Partner of Dragonfly: Discussing the Blueprint and Ultimate Form of Stablecoin Evolution

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, Author: Haseeb Qureshi, Managing Partner, Dragonfly Capital, Compiler: Perry Wang, published with permission.

The newly proposed "STABLE Act" proposed by the U.S. Congress at the end of this year has brought a lot of controversy to the encryption industry. The bill requires stablecoin issuers to obtain a banking license.

If passed into law, the bill would force stablecoin reserves to be regulated like bank deposits. Given that stablecoins are currently the de facto currency of today’s crypto ecosystem, it would be a huge setback for stablecoins if the above scenario were to materialize.

The crypto industry responded swiftly and furiously. For a while, exchanges, wallet institutions and entrepreneurs strongly condemned this bill and its possible consequences.

The sword of Damocles has not yet fallen, because the Stability Act may not pass Congress to become legislation. However, the U.S. President’s Financial Market Working Group has just issued a regulatory statement on stablecoins, stating that stablecoin holders should accept KYC for user identity verification.

The statement has no legal force, but it shows a change in the zeitgeist.

Stablecoins have seen massive growth over the past few years, largely undisturbed by regulation. Is this situation sustainable? Is the Stability Act a harbinger of things to come? What will happen to Tether's stable currency USDT or decentralized stable currency?

I think the answer is simple: regulation is a one-way street. Centralized stablecoins will gradually be subject to more and more restrictions, thereby pushing the crypto economy towards decentralized stablecoins.

It won't happen overnight. But I think that's what will happen eventually.

Let's review the stablecoins first, and then present my views to readers one by one.

Origin of cryptocurrency

Originally, Satoshi Nakamoto invented Bitcoin, creating a decentralized digital currency. In the early days, Bitcoin (BTC) was indeed a "decentralized digital currency".

Prior to 2018, BTC was the denomination asset for cryptocurrencies. If you want to buy something with cryptocurrency, you can do so with BTC, no other cryptocurrency is as global or liquid, and BTC is the reserve currency for nearly all crypto transactions. Even most ICO fundraising is done with BTC and ETH.

But BTC isn't exactly an ideal currency. Its reputation for being volatile, combined with long block intervals of up to 10 minutes and confirmation times of up to one hour, make it less than ideal as a medium of exchange.

So after the ICO bubble collapsed in 2018, we entered the second phase of cryptocurrency: the TetherUSDT stablecoin era. This is the stage we are currently going through.

I prefer not to call it a stablecoin, but rather describe USDT as a crypto dollar. The "crypto dollar" clearly shows that this will be a fundamentally new monetary phenomenon.

You can think of cryptodollars as a new level in the monetary system — they are dollars as abstract monetary assets converted into permissionless ERC-20 tokens with no political authority, effectively decoupling from the US banking system.

USDT is not the only crypto stablecoin. But as of now, it has become the stable currency with the highest market share with an astonishing growth rate.

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Stablecoins provided by the issuer, source: Debank

But USDT has a high-profile history of controversy and is currently under investigation by the U.S. Department of Justice, the Commodity Futures Trading Commission (CFTC), and the New York Attorney General's Office.

Tether acknowledged in 2019 that the USDT supply is not 100% backed by USD, but its supply has only increased monotonically over time. Given this, you might be wondering why Tether’s USDT is preferred over USDC, which is regulated and backed by Circle and Coinbase.

The answer is simple: USDT is the most dominant stablecoin in the world because it was the first stablecoin to enter this market. It has been around for so long that it has become the most liquid, most demanded, and most trusted neutral stablecoin in the world. (In Asia, Tether’s vague regulatory status is a plus compared to the more heavily regulated USDC.)

Most cryptocurrency exchanges quote USDT for the most trading pairs. The transaction volume of USDT is higher than that of BTC itself. It can be said that USDT is now the storage currency of the cryptocurrency field.

How long will USDT's dominance last?

The market share of USDT is growing rapidly. As it gains traction, I expect more and more people around the world to realize that cryptocurrencies are a better way to access open flows of U.S. dollars from anywhere in the world. Cryptocurrencies are truly global digital cash. This makes them extremely attractive internationally, especially in countries with strict exchange rate controls.

Regardless of the country involved, most cross-border transactions are conducted in U.S. dollars. The US dollar is more or less the de facto currency of international commerce. This gives the U.S. government enormous privilege to conduct its foreign policy not just through its military might, but through its control of the global financial infrastructure.

But countries are increasingly dissatisfied with America's strong financial hegemony. In today's cross-border trade, especially in the Sino-Russian border area, the usage of USDT is growing. This allows businesses to embrace the economic stability and neutrality of the U.S. dollar while decoupling from the stick of U.S. sanctions.

