Stablecoin Handbook: How a Trillion-Dollar Market Came into Being

Author: Rui Shang, SevenX Ventures Translator: Mensh, ChainCatcher

Overview: 8 most important stablecoin-related opportunities -

The younger generation is a digital native, and stablecoins are their natural currency. As artificial intelligence and the Internet of Things drive billions of automated microtransactions, global finance needs flexible monetary solutions. As a "currency API", stablecoins are transferred as seamlessly as Internet data and reached a transaction volume of $4.5 trillion in 2024, a figure that is expected to grow as more institutions realize that stablecoins are an unparalleled business model-Tether earned $5.2 billion in profits in the first half of 2024 by investing its US dollar reserves.

In the stablecoin competition, complex cryptographic mechanisms are not the key, distribution and real adoption are crucial. Their adoption is mainly reflected in three key areas: crypto-native, fully banked, and unbanked worlds.

In the $29 trillion crypto-native world, stablecoins are essential for trading, lending, derivatives, liquidity farming, and RWA as an entry point to DeFi. Crypto-native stablecoins compete through liquidity incentives and DeFi integration.

In the fully banked world of more than $400 trillion, stablecoins improve financial efficiency and are mainly used for B2B, P2P, and B2C payments. Stablecoins focus on regulation, licensing, and leveraging banks, card networks, payments, and merchants for distribution.

In the unbanked world, stablecoins provide access to the US dollar and promote financial inclusion. Stablecoins are used for savings, payments, foreign exchange, and yield generation. Grassroots market promotion is critical.

Natives of the Crypto World

In the second quarter of 2024, stablecoins accounted for 8.2% of the total crypto market capitalization. Maintaining exchange rate stability remains challenging, unique incentives are the key to expanding on-chain distribution, and the core problem lies in the limited application of on-chain.

Battle of Fixed Currencies

Fiat-backed stablecoins rely on banking relationships:

93.33% are fiat-backed stablecoins. They have greater stability and capital efficiency, and banks have the final say by controlling redemptions. Regulated issuers like Paxos became the USD issuer for PayPal due to their successful redemption of billions of BUSD.

CDP Stablecoins Improve Collateral and Liquidation for Exchange Rate Stability:

3.89% are Collateralized Debt Position (CDP) stablecoins. They use cryptocurrencies as collateral, but face issues with scaling and volatility. CDPs have improved risk resistance by accepting a wider range of liquidity and stable collateral by 2024, with Aave's GHO accepting any asset in Aave v3 and Curve's crvUSD recently adding USDM (real assets). Some liquidations are improving, especially crvUSD's soft liquidations, which provide a buffer against further bad debt through its custom automated market maker (AMM). However, the ve-token incentive model is problematic because crvUSD's market cap shrank when CRV's valuation fell after a large-scale liquidation.

Synthetic USD Uses Hedging to Stay Stable:

Ethena USDe alone has captured 1.67% of the stablecoin market share in a year, with a market cap of $3 billion. It is a delta-neutral synthetic dollar that fights volatility by opening short positions in derivatives. Funding rates are expected to perform well in the upcoming bull market, even after seasonal fluctuations. However, its long-term viability is largely dependent on centralized exchanges (CEX), which is questionable. With the increase of similar products, the influence of small funds on Ethereum may weaken. These synthetic dollars may be vulnerable to black swan events and can only maintain low funding rates during bear markets.

Algorithmic stablecoins fell to 0.56%.

Liquidity Bootstrapping Challenge

Crypto stablecoins use yields to attract liquidity. Fundamentally, their liquidity costs consist of the risk-free rate plus a risk premium. To remain competitive, stablecoins must earn at least as much as the Treasury bill (T-bill) rate — we’ve seen stablecoin borrowing costs fall as T-bill rates hit 5.5%. sFrax and DAI lead the way with T-bill exposure. By 2024, multiple RWA projects have increased the composability of T-bills on-chain: CrvUSD uses Mountain’s USDM as collateral, while Ondo’s USDY and Ethena’s USDtb are backed by Blackstone’s BUIDL.

Based on the T-bill rate, stablecoins employ a variety of strategies to increase risk premiums, including fixed budget incentives (like DEX issuance, which can lead to constraints and death spirals); user fees (pegged to lending and perpetual contract volume); volatility arbitrage (falls when volatility subsides); and reserve utilization, such as staking or re-staking (less attractive).

