The Future of Stablecoin Design

Functionality

At the heart of stablecoin design is decision-making around its functionality. What functions does the stablecoin serve? What does the stablecoin do for its holders?

Stablecoins, like any money-instrument³, are capable of three different functions:

“Medium of exchange” describes a stablecoin’s ability to facilitate trade. Before the introduction of modern currencies, human society operated on a barter system, an early form of commerce that required a double coincidence of wants; the only condition in which two parties could execute a trade, was if both parties had something the other party wanted (e.g. one individual is willing to exchange their cow for vegetables, and another, coincidentally, seeks a cow in return for their vegetables). Barter systems are highly inefficient because they require perfect matching between market participants. To remedy the inherent inefficiencies with barter systems, currencies were invented. With currencies, no longer did two parties need to maintain a double coincidence of wants, but rather, could effectuate a trade simply by exchanging an accepted currency. 

For a currency or stablecoin to excel as a medium of exchange, it must frictionlessly facilitate trade. This requires that the currency or stablecoin is widely accepted, liquid, and easy to transfer. If the medium of exchange is difficult to transfer due to lack of availability or high transaction costs, market participants will resort to bartering.

‍“Store of value” describes a stablecoin’s ability to save value over time, without depreciation. This functionality is not exclusive to currencies or stablecoins, but applies broadly to all assets, with gold being a prime example. The supply and demand dynamics of gold (finite supply⁴ and growing demand⁵) lead to market expectations that it will retain or even grow in relative value over time. In this sense, for stablecoins to serve as a good store of value, they too, need to be collateralized by an asset that is expected to retain or grow in relative value.

‍Lastly, “unit of account” describes a stablecoin’s ability to measure or denominate a product’s market value. To serve as a good unit of account, stablecoins must be exactly as their name describes, stable. Without stability, the quoted number of stablecoins required to purchase a product will fluctuate irrationally, day to day.

Medium of Exchange

Facilitate trade
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GoalFrictionless transfer (broad acceptance, widely accessible, high liquidity, low transaction costs)

Store of Value

Save value without
depreciation

GoalPurchasing power retention or appreciation overtime. Typically achieved through favorable future supply (e.g. scarcity) and demand dynamics (e.g. increase need)

Unit of Account

Stable measurement
of product market value

GoalPrice stability

While stablecoins can, to a degree, serve as a medium of exchange, store of value, and unit of account, it is impossible for stablecoins to perfectly fulfill all these three dimensions simultaneously. This is because the requirements for excelling in each of these functions are inherently at odds with the other two dimensions. Optimizing a stablecoin in one dimension will inevitably require tradeoffs in a separate dimension.

Consider a stablecoin that aims to be the perfect, frictionless medium of exchange, characterized by low transaction costs and high accessibility. To achieve this functionality, the issuers of a stablecoin decide to distribute the token broadly across different blockchain ecosystems. This aggressive distribution strategy entails significant issuance. Without an equivalent, timely, and opposing increase in demand, the token’s price will drop due to inflationary pressure. Therefore, by optimizing the stablecoin’s functionality as a medium of exchange, the stablecoin’s functionality as a unit of account could suffer. This scenario illustrates just one of the contradictory forces encountered when optimizing for a particular functionality dimension. Figure 4 more comprehensively summarizes the contradictory forces between the dimensions.

During our conversations with Nic, Stephen, and Mark, discussions were primarily centered around future stablecoin functionality. Each shared a nuanced perspective into which dimension might be prioritized in the future. Moreover, they acknowledged the intricate balancing act to maintain the asset's versatility.

Medium of Exchange

Up to this point, stablecoins have been primarily optimized to be a medium of exchange.

For a currency to be a good medium of exchange, it is required to be widely accessible, highly liquid, and maintain low transaction costs. Public blockchain environments cultivate these requirements, perhaps better than any other traditional database. Blockchains are open and decentralized, allowing anyone with an internet connection to access a stablecoin. Furthermore, blockchains are programmable and thus, able to automate and reduce transaction costs typically found within traditional payment rails.⁶ When integrated within larger market structures, stablecoins can serve as the backbone for automated capital markets infrastructure, including debt financing and securities trading. In this way, the benefits of blockchain technology synergistically meet the requirements needed to be a good medium of exchange.
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To further optimize as a medium of exchange, stablecoin issuers have implemented several strategies to reduce transaction costs, whilst simultaneously increasing accessibility, availability, and liquidity. Stablecoins like $DAI and $FRAX have used bridge infrastructure to offer cross-chain liquidity on numerous different blockchains. Separately, stablecoins like $USDC and $USDT, have natively issued their tokens on several different blockchains, attempting to avoid frictions associated with bridging. Lastly, stablecoins have opted for listings on centralized and decentralized exchanges, like Coinbase and Curve, to enhance cross-asset liquidity.

