a16z: The Three Major Challenges for Stablecoins to Become Currency - Liquidity, Sovereignty, and Credit

Author: Sam Broner

Compiled by: Deep Tide TechFlow

Traditional finance is gradually incorporating stablecoins into its system, while the trading volume of stablecoins is also continuously increasing. Stablecoins have become the best tool for building global fintech due to their fast, nearly zero-cost, and programmable characteristics. The transition from traditional technology to new technology signifies that we will adopt fundamentally different business models—yet this transformation will also bring new risks. After all, the self-custody model based on digital assets represents a disruptive change to the banking system that has been in place for centuries, compared to the bank system that relies on registered deposits.

So, in this transformation process, what broader monetary structure and policy issues do entrepreneurs, regulators, and traditional financial institutions need to address?

This article delves into three major challenges and potential solutions, from which both startups and builders in the traditional finance sector can find current focal points: the uniformity of currency; the application of dollar-pegged stablecoins in non-dollar economies; and the impacts that a superior currency backed by government bonds may bring.

1. "The Unity of Currency" and the Construction of a Unified Currency System

The "Singleness of Money" refers to the ability within an economy for various forms of currency, regardless of who issues it or where it is stored, to be interchangeable at a fixed ratio (1:1) and used for payments, pricing, and contract fulfillment. The singleness of money indicates that even with multiple institutions or technologies issuing similar monetary instruments, there exists a unified monetary system within the economy. In practice, whether it’s the dollars in your JPMorgan account, the dollars in your Wells Fargo account, or the balance on Venmo, they should always be equivalent to stablecoins—maintaining that 1:1 ratio. This principle holds true even if these institutions differ in their asset management approaches and have significantly different but often overlooked regulatory statuses.

The history of the American banking industry is, to some extent, the history of ensuring the interchangeability of the dollar and continuously improving the related systems.

Global banks, central banks, economists, and regulatory agencies advocate for the "unity of currency" because it greatly simplifies transactions, contracts, governance, planning, pricing, accounting, security, and daily dealings. Today, both businesses and individuals have long taken the unity of currency for granted.

However, the "currency unification" is not the current operational mode of stablecoins, as stablecoins have not yet been fully integrated with existing infrastructure. For example, if Microsoft, a bank, a construction company, or a home buyer tries to exchange 5 million dollars worth of stablecoins on an automated market maker (AMM), the user will be unable to achieve a 1:1 exchange rate due to slippage caused by insufficient liquidity depth, and the final amount received will be less than 5 million dollars. If stablecoins are to fundamentally transform the financial system, such a situation is clearly unacceptable.

A universal par value exchange system would help stablecoins become part of a unified currency system. If stablecoins cannot be part of a unified currency system, their potential functions and value will be significantly diminished.

Currently, the operation of stablecoins is that issuing institutions (such as Circle and Tether) provide direct redemption services for their stablecoins (USDC and USDT respectively), which are mainly aimed at institutional clients or users who pass a verification process, and usually come with minimum transaction amounts.

For example, Circle provides enterprise users with Circle Mint (formerly Circle Account) to mint and redeem USDC; Tether allows verified users to redeem directly, usually requiring a certain threshold (e.g., $100,000).

The decentralized MakerDAO allows users to exchange DAI for other stablecoins (such as USDC) at a fixed exchange rate through its Peg Stability Module (PSM), effectively serving as a verifiable redemption/exchange mechanism.

Although these solutions are effective, they are not universally available and require integrators to connect with each issuer individually. Without direct integration, users can only exchange or "cash out" between stablecoins through market execution, and cannot settle at face value.

In the absence of direct integration, certain enterprises or applications may claim to maintain extremely narrow exchange ranges—such as consistently exchanging 1 USDC for 1 DAI with a spread of just 1 basis point—but this promise still depends on liquidity, balance sheet capacity, and operational capabilities.

In theory, central bank digital currencies (CBDCs) could unify the monetary system, but they come with numerous issues—privacy concerns, financial surveillance, restricted money supply, slowed innovation speed, etc.—therefore, a better model that mimics the existing financial system is almost destined to prevail.

For builders and institutional adopters, the challenge lies in how to construct systems that allow stablecoins to function as "pure currencies" akin to bank deposits, fintech balances, and cash, despite differences in collateral, regulation, and user experience. The goal of integrating stablecoins into monetary uniformity presents the following opportunities for entrepreneurs:

Widely available minting and redemption mechanism

Stablecoin issuers need to work closely with banks, fintech companies, and other existing infrastructure to create seamless and fiat-based on/off ramps. Achieving fiat interoperability for stablecoins through existing systems can make them indistinguishable from traditional currencies, thereby accelerating their global adoption.

