December 2020

The Role of Stablecoins

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In November we interviewed Do Kwon, the CEO of Terra, and spoke at length about the use of stablecoins in ecommerce and beyond. As Do highlighted, there is clear product-market fit for stablecoins as a method of online payment.

In November we interviewed Do Kwon, the CEO of Terra, and spoke at length about the use of stablecoins in ecommerce and beyond. As Do highlighted, there is clear product-market fit for stablecoins as a method of online payment. Stablecoins are natively digital, have near instant settlement, are incredibly cheap to transact, can be used globally and hold a stable value. These attributes make them the perfect instrument for digital value transfers and their popularity has been exploding. This month, we are going to dive into the use of stablecoins and their role in the future digital economy. With companies like Facebook and Paypal moving aggressively into the crypto space, it is only a matter of time until stablecoins are used for payments by a mass market audience.

A stablecoin is a cryptocurrency that aims to maintain a stable value relative to a specified asset or basket of assets. There are three types of stablecoin in existence at the moment. Firstly, there are asset backed stablecoins that hold their value due to the fact that each coin is physically backed by an asset. For example, every 1 Tether is backed by 1 USD in a bank account. Secondly, there are crypto-backed stablecoins that have digital assets locked in contracts, supporting the value of the stablecoin. Finally, there are algorithmic stablecoins that automatically expand and contract their own money supply in order to keep prices stable. It remains to be seen which of these approaches will prevail or even if one type of stablecoin will dominate. More likely, consumers and vendors will align themselves with different stablecoins, depending on their geography, use case and preferences.

The first major use of stablecoins is for digital asset trading. In the early days of crypto, before stablecoins become prominent, the main trading pair for all tokens was against Bitcoin. This was because Bitcoin was the leading asset in the space, with the most liquidity. However, Bitcoin’s value was far from stable, meaning that prices of all digital assets would fluctuate in line with daily movements in the price of Bitcoin. To address this issue, market participants developed stablecoins which could act as a stable trading pair and provide the ability to hedge between crypto-assets and fiat currencies. The asset that was most widely adopted for crypto trading was Tether, a USD backed stablecoin. Today Tether has a total circulation of USD20bn and daily volume of almost USD50bn, meaning that each coin is rotating an average of 2.5 times a day.  

It is logical that crypto trading became the first significant use case of stablecoins as this is where crypto natives reside online. However, crypto trading is and will remain a niche activity. It is more interesting to look ahead at what real world use cases stablecoins are starting to fulfill. An obvious outlet for stablecoin adoption is in ecommerce. In 2019, an estimated 1.92 billion people purchased goods or services online and e-retail sales surpassed USD 3.5 trillion worldwide. Every ecommerce transaction makes use of a payment provider, like Paypal or Alipay, and transaction fees can cost up to 3% of the purchase price. Ecommerce companies, that operate on razor thin margins, welcome new payment options that reduce these fees. Enter Terra.

Terra is a South Korean based project that offers a suite of stablecoins and has started to roll out consumer facing products. What is unique about Terra is that most of its users have no idea that they are using a stablecoin. All its users know is that they can get a better price on ecommerce purchases by using the Chai app (by Terra) than they can from using other payment solutions. As a result of this simple premise, usage of Chai has been exploding, with the app boasting over 50,000 daily active users.

The success of Terra in South Korea is likely to be replicated in the western world, with Facebook, PayPal and Square all eying up the opportunity. While PayPal and Square are allowing users to purchase Bitcoin and to use it as a funding source for payments to merchants (26m merchants in the case of PayPal), they are yet to announce any stablecoin products. Given the volatility risk of Bitcoin, it is surely a matter of time until these companies incorporate a stablecoin product in their crypto offering. Facebook, on the other hand, has re-branded its Libra platform to “Diem” and is planing to launch this stablecoin in 2021. Facebook has a growing suite of payment products that include Facebook Pay, Whatsapp Pay and Instagram Pay. If Diem is implemented on these platforms, then it will immediately have access to hundreds of millions of retail customers.

The reach and potential usage of Diem is astounding. It will be borderless, potentially making it one of the leading global cross-border payment systems overnight. One can imagine use cases spanning from peer-to-peer payments, to ecommerce and even borrowing and lending products. As well as offering traditional payment products, the fractionalisation of the Diem stablecoin, along with Facebook’s array of digital products could open up innovative micro-payment opportunities. Rather than liking someone’s comment on a Facebook wall, perhaps users will tip a fraction of a Diem. Groups out for dinner could pool funds in a Whatsapp group, with the messaging group being the final distributor of funds to the vendor.

While Facebook may deem its Diem product to be exciting and innovative, global regulators seem less keen on the idea. Germany’s finance minister has called the project “a wolf in sheep’s clothing” and said that “We must do everything possible to make sure the currency monopoly remains in the hands of states.” With this in mind, it is worth evaluating whether central bank digital currencies (CBDCs) could fulfil the functions that stablecoins are trying to address. CBDCs would be backed by central banks and so would not be affected by the stabilization issues that crypto-backed and algorithmic stablecoins face. Governments may also be able to program their stablecoins to better fulfil the purpose that they were created for. For example, a government could mandate that government-to-person payments only be used for grocery shopping. Or they could make it so that funds expire after a certain period of time.

The ability for governments to more tightly censor and observe digital money transfers does not sit well with the more liberally minded engineers in the crypto space. As a result, we are seeing the emergence of fully decentralized stablecoins, some with anonymous teams. A particularly interesting project that has recently appeared is Empty Set Dollar. This Ethereum based algorithmic stablecoin is a couple of months old and already has a marketcap of over USD120m. A fully decentralized project with no corporate backing may well fit the ethos of DeFi projects that are looking to disrupt traditional financial services players.

Stablecoins are emerging rapidly as a payment mechanism for more than just crypto trading. They offer a superior experience to traditional payment gateways owing to their incredibly low transaction fees, borderless nature and the ability to be fractionalized to a greater extent that USD can be. We expect to see a ramp up in the adoption of stablecoins over the coming years and believe that the leading fintech companies of the next decade will rely on stablecoins and a blockchain based settlement system. We are excited to continue supporting Terra as it expands its reach beyond South Korea and look forward to the roll out of original stablecoin designs on smart contract platforms like Ethereum, Solana and Cosmos.