Recently, I’ve started to look into some exciting projects that are pushing the boundaries of stablecoin design. For example, Ethena Labs is working on a synthetic dollar that preserves its peg by maintaing an equivalent short position on its LST assets.

As I started to read up on these types of projects, it didn’t take me long to realize that I lacked a basic understanding of stablecoins and how they’re designed. And so to better my understanding of both-backed stablecoins, I wrote this post. In a few days, I will publish a second entry on crypto-backed stablecoins.

IMO, public blockchains like Ethereum are valuable for at least two main reasons:

1. For some, it’s a safe haven or step-up from their current financial system. In many ways, blockchain-based financial networks can be more accessible, open, and censorship-resistant than the status quo.

2. Additionally, Ethereum can drive efficiencies as an internet-native protocol for value transfer (MoIP). This means that in addition to being more accessible, public blockchains can also enable financial services at a lower cost than tradfi. You can read this post from Paul Frambot, co-founder of Morpho Labs, to better understand how DeFi can lower the operating costs of providing financial services by multiple orders of magnitude.

On paper, these benefits are clear. Yet, in the real world, builders are still working their way towards mass adoption while everyone else speculates over how this can be achieved. And with this speculation comes a lot of volatility.

Here’s a look at how volatile ETH has been relative to the U.S. Dollar since early 2022.

I mentioned above that Ethereum is accessible, censorship-resistant, and has the potential to offer financial services at a lower-cost than tradfi. While these characteristics make it an attractive alternative, most tokens are too volatile to use as a store of value and/or medium of exchange. This includes Ether itself.

To solve this problem, builders have experimented with various stablecoin designs over time. In theory, these types of tokens are meant to help users store wealth and transact onchain without having to worry about volatility. But how?

Well, instead of holding Ether onchain, you can hold a token whose value remains pegged to a more stable offchain asset like Dollars or Euros. this way, you can technically benefit from the accessiblity of a public blockchain without having to sacrifice the stability of a trusted store of value. Pretty useful, right?

I believe the growth in stablecoin total value locked (TVL) is a testament to its utility. Since the beginning of 2020, stablecoin TVL on Ethereum increased 25x from $3B to $75B. Unlike other DeFi products, stablecoins appear to be one of the few existing innovations with present-day utility for the masses, and not just the unbanked.

There are several ways to build a functioning stablecoin. So far, builders have experimented with three main types of design to create a token that maintains stability across a variety of market conditions.

1. Fiat-backed stablecoins

2. Crypto-backed stablecoins

3. Algorithmic stablecoins

I will spend the rest of this post exploring the first alternative.

In their simplest form, these tokens are controlled by centralized entities and are backed 1:1 by fiat reserves held offchain in traditional bank accounts.

For example, let’s assume I wanted to create a stablecoin on Ethereum that maintains its peg with the Canadian Dollar. I will call my stablecoin XCAD, and create the token contract according to the ERC-20 token standard. This will ensure that my token can be used in most venues across DeFi.

To issue the XCAD tokens to users, I might set up a front end that would accept Canadian Dollars from KYC’d accounts through a payment processor like Stripe or Plaid. For each Canadian Dollar received, the token contract would mint 1 XCAD and transfer it to the user’s crypto wallet. Then, the user would be free to use this newly minted stablecoin across the Ethereum network wherever ERC-20’s are accepted.

Hopefully, its now clear how straightforward these types of stablecoins are. You could probably spin up your own fiat-backed stablecoin within a matter of hours, especially if you leveraged some of the tooling provided by Brale. Although, perhaps as a symptom to their simplicity, fiat-backed stablecoins have the following trade-offs.

• Fiat-backed stablecoins are not decentralized. By holding this type of stablecoin, you’re taking on counterparty risk by entrusting the stablecoin provider as the custodian of all fiat collateral. At the same time, you’re hoping that stablecoin providers won’t punish you for bad behavior by freezing your tokens. According to this dashboard, almost $1B of USDT is currently sitting in banned wallet addresses.