Stablecoin Settlement Center

Establish a decentralized cooperative organization—similar to a stablecoin version of ACH or Visa—to ensure an instant, frictionless, and transparent exchange experience with fees. MakerDAO's Peg Stability Module (PSM) has provided a promising model, but expanding the protocol based on this to ensure par value settlements between participating issuers and with fiat USD would be a more revolutionary solution.

Develop a trustworthy and neutral collateral layer

Transfer the interchangeability of stablecoins to a widely accepted collateral layer (such as tokenized bank deposits or wrapped government bonds), allowing stablecoin issuers to innovate in branding, marketing, and incentive mechanisms, while users can easily unwrap and convert based on their needs.

Better exchanges, trading intentions, cross-chain bridges, and account abstraction

Utilize better versions of existing or known technologies to automatically find and execute the best funding inflow and outflow channels or exchange methods to achieve optimal rates. Build a multi-currency exchange to minimize slippage. At the same time, hide this complexity to provide stablecoin users with a predictable fee experience even under large-scale usage.

2. The Global Demand for USD Stablecoins: A Lifeline Amid High Inflation and Capital Controls

In many countries, there is a strong structural demand for the US dollar. For citizens living in high inflation or strict capital control environments, USD stablecoins serve as a lifeline—they not only protect savings but also provide direct access to the global business network.

For businesses, the US dollar is the international pricing unit, making international transactions more convenient and transparent. People need a fast, widely accepted, and stable currency for consumption and savings.

However, current cross-border remittance fees are as high as 13%, and 900 million people live in high-inflation economies without access to stable currencies, while 1.4 billion people are underserved by banking services. The success of the US dollar stablecoin not only reflects the demand for the dollar but also highlights people's desire for "better currency."

Apart from political and nationalist reasons, an important reason for countries to maintain their local currency is that it gives policymakers the ability to adjust the economy according to local economic realities. When disasters affect production, key exports decline, or consumer confidence wavers, central banks can alleviate shocks, enhance competitiveness, or stimulate consumption by adjusting interest rates or issuing currency.

The widespread adoption of the US dollar stablecoin may weaken the ability of local policymakers to regulate the economy. The root of this issue lies in the "Impossible Trinity" principle in economics, which states that a country can only choose two out of the following three economic policies at any given time:

Capital free movement;

fixed or rigidly managed exchange rate;

Independent monetary policy (freely set domestic interest rates).

Decentralized peer-to-peer transfers have impacted all policies in the "impossible triangle." Such transfers bypass capital controls, forcing capital flows to be completely open. Dollarization weakens the policy influence of managing exchange rates or domestic interest rates by anchoring citizens to international pricing units. Countries guide citizens to local currencies through narrow channels corresponding to the banking system to implement these policies.

Nevertheless, US dollar stablecoins remain attractive to foreigners because cheaper, programmable dollars can attract trade, investment, and remittances. Most international business is priced in dollars, so the easier it is to obtain dollars, the faster, simpler, and more widespread international trade becomes. Furthermore, governments can still levy taxes on the channels for funds coming in and out (on/off ramps) and oversee local custodians.

At the level of corresponding banks and international payments, a series of regulations, systems, and tools already exist to prevent money laundering, tax evasion, and fraud. Although stablecoins operate on public and programmable ledgers, making the construction of security tools simpler, these tools still need to be developed in practice. This presents opportunities for entrepreneurs to connect stablecoins with existing international payment compliance infrastructure, thereby supporting and implementing relevant policies.

Unless we assume that sovereign states will abandon valuable policy tools for the sake of efficiency (which is highly unlikely), and ignore fraud and other financial crimes (also unlikely), entrepreneurs will have the opportunity to build systems that can help stablecoins better integrate into local economies.

While embracing better technologies, existing safeguards must be improved, such as foreign exchange liquidity, anti-money laundering (AML) regulation, and other macroprudential buffer mechanisms, so that stablecoins can smoothly integrate into the local financial system. These technological solutions can achieve the following goals:

Localization acceptance of US dollar stablecoins

Integrate USD stablecoins into local banks, fintech companies, and payment systems to support small, optional, and potentially taxable conversions. This approach enhances local liquidity without completely undermining the status of the local currency.

Local stablecoins as a channel for funds to enter and exit

Issuing stablecoins pegged to local currencies and deeply integrating with local financial infrastructure. This type of stablecoin can serve not only as an efficient tool for foreign exchange trading but also as a default high-performance payment channel. To achieve extensive integration, it may be necessary to establish a clearing center or a neutral collateral layer.