In 2024, innovative liquidity strategies are emerging:

• Maximizing intra-block yields: While many yields currently derive from self-consuming DeFi inflation as an incentive, more innovative strategies are emerging. By using reserves as a bank, projects like CAP aim to direct MEV and arbitrage profits directly to stablecoin holders, providing a sustainable and more lucrative source of potential yields.

• Compounding with Treasury Bill Returns: Leveraging the new combination capabilities of RWA projects, initiatives like Usual Money (USD0) offer “theoretically” unlimited returns through their governance tokens, benchmarked against Treasury bill returns — attracting $350 million in liquidity providers and entering Binance’s launch pool. Agora (AUSD) is also an offshore stablecoin with Treasury bill returns.

• Balanced high returns against volatility: Newer stablecoins use a diversified basket approach to avoid single returns and volatility risks, providing balanced high returns. For example, Fortunafi’s Reservoir allocates Treasury bills, Hilbert, Morpho, PSM, and dynamically adjusts each part to incorporate other high-yield assets when necessary.

• Is the total locked value (TVL) a flash in the pan? Stablecoin returns often face scalability challenges. While fixed budget returns can bring initial growth, as the total locked value grows, the returns will be diluted, causing the return effect to weaken over time. Without sustainable returns or real utility in trading pairs and derivatives after incentives, its total locked value is unlikely to remain stable.

DeFi Gateway Dilemma

On-chain visibility allows us to examine the true nature of stablecoins: Are stablecoins a true representation of currency as a medium of exchange, or are they simply financial products that generate returns?

Only the best-yielding stablecoins are used as trading pairs on CEXs:

Nearly 80% of trading still takes place on centralized exchanges, with top CEXs supporting their “preferred” stablecoins (e.g., Binance’s FDUSD, Coinbase’s USDC). Other CEXs rely on overflow liquidity from USDT and USDC. In addition, stablecoins are striving to become margin deposits for CEXs.

Few stablecoins are used as trading pairs for DEXs:

Currently, only USDT, USDC, and a small amount of DAI are used as trading pairs. Other stablecoins, such as Ethena, which has 57% of USDe staked in its own protocol, are purely held as financial products to earn yield, far from being a medium of exchange.

Makerdao + Curve + Morpho + Pendle, combined allocation:

Markets like Jupiter, GMX, and DYDX prefer to use USDC as deposits because the minting-redemption process of USDT is more skeptical. Lending platforms like Morpho and AAVE prefer USDC because of its better liquidity on Ethereum. On the other hand, PYUSD is mainly used for lending on Solana’s Kamino, especially when the Solana Foundation provides incentives. Ethena’s USDe is mainly used for Pendle for yield activities.

RWA is undervalued:

Most RWA platforms, such as Blackstone, use USDC as a minting asset for compliance reasons, and Blackstone is also a shareholder in Circle. DAI has been successful in its RWA product.

Expand the market or explore new areas:

Although stablecoins can attract major liquidity providers through incentives, they face a bottleneck - DeFi usage is declining. Stablecoins are now in a dilemma: they must wait for the expansion of crypto-native activities or seek new utility beyond this field.

An outlier in a fully banked world

Key players are taking action

Global regulation is becoming clearer:

99% of stablecoins are backed by the US dollar, and the federal government has ultimate influence. The US regulatory framework is expected to be clarified after the crypto-friendly Trump presidency, and his promises of lower interest rates and a ban on CBDCs could be a boon to stablecoins. The US Treasury report points to the impact of stablecoins on demand for short-term Treasury bonds, with Tether holding $90 billion in US debt. Preventing crypto crime and maintaining the dominance of the US dollar are also motivations. By 2024, multiple countries have established regulatory frameworks under common principles, including approval for stablecoin issuance, reserve liquidity and stability requirements, restrictions on the use of foreign-currency stablecoins, and generally prohibitions on the generation of interest. Key examples include: MiCA (EU), PTSR (UAE), Sandbox (Hong Kong), MAS (Singapore), PSA (Japan). Notably, Bermuda became the first country to accept stablecoin tax payments and license the issuance of interest-bearing stablecoins.