“A stablecoin needs to be highly liquid. That means it has to be widely available and accessible to almost anyone with an internet connection, with the ability to cross borders near-instantly. It also means compatibility across multiple blockchain networks."

Stephen Leahy
Circle

Stablecoin optimization as a medium of exchange has been a success thus far. In fact, stablecoins are already beating PayPal annual transaction volume and nearing parity with Visa. PayPal and Visa have both taken notice of the rise of the stablecoin as a medium of exchange and in response, have recently begun working on their own stablecoin initiatives, PYUSD and VisaNet Stablecoin Settlement.

“The fact that PayPal and Visa have embraced the market as it is, is very telling.”

Nic Carter
Castle Island Ventures

Beyond payment transmission, stablecoins' role as a medium of exchange has also been evident within capital markets; stablecoins are increasingly being used to facilitate the borrowing, and lending of not only crypto-native (see Figure 12) but also tokenized, offchain assets. Consider the +$691M worth of tokenized Treasury products onchain today. Given that the interest payments on these U.S. Treasury products are denominated in U.S. dollars, the simplest approach for issuers of these tokenized Treasuries to handle their interest liabilities is by using USD-pegged stablecoins. Using stablecoins bypasses the complications and required currency conversions that would arise if the issuers used other onchain assets (e.g. $ETH or $SOL) to pass on interest revenue.

Over time, stablecoins have the potential to become the primary transactional medium within capital markets. Unlike traditional financial systems, stablecoin rails uniquely offer 24/7 trading, programmable transactions, and near-instantaneous settlement. In these ways, stablecoins allow market participants to liberate collateral that was once immobilized by protracted settlement periods, and automate debt repayments that were previously managed by expensive, human, payment agents. Ultimately, the linkage between stablecoins and RWA protocols will support the digitalization of capital markets.

Nic Carter also believes stablecoins are poised to see widespread adoption as a means of exchange. Specifically, Nic expects the growth trajectory of the stablecoin market to be analogous to the eurodollar market in the late 1960s and 1970s.
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For context, eurodollars are U.S. dollars held outside the U.S. banking system. Their origins date back to the post-World War II period when Europe urgently required dollars to finance imports, rebuild economies, and facilitate international trade. The eurodollar market didn’t experience significant growth until late 1960s-1970s, after an era of financial globalization⁷ and two massive oil crises⁸ catalyzed the need for a global, frictionless medium of exchange. Eurodollars, which were free from the operational and regulatory rigidities of onshore dollars, were well-suited to fulfill this need.

Over the next few decades, the size of the eurodollar market would grow to be three to four times larger than the onshore dollar market.⁹  Eurodollars would become the de-facto medium of exchange in almost every major financial vertical, facilitating speculative capital markets transactions, economic trade financing activities, and the lending and borrowing of funds in traditional investment/savings schemes.

In the future, it's expected that the medium of exchange functionality will continue to be a fundamental aspect of most issuers' designs and strategies. Although some stablecoins may be developed with the primary purpose of acting as a store of value or a measure for pricing, blockchain environments promote the effortless and transparent exchange of value. Stablecoins are expected to capitalize on this feature.

Store of Value

Several new entrants to the stablecoin market are increasingly focusing on store of value functionality.

To properly maintain their peg, many stablecoins elect to collateralize their token primarily with U.S. dollars or U.S. dollar equivalents, such as U.S. Treasury bills or overnight repurchase agreements. It should be noted that for most traditional stablecoins, any interest earned on collateral is not passed onto token holders, but instead, retained by the issuers. Effectively, this means that stablecoin holders derive only U.S. dollar exposure when holding the token.

Ultimately, stablecoins can be seen as a proxy for providing exposure to U.S. dollars. Given that purchasing power is relative, the exposure derived from these stablecoins, its sources of yield and nature of yield pass-through, can be perceived as a good or bad store of value, depending on what it is compared to.

