TL;DR

• Demand for stablecoins comes from the need to simplify our financial system, and our desire to expand our earning potential
• If demand continues to grow, we might see the development of full-stack DeFi banks
• The U.S. benefits from stablecoin growth, as more people denominate in USD

Stablecoins have seen meteoric growth over the past few years. Most of us hold at least some in our wallets to preserve capital and explore DeFi.

Despite the occasional criticism, the demand for dollar-pegged cryptocurrencies continues to grow. Bernstein projects a $2.8 trillion marketcap for stablecoins within 5 years. Visa is already settling transactions on-chain. More DeFi protocols offer even more opportunities to generate yield. A snowball effect at full force!

So where does all this demand come from? And more importantly, why does it continue to grow? In this article we try to define the reasons that make stablecoins so popular, and how their adoption reflects on a macroeconomic landscape.

Demand at the midpoint of opposites

Human nature tends to follow the path of least resistance. We want things to be done in the simplest way possible. Why rent a DVD when I can just watch Netflix?

At the same time, we seek to expand. We always want more. More movies to choose from, a bigger house, more work output per unit of time. The intersection of these two forces drives all technological progress, including stablecoins.

We could say that stablecoin demand is found at the resistance point between the need to simplify our financial system and the desire to expand our earning potential.

On the left-hand side, demand comes from the need to resolve the current inefficiencies of the system. We seek more order through fewer interactions, and thus a simpler relationship with money (gimme cash, but virtual).

On the right-hand side, demand comes from on-chain money-making opportunities. This force is inherently chaotic, increasing the complexity and potential of financial products, and thus requiring more interactions (liquid staking > staking, LBPs > ICOs).

Put in another way, we could say that stablecoin demand results from our longing for a simplified financial system with increased earning potential.

To verify the validity of this statement we have to see how the supply side caters to these two components currently.

Simplification of the traditional financial system

At the moment, we are part of an ineffective financial system. Sending money is dependent on geographic limitations and middlemen. Saving money is impossible due to growing inflation. Lending money is harder than ever due to higher interest rates. Putting your money to work is difficult since productive assets are often illiquid and hard to manage.

All these issues arise because those responsible for managing the system introduce profit-driven complexity. We remove (or fold) this complexity by using stablecoins, a representation of our money that is easier to interact with. In our daily lives, we do this all the time. We eat pasta without knowing every single ingredient in the sauce. We take a walk without understanding the complex math and physics that enable our bodies to move in a certain way. We can choose what we interact with.

The demand for the simplification of our traditional financial system can be seen in the evolution of the crypto markets over time:

• Stablecoins are currently responsible for nearly 90% of daily trading volumes in the crypto markets, at 9.2% of the total market share.
• More than a third of Latin Americans have made a purchase using stablecoins. In Venezuela alone, stablecoins are responsible for 34% of all small-retail transactions.
• Higher interest rates create demand for lending protocols. Higher adoption of such protocols leads to more collateral options and a lower collateral ratio over time.
• The increased regulatory pressure around fiat-backed stablecoins has led to the development of algorithmic and decentralized stablecoins, among which we also find OD.
• The growing fees in base-layer networks have led to the development of L2s and seamless cross-chain stablecoin transactions.
• Stablecoins create a safer onboarding experience for institutions due to their fixed price and backing by centralized entities. For example, USDC is controlled by Circle and backed by cash or cash equivalents.

Expansion of earning potential

Through the increased demand for stablecoins, we are able to build more use cases that expand their earning potential. This expansion comes from all the new products and strategies that investors leverage to capitalize on their holdings.

While most of us are familiar with the different types of products stablecoins are used in, there could be more info about the strategies that increase their potential. The whole idea behind this is to make stablecoins as liquid and productive as possible.

Incentive-driven strategies that create demand for stablecoins include:

• Earn by providing liquidity. Stablecoins act as (independent) LP tokens in pools. Rewards are proportionate to the size of the pool and the potential volatility (if any) of the pair.
• Lending and borrowing. A user may lock stablecoins in a lending protocol to earn yield from the interest of borrowers. On the flip side, they can borrow stablecoins to create arbitrage opportunities.
• Creating leveraged positions. E.g. User locks ETH as collateral and borrows stablecoin against it. He then proceeds to swap the stablecoin into ETH and holds until the price increases. Finally, he sells the ETH to pay back the loan, get back the collateral, and earn more profit (due to leverage). Here’s a video that explains the process in more detail.
• Side-chain gas token. (Wrapped) stablecoins are able to offer lower transaction fees and faster settlement times when used on sidechains. E.g. xDAI is cheaper and faster to use as a gas token on Gnosis chain compared to DAI on the Ethereum base layer. The importance of this strategy is proportionate to the number of transactions of a user. In this case, instead of earning, the user is saving money.

The inevitability of DeFi banks

Central banks are confident that CBDCs can work with private stablecoins, while simultaneously building systems to manage stablecoin balance sheets. Analysts believe that their growth will eventually compete with traditional bank deposits and saving instruments.

On a micro-scale, we find ourselves on a battlefield between those who are pro-change and those who are against it. And it seems that each party really dislikes the other one. So what happens when an immovable object meets an unstoppable force? In our case, we get DeFi banks. Borderless, regulatory-compliant services, run by smart contracts. The availability of financial products in such “banks” can be left to the imagination.

While the concept may seem unlikely at the moment, it is the most rational way to find common ground between the two parties. It also seems to be the way toward more regulatory clarity around the tokenization of RWAs, increased stablecoin adoption, and lower collateralization ratios for loans.

On a macro scale, things get even more interesting.

Geopolitical implications

Many might claim that the U.S. dollar is losing its dominance and status as a reserve currency. Several countries are adopting non-dollar currencies for oil trade while Bitcoin maxis continue to pray for “hyperbitcoinization”.

However, a closer look at growing stablecoin demands paints a different picture. Nearly all stablecoins are either backed by or pegged to the U.S. dollar. If they eventually become more intertwined with a borderless and permissionless financial system, we’d witness a USD expansion unlike anything we’ve seen before! If the whole world uses USDC, for example, they are essentially using a proxy for USD. Over time, this shift would restore the dominance and status of the U.S. dollar while cementing the financial hegemony of the U.S. for one more generation.

Summing up

In this article, we took a philosophical approach to explore the growing demand for stablecoins. We described how their growing adoption results primarily from our need to simplify the existing financial system, which is inefficient at best, and our desire to profit from our capital.

When looking at the current progress, both in terms of stablecoin utility and productivity, we can speculate on the development of DeFi banks, which could massively increase the adoption of stablecoins on a global scale.

If, indeed, stablecoin adoption continues to grow, more people would denominate in USD, which would strengthen the position of the latter as a reserve currency for the global economy.

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Open Dollar is a DeFi lending protocol built on Arbitrum for borrowing against liquid staking tokens while earning staking rewards and providing CDP liquidity with Non-Fungible Vaults (NFVs).

Try the Open Dollar App today and follow us on our socials.

Written by Dimitris Tsapis

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