On-chain foreign exchange market

Develop a matching and price aggregation system that spans stablecoins and fiat currencies. Market participants may need to support existing foreign exchange trading strategies by holding yield-bearing reserve assets and utilizing high leverage.

Challenging MoneyGram's competitors

Build a compliant cash deposit and withdrawal network based on physical retail, rewarding agents with stablecoin settlements. Although MoneyGram recently announced a similar product, there are still ample opportunities for other businesses with established distribution networks to compete.

Improve compliance

Upgrade existing compliance solutions to support stablecoin payment networks. Leverage the stronger programmability of stablecoins to provide richer and faster insights into cash flow, further enhancing transparency and security.

3. Consider the impact of using government bonds as collateral for stablecoins.

The popularity of stablecoins is not due to the backing of government bonds, but rather their almost instantaneous, nearly free transaction characteristics and infinite programmability. Fiat-collateralized stablecoins were widely adopted first because they are easy to understand, manage, and regulate. However, the core driving force behind user demand lies in their practicality and trustworthiness (such as 24/7 settlement, composability, and global demand), rather than the specific form of their collateral.

Fiat-backed stablecoins may face challenges due to their success: what will happen if the issuance scale of stablecoins grows from the current $262 billion to $2 trillion in a few years, and regulators require that stablecoins be backed by short-term U.S. Treasury bills (T-bills)? This scenario is not impossible, and its impact on the collateral market and credit creation could be significant.

Potential impacts of holding government bonds

If $2 trillion of stablecoins are required to be invested in short-term U.S. Treasury bonds (currently one of the few assets recognized by regulators), then stablecoin issuers would hold about one-third of the $7.6 trillion in Treasury bonds outstanding. This shift is similar to the role of Money Market Funds today—concentrating liquidity in low-risk assets, but the impact on the Treasury bond market could be even more profound.

Short-term government bonds are considered ideal collateral because they are widely regarded as one of the lowest risk and most liquid assets in the world, and they are denominated in US dollars, which simplifies currency risk management.

However, if the issuance of stablecoins reaches 2 trillion USD, this could lead to a decline in government bond yields and reduce active liquidity in the repurchase market. Each new stablecoin issued equates to additional demand for government bonds, which will allow the U.S. Treasury to refinance at a lower cost, while also making government bonds scarcer and more expensive for other financial systems.

This situation may reduce the income of stablecoin issuers while making it more difficult for other financial institutions to obtain the collateral needed to maintain liquidity.

A potential solution is for the U.S. Treasury to issue more short-term debt, for example, expanding the circulation of short-term government bonds from $7 trillion to $14 trillion. However, even so, the rapid growth of the stablecoin industry will continue to reshape supply and demand dynamics, bringing new market challenges and transformations.

Narrow Banking Model

Essentially, fiat-backed stablecoins are very similar to narrow banking: they hold 100% reserves (cash or equivalents) and do not engage in lending. This model carries lower risks, which is one of the reasons why fiat-backed stablecoins were able to gain early regulatory approval.

Narrow banking is a trustworthy and easily verifiable system that provides clear value assurance to token holders while avoiding the comprehensive regulatory burdens faced by fractional reserve banking.

However, if the scale of stablecoins grows tenfold to reach 2 trillion USD, its characteristics fully supported by reserves and government bonds will have a chain reaction on credit creation.

Economists are concerned about the narrow banking model because it restricts the ability of capital to provide credit to the economy. Traditional banks (i.e., fractional reserve banks) keep only a small portion of customer deposits as cash or cash equivalents, while lending most of the deposits to businesses, home buyers, and entrepreneurs. Under the supervision of regulators, banks ensure that depositors can withdraw funds when needed by managing credit risk and loan terms.

This is why regulators do not want narrow banks to accept deposits—the funds under the narrow bank model have a lower money multiplier (i.e., the credit expansion multiple supported by a single dollar is lower). Fundamentally, the economy relies on the flow of credit: regulators, businesses, and ordinary consumers all benefit from a more active and interconnected economy. If even a small portion of the $17 trillion U.S. deposit base migrates to fiat reserve-backed stablecoins, banks may lose their cheapest source of funds.

Faced with the loss of deposits, banks will have two less than ideal choices: either reduce credit creation (for example, by decreasing mortgages, auto loans, and credit lines for small and medium-sized enterprises); or replace the lost deposits through wholesale financing (such as prepayments from the Federal Home Loan Bank), which come at a higher cost and shorter terms.

However, stablecoins, as a "better currency", support a higher velocity of currency circulation. A single stablecoin can be sent, spent, lent, or borrowed within a minute — in other words, it can be used frequently! All of this can be controlled by humans or software, and it operates 24 hours a day, 7 days a week without interruption.