In Making Sense of Tether on Tron, Liam Horne highlights that stablecoins are “seriously helping people” in regions with inflation-ridden currencies.¹⁰ In Argentina, the Peso has experienced 100% annual inflation for over a century.¹¹ In a study conducted by Mastercard, more than a third of Latin American consumers reported that they have previously made a payment for an everyday purchase with a stablecoin.¹² In Turkey, after the Lira inflated by +80.5% in 2022, ownership of cryptocurrencies rose to the highest level in the world at 27.1%, well above the global average of 11.9%. According to Reuters, “much of the safe-haven buying [in Turkey] has been of stablecoins.”¹³ Relative to down-trodden domestic currencies, it is clear that U.S. dollar stablecoins are serving as a critical store of value.

“People in the US and first world countries don’t realize how critical it is, when there is corruption and unstable economies, to be able to take their hard-earned earnings and put them into a reliable medium they can use to make purchases in the future with."

Mark Phillips
Steakhouse Financial

However, when compared to other assets, U.S. dollar exposure is not as competitive as a store of value. As demonstrated in Figure 9, since 1971, the purchasing power of $100 has decreased when held in U.S. dollars and alternatively, has increased when invested in assets like gold, silver, stocks, or real estate.

A growing trend within stablecoin design, and where we’ve seen real-world assets play the largest role, is to optimize stablecoins as a store of value. Historically, leading stablecoins were designed with an emphasis on being a medium of exchange. Now several new stablecoins are carving out a niche by concentrating on store of value characteristics.
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To enhance their stablecoins as a store of value, issuers are adopting two primary design approaches:
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First, issuers are electing to pass on the interest they earn on their collateral back to their holders. Two notable issuers who are employing this strategy are Mountain Protocol with $USDM and Ondo with U.S. Dollar Yield Token ($USDY). Unlike other stablecoins, $USDM, through a rebasing mechanism, and $USDY, through an accumulating mechanism, return almost all the yield from the stablecoin’s U.S. Treasury collateral base back to the holders. Theoretically, over time, holders of $USDM or $USDY would expect to have greater purchasing power than if they simply held onto a non-interest-bearing stablecoin.

Second, issuers are diversifying their token’s collateral base away from U.S. dollar and U.S. dollar equivalents toward other assets, such as private credit and other assets. For example, around 46% of MakerDAO’s dollar stablecoin, $DAI, as of January 25th, 2024, is collateralized by a portfolio of real-world assets (RWAs) made up of both private credit loans through Centrifuge and U.S. Treasuries through BlockTower and others. On an annualized basis, this RWA collateral generates $118.5M or ~48% of the protocol’s total revenue.¹⁴ A portion of this revenue can be passed back to $DAI holders if they lock their $DAI into the protocol’s DAI Savings Rate (DSR) module, which in many ways acts like a savings account for $DAI holders.

A global rise in interest rates and MakerDAO’s successful structural integration of RWAs have inspired other decentralized stablecoins to similarly diversify their collateral bases. Aave’s $GHO, Frax’s $FRAX-USD (recently choosing to partner with Centrifuge) and Tether’s $stUSDT, have all begun to onboard RWA collateral to generate yield and ultimately be passed back to stablecoin holders.

It should be clear that electing to (1) pass interest back to holders and (2) diversify collateral beyond U.S. dollar and U.S. dollar equivalents, alters the operational structure, risk profile, and regulatory treatment of the stablecoin.
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‍As such, issuers must redefine how they source, evaluate, manage, and report on their collateral. Maintaining a collateral base of private credit assets inherently involves more complexities, and typically more intermediaries, than a stablecoin with a 1:1 collateral base. Operationally, there will be a need for:‍

• Service providers who are well equipped to source and evaluate high-quality assets as potential stablecoin collateral (e.g. Centrifuge Prime),
• Underwriters, investment managers, and risk experts to manage collateral and the risks associated with those assets (e.g. Centrifuge Credit Group), and
• Service providers who can financially report on assets that exist offchain(e.g. Centrifuge Proof of Portfolio & Steakhouse Financial). This type of reporting is likely to be more complex than a simple cash, proof of reserves report from a custodian.

In the eyes of Stephen Leahy, diversified collateral bases entail high degrees of operational complexity, and thus, may not be readily accepted by stablecoin consumers.

“There are certainly stablecoins that can be linked to other types of real-world assets or even crypto-native assets. I look forward to the experimentation that is coming, but again, in my mind…for true acceptance one has to provide a simplified offering to users. There is already the complexity of layers of intermediation between the functioning of the digital assets onchain versus what an end user is seeing on their phone. Adding the need for a consumer to understand the workings of an algorithm before one trusts the stability seems very challenging and superfluous.”