• Fiat-backed stablecoins do not share yield earned on collateral assets. To avoid violating securities regulations, stablecoin providers like Circle (USDC) and Tether (USDT) do not pass on any yield to depositors or coin holders. According to Circle’s latest reporting, 90% of the deposited collateral backing its USDC stablecoin is earning a passive yield of around 5%, which amounts to over 1B in interest income annually. By not sharing a portion of this yield with token holders, one could argue that Circle is distributing risk while centralizing the reward.

https://x.com/milesjennings/status/1740790380315201752?s=20

Despite these disadvantages, fiat-backed stablecoins continue to dominate the stablecoin landscape with around 90% market share on Ethereum. According to this dashboard maintained by 21.co, USDT and USDC alone are responsible for 86% of stablecoin TVL on the network.

By holding a stablecoin like USDT, you’re essentially holding a digital fiat currency equivalent that can be used onchain and is backed by a real unit of fiat sitting in a bank account somewhere. IMO, these types of stablecoins operate as a bridge between fintech (traditional payment rails) and crypto (blockchains). Thus, if you are worried about the long-term health of certain fiat currencies, then holding these types of stablecoins might not be for you.

However, the following advantages could help explain the dominance of fiat-backed stablecoins:

• Transacting onchain can be more efficient than via tradfi or fintech. If you have $10,000 U.S. Dollars that you want to send to a relative in Europe, Wise will charge a 0.43% transaction fee, which comes out to $43. In comparision, if you held this amount on an Ethereum L2 network, the same transaction would likely cost less than $0.50. See this site for a listing of L2s and their current transfer fees.

• Fiat-backed stablecoins can be more accessible than traditional fiat currencies. Anecdotally, its quite difficult for those living in Africa, India, and other regions of the world to convert their savings into more stable currencies like the Dollar without incurring high transaction fees. Thus, in many cases it might be easier and cheaper for them to buy USDC and USDT.

https://x.com/jerallaire/status/1732804714805252106?s=20

• Given their TVL, these stablecoins have deeper liquidity across DeFi. While these types of stablecoins might not embody the decentralized nature of networks like Ethereum, they were able to benefit from a first-mover advantage and are still the most popular alternative by TVL right now. With a higher TVL comes more liquidity and accessbility across DeFi. And as a result, there are more high-quality opportunities to earn yield on fiat-backed stablecoins compared to other types.

Recently, I’ve started to look into some exciting projects that are pushing the boundaries of stablecoin design. For example, Ethena Labs is working on a synthetic dollar that preserves its peg by maintaing an equivalent short position on its LST assets.

As I started to read up on these types of projects, it didn’t take me long to realize that I lacked a basic understanding of stablecoins and how they’re designed. And so to better my understanding of both-backed stablecoins, I wrote this post. In a few days, I will publish a second entry on crypto-backed stablecoins.

IMO, public blockchains like Ethereum are valuable for at least two main reasons:

1. For some, it’s a safe haven or step-up from their current financial system. In many ways, blockchain-based financial networks can be more accessible, open, and censorship-resistant than the status quo.

2. Additionally, Ethereum can drive efficiencies as an internet-native protocol for value transfer (MoIP). This means that in addition to being more accessible, public blockchains can also enable financial services at a lower cost than tradfi. You can read this post from Paul Frambot, co-founder of Morpho Labs, to better understand how DeFi can lower the operating costs of providing financial services by multiple orders of magnitude.

On paper, these benefits are clear. Yet, in the real world, builders are still working their way towards mass adoption while everyone else speculates over how this can be achieved. And with this speculation comes a lot of volatility.

Here’s a look at how volatile ETH has been relative to the U.S. Dollar since early 2022.

I mentioned above that Ethereum is accessible, censorship-resistant, and has the potential to offer financial services at a lower-cost than tradfi. While these characteristics make it an attractive alternative, most tokens are too volatile to use as a store of value and/or medium of exchange. This includes Ether itself.

To solve this problem, builders have experimented with various stablecoin designs over time. In theory, these types of tokens are meant to help users store wealth and transact onchain without having to worry about volatility. But how?

Well, instead of holding Ether onchain, you can hold a token whose value remains pegged to a more stable offchain asset like Dollars or Euros. this way, you can technically benefit from the accessiblity of a public blockchain without having to sacrifice the stability of a trusted store of value. Pretty useful, right?

