#62 - What Makes a Stablecoin, Stable?
An Interview with Dr. Gordon Liao, the Chief Economist and Head of Research at Circle International Financial, the origin of USDC.
Stanford Blockchain Review
Volume 7, Article No. 2
📚 Author: Austin Bennett - Stanford Blockchain Club (VP of Finance)
🌟 Technical Prerequisite: Low
Stability in the Best of Times vs the Worst of Times
With the advent of a new federal regime, the crypto market has been more optimistic than ever. At the time of writing, Bitcoin is pushing $100,000 per token and altcoins have risen over 50% in a week.1 Despite these gains, however, some top coins have held constant in their price – and that’s a very good thing.
While speculating on the value of cryptocurrencies can generate excitement in the space, the volatility associated with it serves as a major barrier to adoption. Cryptocurrencies are transacted quickly, but when trading pairs fluctuate by more than 1% in an hour, the result is an unstable medium of exchange. Users seek decentralization, but not at the cost of a potential default. Stablecoins may be the solution – providing order in a market that’s rife with uncertainty.
A stablecoin is a cryptocurrency that attempts to fix its value in line with some underlying asset, be it a fiat currency, like US Dollars, or a commodity, like gold. By pegging their value to another asset, these tokens stabilize transactions by removing the incentive to speculate on their value. Using them is analogous to putting assets in a blockchain bank: you gain access to its fast, decentralized financial infrastructure, but still maintain a redeemable digital representation of them as a store of value.
Though what makes a stablecoin, stable? How do stablecoins keep their value? And to what extent should we be using stablecoins? I sat down with Dr. Gordon Liao, the Chief Economist of a major stablecoin provider, Circle, to learn a little bit more.
All Dollars May Be Equal, but their Stablecoins Are Not
While the Department of the Treasury reports stablecoin usage has increased dramatically in the past few years,2 their presence in the crypto market is longstanding. Because they resist price fluctuations, stablecoins like Tether, USDC, and Dai are popular choices for transacting cryptocurrencies both with exchanges and on-chain. They all seek to hold a peg at a US Dollar, but their mechanisms for doing so vary dramatically.
Depending on their construction, some stablecoins prioritize decentralization, while others prioritize regulatory compliance. Although they may be pegged to the same asset, they have different processes for obtaining the tokens and may even require different kinds of assets to mint them. Clearly, designing a stablecoin is no easy feat – though according to Dr. Liao, much of the work has already been done.
He mentioned that asset-backed stablecoins are well studied, so their risks are relatively known. In particular, he mentioned that it’s important to have a highly liquid asset backing the stablecoin as well as ensure that the backing assets are segregated for the benefit of the stablecoin holders. Additionally, providers need to manage issues outside of the stablecoins themselves, such as credit, market, and operational risks. Given this large set of issues, Dr. Liao’s team recently published the Token Capital Adequacy Framework3 to help synthesize all of these complicated metrics into one place. In doing so, he hopes to help create industry standards for stablecoins, so that users can make an informed choice about their provider.
Stability in Different States
Circle, for example, emphasizes transparency and stability. Unlike its peers, Circle publishes both their Reserves Composition4 as well as advertises third-party daily reporting on the Circle Reserve Fund.5 Dr. Liao further explained that due to these reserves, a user should always be able to redeem their USDC for an equivalent fiat value in the long term. The assets backing the USDC stablecoins, themselves, are segregated; and therefore, offer strong assurance to Stablecoin users.
In the short-term, however, spot market prices for USDC can still be slightly different than a dollar. This is because tokens like USDC are traded on a secondary market, so short-term inefficiencies in trading pairs can cause the price of USDC to diverge slightly from its dollar peg. Usually, this is due to the liquidity of market makers. He gave the example of a crashing Bitcoin price, where traders will rush into USDC as a “safer” asset. In doing so, they can artificially inflate the value of USDC to be slightly over a dollar, before it quickly moves back to its pegged value.