Stablecoins do not necessarily have to be backed by government bonds. Tokenized Deposits are another solution that allows the value proposition of stablecoins to remain on the bank's balance sheet while circulating in the economy at the speed of modern blockchain.

In this model, deposits will continue to remain in the fractional reserve banking system, and each stable-value token is effectively still supporting the lending business of the issuing institution.

The currency multiplier effect has been restored—not only through the velocity of circulation, but also through traditional credit creation—while users can still enjoy 24/7 settlement, composability, and on-chain programmability.

When designing stablecoins, the balance between economy and innovation can be achieved through the following methods:

Tokenized Deposit Model: Keeping deposits in a fractional reserve system;

Diversified collateral: extending beyond short-term government bonds to include other high-quality, highly liquid assets;

Embedded automatic liquidity pipeline: Reinject idle reserves into the credit market by utilizing on-chain repurchases, third-party facilities, CDP (Collateralized Debt Position) pools, and other mechanisms.

These designs do not compromise with traditional banks but provide more options to maintain economic vitality.

The ultimate goal is to maintain an interdependent and continuously growing economy, making reasonable commercial loans easily accessible. Innovative stablecoin designs can achieve this by supporting traditional credit creation while increasing the velocity of money circulation, decentralized collateralized lending, and direct private lending.

Although the current regulatory environment makes tokenized deposits unfeasible, the regulations surrounding fiat-backed stablecoins are gradually becoming clearer, opening the door for stablecoins that are collateralized by bank deposits.

Deposit-backed Stablecoins allow banks to enhance capital efficiency while providing credit services, bringing the programmability, cost advantages, and fast transaction characteristics of stablecoins. When users choose to mint deposit-backed stablecoins, the bank will deduct the corresponding amount from the user's deposit balance and transfer the deposit obligation to a comprehensive stablecoin account. These stablecoins will represent dollar-denominated claims on these assets, which users can send to a public address of their choice.

In addition to deposit-backed stablecoins, the following innovative measures will also help improve capital efficiency, reduce friction in the government bond market, and accelerate currency circulation:

Help banks embrace stablecoins

By adopting or even issuing stablecoins, banks can allow users to withdraw funds from deposits while retaining the yield on the underlying assets and maintaining relationships with customers. Stablecoins also provide banks with payment opportunities without the need for intermediaries.

Help individuals and businesses embrace decentralized finance (DeFi)

As more and more users manage their funds and wealth directly through stablecoins and tokenized assets, entrepreneurs should help these users access funds quickly and securely.

Expand collateral varieties and achieve tokenization

Expand the range of acceptable collateral assets beyond short-term Treasury bills (T-bills) to include municipal bonds, high-rated corporate notes, mortgage-backed securities (MBS), or secured real-world assets (RWAs). This will not only reduce reliance on a single market but also provide credit to borrowers outside the U.S. government, while ensuring the high quality and liquidity of collateral assets to maintain the stability of stablecoins and user confidence.

Put collateral on-chain to enhance liquidity

Tokenize these collateral assets (such as real estate, commodities, stocks, and government bonds) to create a richer collateral ecosystem.

Adopting Collateralized Debt Position (CDP) model

Referencing MakerDAO's DAI and other CDP-based stablecoins, these stablecoins utilize a diversified set of on-chain assets as collateral to mitigate risk, while replicating the monetary expansion function provided by banks on-chain. Additionally, these stablecoins should be subject to rigorous third-party audits and transparent disclosures to validate the stability of their collateral models.

The stablecoin sector faces enormous challenges, but each challenge also brings significant opportunities. Entrepreneurs and policymakers who can deeply understand the complexities of stablecoins have the chance to shape a smarter, safer, and superior financial future.

Acknowledgment

Special thanks to Tim Sullivan for his unwavering support. Also, thanks to Aiden Slavin, Miles Jennings, Scott Kominers, Christian Catalini, and Luca Prosperi for their insightful feedback and suggestions that made this article possible.

About the Author

Sam Broner is a partner at the a16z crypto investment team. Before joining a16z, he was a software engineer at Microsoft, where he helped create the Fluid Framework and Microsoft Copilot Pages. Sam also studied at the MIT Sloan School of Management, participated in the Hamilton Project at the Boston Federal Reserve, led the Sloan Blockchain Club, organized the first AI summit at Sloan, and received the MIT Patrick J. McGovern Award for creating an entrepreneurship community. You can follow him on X (formerly Twitter) @SamBroner, or visit his personal website sambroner.com for more information.