In the wake of the COVID-19 pandemic, the emerging middle class around the world may increasingly seek monetary security and diversification. For many, permissionless cryptocurrencies will be their on-ramp.

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Growth in active Ethereum stablecoin recipient addresses (primarily USDT), source: Joel John

The future of cryptocurrencies is bright. But will USDT survive long enough to see that bright future?

This is a serious question at the heart of the crypto industry.

USDT is essentially a free storage currency.

Recall that USDT is under investigation by various U.S. agencies and prosecutors, and so far, there has been little evidence of any strong defense. It never conducted a full review of its reserves. Tether does perform KYC on its on- and off-ramps, but this extremely weak mask of compliance is unlikely to allow them to evade U.S. government oversight. Note that Tether has blacklisted 250 addresses out of its millions of token holders.

Everyone knows this situation is unsustainable. The larger the USDT market size, the bigger the target.

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Banned Tether addresses over time (less than 0.1% of total addresses), Source: Dune Analytics

Of course Tether is well aware of this. Now they are playing cat and mouse with their bank relationships, jumping from bank to bank (Wells Fargo, ING, Noble Bank, Deltec) until they find one that accepts their money.

This won't last forever: eventually Tether will be shut down or regulated and eliminated.

Make no mistake: the day Tether shuts down will have catastrophic consequences.

Crypto markets will be censored, exchanges will be in disarray, millions of crypto traders will likely have their assets frozen, and prices will plummet everywhere. (This would be another death to Bitcoin.)

But as always, cryptocurrencies will die and rise again. When the dust settles, we will enter the third phase of cryptocurrency.

The order book will be restructured around the new cryptocurrency. The international cryptocurrency market will soon recognize this new standard, eager to get back to business.

But which crypto dollar will replace Tether's USDT?

Rise of RUSD

Currently competing with Tether's USDT are regulated stablecoins such as USDC, BUSD and TUSD (soon to be joined by Facebook-owned crypto project Libra "aka Diem"). We don’t have to care which stablecoin wins the battle, let’s call the winner “RUSD” for regulated dollars.

RUSD will have the same intuitive features as USDT, but more compliant and trustworthy. Over time, RUSD will replace USDT's role in international markets, filling the need for a permissionless, apolitical dollar.

Will this be the final stage? The ultimate form of the dollar in the world?

I do not think so. In my opinion, the third stage, the era of RUSD will also come to an end.

The Curse of Digital Cash

Stablecoins currently backed by fiat currencies are effectively considered cash. Anyone, anywhere can pay whomever they want in any amount they want. A legal checkpoint is only reached when these tokens are exchanged for their underlying USD. Prior to this, there had been no meaningful legal oversight of the circulation of these tokens.

If this continues, stablecoins will become the most powerful bank hack ever. Once bank deposits become the target of financial supervision, they will be seriously inferior to digital cash. If this is approved by regulators, it will only be a matter of time before stablecoins swallow most of the world's dollar settlements.

I'm not saying it's impossible! But I seriously doubt it.

Over the past 50 years, regulatory developments have been one-way: increasing financial regulation, domestic and foreign policies combined with economic control of the global financial system. This trend accelerated after 9/11 and the 2008 financial tsunami.

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Source: Mercatus Center

Of course, permissionless digital currencies will eventually exist whether or not the U.S. government sends its blessing. But will regulators recognize its inevitability and have the U.S. government sanction its own digital dollar?

I suspect they will not be able to resist the temptation to enter the ledger to block the addresses of their enemies, reward their allies, and pursue policy goals directly by controlling the monetary system. If they do, this version of the digital dollar will be indistinguishable from the current banking system.

At present, due to the high-profile pursuit of "innovation", "RUSD" has been retained. However, Rohan Gray, the architect of the Stability Act and an assistant professor at Willamette University, gave us a brief overview of the regulator's thinking: Aren't these fiat-backed stablecoins just digital banks with full reserves?

Should their debt really be permanently treated as cash rather than bank deposits? Can the U.S. regulatory machine resist the urge to regulate the matter? The short history of America since the Patriot Act tells us: probably not.

Even the Financial Action Task Force (FATF), a global intergovernmental organization that sets global standards for anti-money laundering regulations, recently wrote that stablecoins “should never be outside the purview of anti-money laundering controls.” Similarly, the U.S. Financial Stability Board (FSB) recently urged regulators to follow the principles of “same business—same risk—same rules, independent of underlying technology” when regulating stablecoins. The president of the European Central Bank recently agreed.

These RUSDs are currently entering the regulatory radar as "digital cash". But make no mistake: Regulators don't want any of this to exist.