Circle, however, doesn’t see much secondary market conversion against fiat. Dr. Liao noted that approximately 95% of the USDC redemptions occur on the primary market, directly through Circle as the issuer. This has held even in cases of uncertainty, such as the collapse of Silicon Valley Bank,6 which led to billions in USDC redemptions.7 Thus, while the spot price of USDC may be slightly different at times, it doesn’t necessarily mean that USDC has lost its peg. It’s often just a matter of temporary market inefficiency.
On the other hand, cases like the SVB crash could provide evidence that transparency in assets backing a stablecoin may sometimes be a double-edged sword. While transparency is a highly desirable trait in a stablecoin, especially one with a multi-billion dollar company behind it,8 listing the location of assets could certainly stoke fears in the market. That being said, one would be hard-pressed to find a crypto advocate who believes that absconding financial information is the best method of financial security. Blockchains are built on truth; and even if it sometimes hurts, it’s best that the public is well informed of the issues.
Stablecoins and Decentralized Finance
Beyond serving as a store of value, stablecoins have a long found utility as a method of powering Decentralized Finance (DeFi) applications. In fact, MakerDAO, one of the first major DeFi protocols, is a decentralized stablecoin provider that mints the popular US Dollar stablecoin, Dai, in exchange for an Ethereum lockup.9 Despite Circle’s existence as a centralized financial institution, Dr. Liao recognizes the importance of the DeFi ecosystem, claiming that it’s central to the blockchain and web3 space.
Unfortunately, much like the broader crypto market, the DeFi ecosystem is marred by a history of volatility. For example, consider the spectacular collapse of UST, an algorithmic US Dollar stablecoin managed by the Terra Blockchain.10 Instead of relying on equivalent backing in fiat funds, UST derived its value in part from its governance token, LUNA. Given their symbiotic relationship, when both tokens suddenly collapsed, it wiped out billions of dollars in value. For this reason, Dr. Liao argues that we should “want the safest form of a store of value and a unit of account to be the bedrock of DeFi.” By this criteria, USDC is certainly a strong contender to underpin the ecosystem.
At the same time, however, DeFi advocates could argue that there’s something inherently contradictory with using a centralized stablecoin, like USDC, to power DeFi infrastructure. While perhaps less secure, if we seek to truly embody the ethos of decentralized finance we may want stablecoins run through DAO Governance, such as MakerDAO’s Dai, Under this argument, however, one could reasonably argue that underpinning the global DeFi with a stablecoin tied to a national currency is centralized for the same reason – yet this hasn’t stopped the US Dollar from serving as a stablecoin gold standard.
Dr. Liao has a different perspective on what DeFi really means: “DeFi, overall, is not necessarily about decentralizing governance or decentralizing permissioning even, it’s about decentralizing balance sheet capacity.” From the failures he’s seen in the legacy financial system, he explains that he believes “the biggest innovation is the ability for you to really decentralize risk-taking to a greater set of participants that otherwise wouldn’t have the technology to participate.”
He offers the example of market making, where he claims that historically we’ve needed “highly sophisticated technology and highly sophisticated capital to participate”; thereby, leading to a highly concentrated market structure with high frequency trading firms running the show. Dr. Liao claims that “the difference with DeFi is that you can harness the technology to use a broader set of participants – it’s not just specialized firms, but also just everyday capital owners.”
Perhaps the best example of this collective impact are on Decentralized Exchanges (DEXs). Besides serving as an oasis for meme coins, DEXs democratize the traditional order book in a way that’s fast and easy-to-use. As a course assistant for the new Stanford GSB Pathfinder course, BUSGEN 102, I saw this first-hand. Students with no prior experience suddenly became traders and liquidity providers for our fictitious “Red” and “Blue” tokens on Uniswap’s Sepolia Testnet. No longer were they bound to centralized exchange to trade – they could do it with each other.
When DeFi provides this level of access, the issue of stablecoin centralization might be moot. After all, if our goal is to truly achieve a truly decentralized financial infrastructure then we should be able to work with all stablecoins without consequence – be it USDC, Tether, or Dai – bearing in mind that DeFi protocols may choose the same. There may not be a one-size-fits-all stablecoin, but the other ones are always just a swap away.