Licensed issuers gain trust:

The issuance of stablecoins requires technical capabilities, inter-regional compliance, and strong management. Key players include Paxos (PYUSD, BUSD), Brale (USC), and Bridge (B2B API). Reserve management is handled by trusted institutions such as BNY Mellon, safely generating income through investments in its Blackstone-managed funds. BUIDL now allows a wider range of on-chain projects to earn income.

Banks are the gatekeepers for withdrawals:

While deposits (fiat to stablecoins) have become easier, withdrawals (stablecoin to fiat) remain challenging as banks have difficulty verifying the source of funds. Banks prefer to use licensed exchanges like Coinbase and Kraken, which conduct KYC/KYB and have similar anti-money laundering frameworks. While high-reputation banks like Standard Chartered are beginning to accept withdrawals, small and medium-sized banks like Singapore's DBS Bank are moving quickly. B2B services like Bridge aggregate withdrawal channels and manage billions of dollars in trading volume for high-profile clients including SpaceX and the US government.

Issuers have the final say:

Circle, the leader in compliant stablecoins, relies on Coinbase and is seeking global licenses and partnerships. However, this strategy could be compromised as institutions issue their own stablecoins, as the business model is unparalleled - Tether, a company with 100 employees, made $5.2 billion from investing its reserves in the first half of 2024. Banks like JPMorgan have already launched JPM Coin for institutional trading. Payment app Stripe's acquisition of Bridge shows interest in owning a stablecoin stack, not just integrating USDC. PayPal also issued PYUSD to capture reserve returns. Card networks such as Visa and Mastercard are tentatively accepting stablecoins.

Factors behind the efficiency improvement

Backed by a trusted issuer, healthy banking relationships and distributors as a foundation, stablecoins can improve the efficiency of large-scale financial systems, especially in the payment field.

Traditional systems face efficiency and cost limitations. In-app or intra-bank transfers offer instant settlement, but only within their ecosystem. Interbank payments cost around 2.6% (70% to the issuing bank, 20% to the receiving bank, and 10% to the card network), and settlement takes more than a day. Cross-border transactions cost even more, around 6.25%, and settlement can take up to five days.

Stablecoin payments provide instant peer-to-peer settlement by eliminating intermediaries. This speeds up the flow of funds and reduces capital costs, while providing programmable features such as conditional automatic payments.

• B2B ($120-150 trillion annual transaction volume): Banks are in the best position to promote stablecoins. JPMorgan developed JPM Coin on its Quorum chain, and as of October 2023, JPM Coin is used for about $1 billion in transactions per day.

• P2P ($1.8-2 trillion annual transaction volume): E-wallets and mobile payment applications are in the best position. PayPal has launched PYUSD, which currently has a market value of $604 million on Ethereum and Solana. PayPal allows end users to register and send PYUSD for free.

• B2C Commerce ($5.5-6 trillion in annual transactions): Stablecoins need to work with POS, bank APIs, and card networks, with Visa becoming the first payment network to settle transactions using USDC in 2021.

Innovators in an Underbanked World

Shadow Dollar Economy

Emerging markets are in desperate need of stablecoins due to severe currency devaluation and economic instability. In Turkey, stablecoin purchases account for 3.7% of its GDP. People and businesses are willing to pay a premium over fiat dollars for stablecoins, reaching 30.5% in Argentina and 22.1% in Nigeria. Stablecoins provide access to dollars and financial inclusion.

Tether dominates this space with a proven 10-year track record. Even in the face of complex banking relationships and redemption crises — Tether admitted in April 2019 that USDT was only 70% backed by reserves — its peg remains stable. This is because Tether has built a strong shadow dollar economy: in emerging markets, people rarely exchange USDT for fiat, they treat it as dollars, which is particularly evident in regions such as Africa and Latin America to pay employees, invoices, etc. Tether achieves this without incentives, simply by virtue of its long-term existence and continued utility, which enhances its credibility and acceptance. This should be the ultimate goal of every stablecoin.

Dollar Access

• Remittances: Remittance inequality slows economic growth. In sub-Saharan Africa, economically active individuals pay an average of 8.5% of the total remittance amount when sending remittances to low- and middle-income countries and developed countries. For businesses, the situation is even more dire, with barriers such as high fees, long processing times, bureaucracy, and exchange rate risk directly impacting the growth and competitiveness of businesses in the region.