Cash, what anonymity and untraceability do you want? Cash reduces the readability of the economy, so it is the enemy of the state. If cash doesn't exist, governments will never allow it to be reinvented.

The only saving grace for RUSD today is that RUSD today is too small to get real attention from regulators. These days they are mostly used for speculative trading in cryptocurrencies, which is a harmless pastime. In the US dollar environment, they are just a bright spot on the map (in general, the total issuance of all RUSD stablecoins is less than 20 billion US dollars, which is about one percent of commercial bank US dollar deposits).

So, what factors will pull the trigger for regulators to step in and stop the cryptocurrency feast?

I can imagine two scenarios. One possibility is that the issuance of RUSD proliferates to meet growing global demand. Fears that stablecoins are showing exponential growth could lead to a U.S. Congress punching hard to reverse the situation.

The second scenario could be triggered by a black swan event: for example, headlines about someone using a stablecoin to fund terrorists, or an authoritarian state using a stablecoin to evade U.S. sanctions. Then there will be calls for immediate regulation of cryptocurrencies.

Please note that I don't think RUSD will completely disappear from the stage of history. They will most likely allow small balances without KYC, but beyond a certain size, the account must go through KYC to receive more funds. Alternatively, they could be regulated like banks and enforce KYC on all cryptocurrency holders. RUSD will have to start enhancing the terms of use and actively police account fraud (not very strict at the moment).

Once this happens, RUSD will no longer be a satisfactory solution to the global demand for crypto dollars. They will be used in the US for institutional use, but they are overly regulated and out of reach for non-US individuals or those who are excluded from financial services. RUSD will essentially be an enhanced bank deposit.

Until then, and only then, will we enter the fourth phase of stablecoins: the phase in which the decentralized cryptodollar prevails.

The ultimate form of the encrypted dollar

So far in this article, I haven't mentioned any decentralized stablecoins. This is by design: until the point mentioned above, decentralized stablecoins have no chance of real adoption.

The main characteristic of a stablecoin is of course that it has a value of $1. But the price anchor of decentralized stablecoins has always been relatively weak, so they are at a disadvantage compared with centralized stablecoins.

Relationship between USDT price peg (green line) and Dai price peg (red line) in 2020, source: Coinmetrics

Fiat-backed stablecoins maintain their price peg through a create-cash cycle, similar to an ETF. If the price is too high, arbitrageurs can put in dollars to mint a new stablecoin and sell that stablecoin on the open market for a profit. If the price is too low, they can make a profit by buying the stablecoin and exchanging it for dollars. It’s all a quick and low-risk operation, allowing arbitrageurs and market makers to quickly secure the stablecoin’s peg to the U.S. dollar.

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ETF Creation - Demonstration of Redemption Arbitrage, Source: Michael Kitces

Crypto-native stablecoins are different. They have weak price anchors because there is no real arbitrage in their price anchors, and they work more like a central bank setting a price range target. Monetary policy runs slowly, and central banks do their best to react in real time when currencies are detached from their pegs. Speculators may bet that the anchor will be restored soon, but this is not arbitrage; it is best described as "short-term speculation on the future effectiveness of monetary policy."

But this mechanism works! It does create a decentralized stablecoin. This is evidenced by the current generation of Dai, which survived a one-year price drop of around 95% in ETH collateral in 2018, maintained its peg to the U.S. dollar, and even survived Black Thursday, when ETH collateral dropped at The price plummeted by more than 50% in one day.

We know that the mechanics behind decentralized price pegs can work in highly volatile markets. But we also know that they are not as prosperous as centralized stablecoins, which is not surprising given that their mechanics are much more complex.

Decentralized stablecoins cannot compete head-on with USD-pegged stablecoins. But decentralized stablecoins have an advantage: decentralized stablecoins are indeed censorship-resistant.

Sadly, the market simply doesn't care. Because right now, no one is doing a massive stablecoin review.

If none of these centralized stablecoins actually faced censorship, then USDT would offer the same thing that Dai would give you, only with more liquidity and a tighter price anchor. Dai is currently a poorer stablecoin than USDT for practical purposes.

But this situation will eventually change.

The knife of scrutiny will fall as regulators will not tolerate truly unregulated digital cash. Once they implement regulations for fiat-backed stablecoins, censorship resistance in stablecoins is only valuable, and then only assets such as Dai, Celo, or ESD will be suitable denomination assets for the crypto industry.

This is why I believe a decentralized crypto dollar will be the long-term view of the future currency of the crypto world. I believe they will fundamentally change the global financial landscape.

But none of this will happen anytime soon. It's hard to pin down a timeline here, but it could take 3+ years to fully manifest. Given the many other aspects of the world that will change by then, any prediction that seems so far-fetched will inevitably be clouded.