Stephen Leahy
Circle

Diversifying away from U.S. dollars and U.S. dollar equivalents also entails new decisions around the asset composition of the stablecoin. Issuers will need to tailor the asset composition of stablecoins to their target risk profile. Some issuers will optimize for the quality and safety of underlying assets, whereas others will optimize for the return the stablecoin and its holders can earn from the underlying assets.

Lastly, the regulatory treatment of a stablecoin backed by alternative assets will likely be very different than that of a stablecoin backed by U.S. dollars and U.S. dollar equivalents. Questions around minting, redemption, and transferability all already come into question for traditional 1:1 U.S. dollar-backed stablecoins. If a stablecoin is backed by private assets or assets that offer yield, a whole new set of regulatory uncertainties arise. In attempts to remain compliant with regulations, issuers will likely self-impose restrictions on the types of users who can mint, redeem, or hold a stablecoin. This will limit the stablecoins' ability to function as a medium of exchange, as the stablecoin will only be accessible to certain users.
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In the eyes of Mark Phillips, limited medium of exchange functionality is totally worth it if stablecoins, like $DAI, can continue to offer a store of value utility functionality to users who need it most.

“Empowering individuals to save their income and make purchases is extremely important, and a higher value add to society, than a medium of exchange.”

Mark Phillips
Steakhouse Financial

A Future of Unit of Account Optimized-Design

The last dimension of future stablecoin functionality is a stablecoin’s ability to serve as a unit of account. Evaluating stablecoins as a unit of account presents two layers of consideration.

First, stablecoins are heavily influenced by traditional units of account like the U.S. Dollar, Euro, etc. Virtually all stablecoins (+99.2%) are pegged to traditional units of account, rather than to alternative assets, such as gold, commodities, or real estate. This ties the pricing of stablecoins back to the traditional financial system, offering a familiarity to users, and perhaps even the semblance of stability.

Second, particularly within blockchain economies, stablecoins have transcended their role as mere digital representations of fiat currencies; they have established themselves, in their own right, as independent units of account, serving to denominate a large portion of blockchain-based products, such as crypto FX swaps¹⁵ (e.g. BTC/USDC) borrowing/lending pools¹⁶ (e.g. .06% $USDT APY from JustLend’s USDT borrowing/lending pool), and even gas fees (e.g. 3 $USDC to complete transaction) through account abstraction.

There have also been a few instances where stablecoins, not fiat currencies, serve as the unit of account for loans to real-world businesses. For example, businesses such as New Silver (a non-bank financier who extends loans to real-estate lenders) and Huntingdon Valley Bank (a community bank in Philadelphia, USA) have borrowed over millions of loans denominated in $DAI from MakerDAO.^17
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‍In the future, decentralized stablecoins arguably have greater incentive to optimize for unit of account functionality as compared to centralized stablecoins.

If decentralized stablecoins are focused on providing an alternative to the traditional, centralized financial system, it makes sense for them to decouple from traditional units of accounts, and instead attempt to establish a new decentralized, unit of account. To support this functionality, these decentralized stablecoins are likely to market themselves as their own, distinct unit of account. This can be seen by the names that decentralized issuers have chosen for their stablecoins (e.g. “$DAI” or “$GHO”). These names contrast with the naming convention of centralized stablecoins, which almost always mention the traditional unit of account within their ticker (e.g. “$USDC” or “$EURT”).

In contrast to their decentralized counterparts, centralized stablecoins are purposefully reliant on the traditional financial system and corresponding units of account. This is evident from the way centralized stablecoins are operated and marketed. Their minting/redemption mechanisms require connection to bank accounts denominated in traditional units of account and filled with fiat reserves. Their proof of reserves systems emphasize 1:1 backing by traditional units of account. For these reasons, in the future, it is in the best interests of most centralized stablecoins to remain a virtual representation of U.S. dollars or Euros, instead of attempting to establish an independent, new unit of account.

Other Design Considerations

Other design features directly interact with and support the functionality of the stablecoin. In this section, we highlight some of those key features.

Peg Stability

Since the Terra Luna and Silicon Valley Bank crises, the stablecoin market has had trepidation when experimenting with peg stability.