• Access to USD: Currency volatility cost 17 emerging market countries $1.2 trillion in GDP between 1992 and 2022 — a staggering 9.4% of their combined GDP. Access to USD is critical to local financial development. Many crypto projects are working on onboarding, with ZAR focusing on grassroots “DePIN” approaches. These approaches leverage local agents to facilitate cash-to-stablecoin transactions in Africa, Latin America, and Pakistan.

• Foreign Exchange: Today, the foreign exchange market trades over $7.5 trillion per day. In the global south, individuals often rely on the black market to convert local fiat to USD, primarily because the black market exchange rate is more favorable than official channels. Binance P2P is starting to gain adoption, but lacks flexibility due to its order book approach. Many projects such as ViFi are building on-chain automated market maker foreign exchange solutions.

• Humanitarian Aid Distribution: Ukrainian war refugees can receive humanitarian aid in the form of USDC, which they can store in digital wallets or cash out locally. In Venezuela, frontline health workers use USDC to pay for medical supplies during the COVID-19 outbreak as the political and economic crisis deepens.

Conclusion: Interweaving

Interoperability

FX:

The traditional FX system is highly inefficient and faces multiple challenges: counterparty settlement risk (CLS is enhanced but cumbersome), the cost of a multi-bank system (six banks are involved when an Australian bank buys yen to its London dollar office), global settlement time zone differences (CAD and JPY banking systems overlap for less than 5 hours per day), limited access to the FX market (retail users pay 100 times the fees of large institutions). On-chain FX offers significant advantages:

• Cost, Efficiency, and Transparency: Oracles like Redstone and Chainlink provide real-time price quotes. Decentralized exchanges (DEXs) offer cost efficiency and transparency, with Uniswap CLMM bringing transaction costs down to 0.15-0.25% — about 90% lower than traditional FX. Moving from T+2 bank settlement to instant settlement enables arbitrageurs to employ a variety of strategies to correct mispricing.

• Flexibility and Accessibility: On-chain FX gives corporate treasurers and asset managers access to a wide range of products without the need for multiple currency-specific bank accounts. Retail users can access the best FX prices using crypto wallets with DEX APIs embedded.

• Decoupling of Currency and Jurisdiction: Transactions no longer require a domestic bank, decoupling them from the underlying jurisdiction. This approach leverages the efficiencies of digitization while maintaining monetary sovereignty, though drawbacks remain.

However, challenges remain, including scarcity of non-USD-denominated digital assets, oracle security, support for long-tail currencies, regulation, and unified interfaces with on-chain and off-chain. Despite these obstacles, on-chain FX still presents an attractive opportunity. For example, Citi is developing a blockchain FX solution under the guidance of the Monetary Authority of Singapore.

Stablecoin Exchanges:

Imagine a world where most companies are issuing their own stablecoins. Stablecoin exchanges present a challenge: using PayPal’s PYUSD to pay JPMorgan’s merchants. While on-chain and off-chain solutions can solve this problem, they lose the efficiency promised by cryptocurrencies. On-chain automated market makers (AMMs) offer the best real-time, low-cost stablecoin-to-stablecoin trading. For example, Uniswap offers multiple such pools with fees as low as 0.01%. However, once billions of funds enter the chain, the security of smart contracts must be trusted, and there must be deep enough liquidity and instant performance to support real-life activities.

Cross-chain exchanges:

Major blockchains have diverse strengths and weaknesses, resulting in stablecoins being deployed on multiple chains. This multi-chain approach introduces cross-chain challenges, and bridges present huge security risks. In my opinion, the best solution is for stablecoins to launch their own Layer 0, such as USDC's CCTP, PYUSD's Layer 0 integration, and the move we witnessed by USDT to recall bridge-locked tokens, which may launch a similar Layer 0 solution.

At the same time, there are still several unanswered questions:

Will compliant stablecoins hinder "open finance" because compliant stablecoins can potentially monitor, freeze, and withdraw funds?

Will compliant stablecoins still avoid offering returns that could be classified as securities, preventing on-chain decentralized finance (DeFi) from benefiting from its massive expansion?

Given the slow speed of Ethereum and its L2 reliance on a single sorter, Solana’s imperfect operating record, and the lack of long-term performance records of other popular chains, can any open blockchain really handle huge amounts of money?

Will the separation of currency and jurisdiction introduce more confusion or opportunity?

The financial revolution led by stablecoins is both exciting and unpredictable before us - a new chapter in which freedom and regulation dance in a delicate balance.