Stablecoins in the Modern Era
Recognizing these various preferences within the crypto community, Circle has also taken major steps to make USDC interoperable across a variety of chains. Dr. Liao discusses Circle’s software that allows users to burn USDC tokens across one chain and mint an equivalent amount on another chain. He claims this functionality is a major benefit of USDC, as it’s relatively seamless compared to using a bridge to move assets between blockchains, which historically are quite bug-prone. Dr. Liao acknowledged that while Circle’s trust–based intermediation is centralized, as DeFi continues to expand the need for these platforms will grow to prevent the space from becoming too fragmented.
Finding the right amount of centralization, if any, within blockchains has also gathered a substantial amount of regulatory interest. In addition to litigation, governments have experimented with a controversial new class of stablecoins known as Central Bank Digital Currencies (CBDCs). Usually issued by a central bank, these cryptocurrencies can be thought of as a stablecoin representation of a national currency. Given their blockchain-based implementations, they offer significant advantages over legacy banking systems with respect to efficiency; but at the same time, the transparency that makes crypto projects successful might be exactly what makes them dangerous.
While CBDCs may leverage blockchain technology, current implementations offer a marked departure from the stablecoin structures we know today. Perhaps the most well known implementation of a CBDC is the e-CNY, a stablecoin pegged to the Chinese Yuan organized by the People’s Bank of China. As of July 2024, the token has been piloted inside 29 pilot areas with personal identifiers being needed to access the token.11 Given its lukewarm reception, however, the Chinese government has become more aggressive with their adoption efforts with some cities mandating that public sector employees receive their salary in the token.12
Dr. Liao noted that the places where CBDCs have been launched in beta modes, tend to be more controlling. Indeed, the Royal Bank of Canada recently confirmed to CBC that they’ve shifted focus away from CBDC development and Jerome Powell,13 Chairman of the Federal Reserve, has claimed that the creation of a US Dollar CBDC would require congressional approval.14 That being said, we may see the first government sponsored US dollar stablecoin in the Wyoming State Token,15 which is set to launch in 2025.16 Regardless of the token provider, however, Dr. Liao still emphasizes that high standards are needed in terms of reserve backing.
Whether operated by a government entity, private corporation, or smart contract, the future of stablecoins remains an exciting prospect. Grounding the blockchain space in real-world assets may just bridge the gap between our banking institutions and a future of decentralized finance; but at the same time, we must remain vigilant to ensure this balance is properly struck. Without sufficiently decentralized stablecoin infrastructure, we risk losing Satoshi’s vision. Blockchains may devolve to the very centralized institutions they were created to avoid. Though, without proper stablecoin backing, our tokens may have no teeth. There’s no value to rely upon and no one to shoot if it all goes wrong.
About the Authors
Gordon Liao
Gordon Liao is the Chief Economist and Head of Research at Circle International Financial, a leading financial services firm building payment infrastructure for the internet. He is also a Research Fellow at the Cornell Fintech Initiative and a co-chair of the National Association for Business Economics Finance Roundtable. Gordon’s career has encompassed diverse areas within finance and technology, including fixed income relative value trading at the Harvard endowment, machine learning and AI at Kensho, policy advising on short-term funding markets at the Federal Reserve Board of Governors, and leading research and development in decentralized finance and tokenization. His research contributions have been published in respected journals such as the Review of Financial Studies and Journal of Financial Economics. His work has been featured in Bloomberg, WSJ, Barrons, PYMNTS, among others. Gordon holds a Ph.D. in Economics from Harvard University. He received his Bachelor’s degree in Applied Mathematics from Harvard College.
Austin Bennett
Austin Bennett is the VP of Finance at Stanford Blockchain, pursuing a triple major in Data Science, Economics, and Public Policy as well as a Master’s in Computer Science. At Stanford, he works as a researcher for Stanford CodeX, the Computational Law Center, as well as the Finance Department at the Graduate School of Business. There, he helped create a GSB class on stablecoins called “BUSGEN 102: The Future of Money and Payments”, for which he serves as a course assistant. Beyond these pursuits, Austin is passionate about Blockchain Governance, Crypto Law, and his hometown Boston Bruins.
https://coinmarketcap.com/, as of November 25th, 2024.
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