Out of post-traumatic fear of redemption issues, stablecoin issuers have consolidated toward employing fiat or crypto-over collateralized peg stability mechanisms. These mechanisms offer high liquidity and reduce the risk of redemption issues. Conversely, issuers have mainly strayed away from peg stability mechanisms that rely on low liquidity collateral, such as real estate, or algorithms, given that these mechanisms have failed in several notable stablecoins in the past (e.g. Tangible $USDR, Terra Luna).
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A November 2023 paper from the Bank for International Settlements found that over five years, fiat-collateralized and crypto-collateralized were the most stable peg mechanisms, at 94% and 77% of the time, respectively. In contrast, commodity-pegged stablecoins were only at par with their peg 50% of the time. Algorithmic stablecoins were infrequently at par with their peg.¹⁸

Transparency

In 2022, there was a large push to encourage stablecoin issuers to implement proof of reserves. Since 2022, almost every major stablecoin issuer has implemented some form of transparency report (e.g. $USDT, $USDC).

Transparency plays a crucial role in enhancing the acceptance of stablecoins. Increased trust and acceptance derived from asset-level transparency can transform the stablecoin into a more reliable and broadly used means of exchange, especially when market expectations are optimistic and conversion is costly.¹⁹ Ultimately, in this way, transparency into the collateralization of a stablecoin can result in efficiency benefits to all market participants involved.

“For a stablecoin to succeed, they need to build trust. The best way to build trust is through radical transparency.”

Mark Phillips
Steakhouse Financial

In the future, as stablecoins diversify their asset composition, maintaining transparency becomes increasingly complex. Consider a stablecoin that is backed by an offchain, securitized product. Stablecoin holders will seek transparency regarding the underlying assets of this securitized product. Without the ability to report asset-level data back to the blockchain, such as what is made possible with Centrifuge NFTs, stablecoin holders will be unaware of risks associated with any particular component of the collateral. This could hinder the transparency of future stablecoins and potentially deter issuers from adopting certain types of asset structures.

Regulatory

Currently, the regulatory postures of different stablecoins are varied. For this reason, it is unclear what types of regulatory strategies are most likely to be employed by issuers in the future.

Some stablecoins, like Circle, see regulatory acceptance as critical to their mission.

“For a stablecoin to be excellent it needs to be regulated, transparent and fully-reserved.”

Stephen Leahy
Circle

Mark Phillips believes that decentralized stables have more value to add in emerging markets and other markets where there is less regulation.

“I think it's likely that decentralized stablecoins will proliferate in those markets first. Those governments and regulators are more crypto-friendly than developed markets who don’t see use cases as clearly as those in developing economies. If a certain stablecoin starts getting momentum and broad market acceptance in an economy or country, then it can carve out a niche.”

Mark Phillips
Steakhouse Financial

Ultimately, the regulatory strategy of stablecoins will differ depending on their target customer and the scope of their operations. In the future, regulations will increasingly become more clear. At this point, regulations are likely to have large implications on what kind of stablecoins can operate and within which particular regions.

“The future is a vibrant sector of many different competing stablecoins in many different regulatory regimes with different risk characteristics.”

Nic Carter
Castle Island Ventures

Conclusion

In conclusion, the direction of stablecoin design is mainly concentrated on reinforcing stablecoin’s functionality as a medium of exchange, while also simultaneously pioneering new ways to serve as a store of value. This dual-focus approach necessitates a balance between seamless transaction capabilities and the preservation of value over time.

Central to a stablecoin’s store of value functionality are strategic decisions around asset composition. Tokenization platforms, like Centrifuge, play a critical role here, offering RWA solutions that serve to bolster the diversity, quality, and credibility of stablecoin collateral. Backing a stablecoin with RWAs not only enhances the stablecoin's appeal as a money instrument but also its resilience and adaptability in dynamic market conditions.
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Other critical aspects like the stability of the peg, adherence to regulatory requirements, and transparency in operations play a significant role. These elements collectively support a stablecoin's functionality and acceptance across various financial ecosystems.
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Although current stablecoin design trends are evident, the future landscape of the stablecoin market is still uncertain. Expert opinions on the stablecoin market's endgame vary significantly, ranging from a future dominated by a few leading stablecoins to a diversified ecosystem where multiple stablecoins cater to distinct preferences and use cases. Ultimately, this diversity of thought underscores stablecoins’ potential for innovation and adaptation, alongside a broader trend toward a future of more digitized and user-centric financial products.