencies is that each stablecoin is worth one dollar. They are not an investment. They are 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, redeem it with the issuing company for $1, and pocket the difference.

That buying pressure should push the price back toward $1. If it trades at $1.01, traders can 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 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 $1 billion in stablecoins, then they have to have $1 billion in assets. Cash can handle typical day-to-day redemptions, and the treasury notes can be sold if there are larger redemptions.

This is why they are called stablecoins. It is 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 might remember the speech that Jimmy Stweard gives during the bank run about how everyone’s money is invested in the community.

In theory, everyone who owns a stablecoin with 100% reserves could get it redeemed in exchange for cash, which would 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 and send money to anyone.

Whereas bank or credit card transactions might 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 pay fees of 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 dollars in developing countries. People in foreign countries who want to own US dollars don’t have to open a bank account. They just need to set up a wallet and hold dollars as a stablecoin.

Another benefit of stablecoins is that, again in theory, they can handle extremely small payments. There is usually a minimum payment 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 trading. Something that can’t really be done with the current banking or credit card system.

There is 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 U.S. 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 stablecoin growth could add hundreds of billions, and possibly up to $1 trillion, in new T-bill demand by 2028.

There is 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 U.S. bank accounts.

From Washington’s perspective, that can reinforce the dollar’s role as the dominant global currency while pulling more digital finance activity into a U.S.-regulated framework.

So how do stablecoin companies 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 percent, that interest income can be enormous.

So, if an issuer has $100 billion in reserves earning 4 percent, that is $4 billion a year in gross interest income before expenses, partner payments, compliance costs, technology costs, and taxes.

They can also make money from fees, though these are usually less important than reserve income for the biggest issuers.

Stablecoin issuers can also make money by offering related services. These 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 platform.

So far, I’ve been speaking in generalities. In reality, there are currently two major issuers of U.S. 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 is run by Circle. It’s the preferred stablecoin in US-regulated environments and Decentralized Finance applications because Circle is more transparent about its reserves and operates under US money transmission licenses.

USDC briefly lost its peg in March 2023 when news broke that Circle had $3.3 billion sitting at Silicon Valley Bank, which had just failed. It recovered quickly after the FDIC backstopped bank depositors, but the episode was a reminder that “backed by cash” means something specific about where that cash lives.

So, if stablecoins can process transactions 24/7, faster and cheaper than traditional banking, what is the downside?

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, they should just become banks.

The other major problem is that this industry is so new, 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 they can reduce their risks.

Another big issue will be transparency surrounding reserves. The trust people have in stablecoins will be tied to the company’s ability to prove it has reserves to cover all its stablecoins.

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 you would use stablecoins.

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. Most of this will occur on the back end and might not even be seen by most consumers.

Likewise, consumers with the greatest incentive to use stablecoins would be outside the United States, where it is harder to obtain and retain dollars.

Stablecoins are still brand new and have low adoption, but they have enormous potential to upend the entire finance industry. Stablecoin transactions can bypass banks, rendering many of their functions irrelevant.

Moreover, this might just be the opening act in the tokenization of stocks and bonds as well, which would enable global 24/7 trading and near-immediate clearance of trades, just like with stablecoins.

Banks have been around for a very long time and it is a very conservative industry, so it is too early to know what is going to happen. However, the potential for truly transforming the world of finance might already be right in front of us.