I believe the growth in stablecoin total value locked (TVL) is a testament to its utility. Since the beginning of 2020, stablecoin TVL on Ethereum increased 25x from $3B to $75B. Unlike other DeFi products, stablecoins appear to be one of the few existing innovations with present-day utility for the masses, and not just the unbanked.

There are several ways to build a functioning stablecoin. So far, builders have experimented with three main types of design to create a token that maintains stability across a variety of market conditions.

1. Fiat-backed stablecoins

2. Crypto-backed stablecoins

3. Algorithmic stablecoins

I will spend the rest of this post exploring the first alternative.

In their simplest form, these tokens are controlled by centralized entities and are backed 1:1 by fiat reserves held offchain in traditional bank accounts.

For example, let’s assume I wanted to create a stablecoin on Ethereum that maintains its peg with the Canadian Dollar. I will call my stablecoin XCAD, and create the token contract according to the ERC-20 token standard. This will ensure that my token can be used in most venues across DeFi.

To issue the XCAD tokens to users, I might set up a front end that would accept Canadian Dollars from KYC’d accounts through a payment processor like Stripe or Plaid. For each Canadian Dollar received, the token contract would mint 1 XCAD and transfer it to the user’s crypto wallet. Then, the user would be free to use this newly minted stablecoin across the Ethereum network wherever ERC-20’s are accepted.

Hopefully, its now clear how straightforward these types of stablecoins are. You could probably spin up your own fiat-backed stablecoin within a matter of hours, especially if you leveraged some of the tooling provided by Brale. Although, perhaps as a symptom to their simplicity, fiat-backed stablecoins have the following trade-offs.

• Fiat-backed stablecoins are not decentralized. By holding this type of stablecoin, you’re taking on counterparty risk by entrusting the stablecoin provider as the custodian of all fiat collateral. At the same time, you’re hoping that stablecoin providers won’t punish you for bad behavior by freezing your tokens. According to this dashboard, almost $1B of USDT is currently sitting in banned wallet addresses.

• Fiat-backed stablecoins do not share yield earned on collateral assets. To avoid violating securities regulations, stablecoin providers like Circle (USDC) and Tether (USDT) do not pass on any yield to depositors or coin holders. According to Circle’s latest reporting, 90% of the deposited collateral backing its USDC stablecoin is earning a passive yield of around 5%, which amounts to over 1B in interest income annually. By not sharing a portion of this yield with token holders, one could argue that Circle is distributing risk while centralizing the reward.

https://x.com/milesjennings/status/1740790380315201752?s=20

Despite these disadvantages, fiat-backed stablecoins continue to dominate the stablecoin landscape with around 90% market share on Ethereum. According to this dashboard maintained by 21.co, USDT and USDC alone are responsible for 86% of stablecoin TVL on the network.

By holding a stablecoin like USDT, you’re essentially holding a digital fiat currency equivalent that can be used onchain and is backed by a real unit of fiat sitting in a bank account somewhere. IMO, these types of stablecoins operate as a bridge between fintech (traditional payment rails) and crypto (blockchains). Thus, if you are worried about the long-term health of certain fiat currencies, then holding these types of stablecoins might not be for you.

However, the following advantages could help explain the dominance of fiat-backed stablecoins:

• Transacting onchain can be more efficient than via tradfi or fintech. If you have $10,000 U.S. Dollars that you want to send to a relative in Europe, Wise will charge a 0.43% transaction fee, which comes out to $43. In comparision, if you held this amount on an Ethereum L2 network, the same transaction would likely cost less than $0.50. See this site for a listing of L2s and their current transfer fees.

• Fiat-backed stablecoins can be more accessible than traditional fiat currencies. Anecdotally, its quite difficult for those living in Africa, India, and other regions of the world to convert their savings into more stable currencies like the Dollar without incurring high transaction fees. Thus, in many cases it might be easier and cheaper for them to buy USDC and USDT.

https://x.com/jerallaire/status/1732804714805252106?s=20

• Given their TVL, these stablecoins have deeper liquidity across DeFi. While these types of stablecoins might not embody the decentralized nature of networks like Ethereum, they were able to benefit from a first-mover advantage and are still the most popular alternative by TVL right now. With a higher TVL comes more liquidity and accessbility across DeFi. And as a result, there are more high-quality opportunities to earn yield on fiat-backed stablecoins compared to other types.