Intermediaries - Making or Breaking the (Stablecoin) Market - Part 2

by Nadiem Sissouno, Head of Economics at Mento Labs, during StableSummit in Paris, July 2023

Watch the recording here.

The first part of this article series concluded with a distinction between externally and directly distributed stablecoins and the observation that the most successful stablecoins fall into the externally distributed category. To delve deeper into this observation, this part aims to explore the user experience of stablecoin users across five key areas: fiat tie-ins, interoperability costs, transparency and auditability, decentralization and governance, and user accessibility and adoption. By comparing these aspects for externally and directly distributed stablecoins, we seek to unravel why externally distributed stablecoins have gained prominence in the market.

Fiat Tie-ins

Stablecoins often rely on connections with fiat currencies, such as the US dollar (USD), to maintain stability and enable seamless transactions. However, the challenge arises when users need to convert between their local fiat currency and the stablecoin, known as the "on-ramp" and "off-ramp" process. During these conversions, users expect minimal deviation from the value of their fiat currency to the stablecoin. There are two primary approaches to achieving these fiat tie-ins. The first method involves direct integration with centralized exchanges (CEXs), where users can easily convert fiat currency to stablecoin and vice versa. The second method, utilized by directly distributed stablecoins, involves indirect tie-ins through auxiliary assets. In this approach, users may need to navigate multiple swaps and decentralized platforms to convert fiat to stablecoin.

Assessment - Externally Distributed Stablecoins:

Externally distributed stablecoins like USDT and USDC have established strong ties with fiat currencies, often facilitated through centralized exchange listings. This integration allows for relatively seamless conversions between fiat and stablecoin, minimizing costs and friction for users. While some fees may still apply during fiat-to-stablecoin conversions, the process is generally efficient and transparent. As a result, externally distributed stablecoins have gained widespread adoption and trust among users and exchanges alike.

Assessment - Directly Distributed Stablecoins:

Directly distributed stablecoins face greater challenges in maintaining fiat tie-ins. Without direct access to centralized exchanges or banking partners, these stablecoins often rely on multiple swaps on decentralized platforms and auxiliary assets for fiat conversions. Each swap introduces costs, fees, and spreads, which diminish the value that users receive when converting their fiat currency into the stablecoin. Consequently, users may experience discrepancies between the expected value and the actual value received, leading to dissatisfaction and inhibiting broader adoption. As a result, users may encounter higher costs, longer transaction times, and increased complexity when converting fiat to stablecoins.

Interoperability Costs

Interoperability refers to the ability of stablecoins to function seamlessly across different platforms, blockchains, or ecosystems. When users seek to move stable assets or value from one environment to another, they often encounter interoperability challenges. Two common methods for achieving interoperability are through decentralized bridges or centralized exchanges. Decentralized bridges facilitate cross-chain transactions by enabling assets to move between different blockchain networks. However, these bridges may involve multiple steps and incur associated costs, such as network fees and conversion rates. On the other hand, centralized exchanges offer a more direct route for asset transfers, but may also impose fees or restrictions on withdrawals and deposits.

Assessment - Externally Distributed Stablecoins:

Externally distributed stablecoins typically benefit from robust interoperability, often facilitated by their integration with centralized exchanges and financial platforms. Users can easily transfer these stablecoins between different exchanges and wallets, minimizing interoperability costs and delays. The availability of fiat trading pairs and liquidity pools further enhances the seamless movement of stable assets across various platforms. As a result, externally distributed stablecoins offer greater flexibility and accessibility for users seeking interoperability.

Assessment - Directly Distributed Stablecoins:

Directly distributed stablecoins face interoperability challenges due to their reliance on decentralized infrastructure and auxiliary assets. While decentralized bridges enable cross-chain transactions, users may encounter complexities and costs when moving stable assets between different blockchain networks. Additionally, the lack of widespread support for directly distributed stablecoins on centralized exchanges limits their interoperability with traditional financial systems. As a result, users may experience higher friction and expenses when seeking to transfer directly distributed stablecoins across various platforms and ecosystems.

Transparency and Auditability

Transparency and auditability are fundamental pillars of stablecoin credibility. At its core, a stablecoin represents a claim on collateral value, making users' trust contingent upon their confidence in the underlying assets. This confidence is influenced by several factors. Firstly, users need assurance regarding the existence and accessibility of the collateral assets - knowing that they indeed exist and are readily available to back the stablecoin. Secondly, the integrity and verifiability of the collateral are crucial; users must be confident that the assets backing the stablecoin are genuine, accurately represented, and not subject to manipulation or embezzlement. Therefore, transparency measures, such as regular audits and public disclosure of collateral holdings, play a vital role in instilling confidence and fostering trust among stablecoin users.

Assessment - Externally Distributed Stablecoins:

Externally distributed stablecoins, exemplified by USDT and USDC, typically rely on centralized intermediaries for collateral management and auditing. While periodic audits and reports offer a degree of transparency, users must place trust in these intermediaries to accurately represent the state of collateral reserves. This reliance on intermediaries introduces inherent risks and uncertainties.

Assessment - Directly Distributed Stablecoins:

Directly distributed stablecoins prioritize transparency and auditability by leveraging blockchain technology. On-chain collateralization enables users to directly verify the existence and integrity of collateral assets. Smart contracts ensure secure and accessible collateral locking. This approach enhances trust and confidence in stablecoin stability. However, challenges such as regulatory compliance and scalability may arise for directly distributed stablecoins. Balancing compliance with decentralization and addressing scalability issues are critical considerations. Despite these challenges, direct distribution offers promising solutions to enhance transparency and trust in stablecoin ecosystems.

Decentralization and Governance

Decentralization and governance are foundational elements in stablecoin ecosystems, determining the distribution of privileges and responsibilities among users and stakeholders. While their significance may not always be apparent during stable market conditions, their impact becomes pronounced during periods of market stress or volatility. One critical aspect influenced by decentralization and governance is the issuance and redemption process. While this process may remain inconspicuous during periods of market stability, it becomes acutely felt by non-institutional users when faced with selling pressure or market turbulence.

Assessment - Externally Distributed Stablecoins:

Externally distributed stablecoins often employ centralized governance models, wherein key decisions are made by a selected group of stakeholders or custodians. While this approach may streamline governance processes, it introduces vulnerabilities such as preferential and privileged treatment for institutional actors during redemption events. Retail users may face challenges redeeming stablecoins at parity from the secondary market, especially if liquidity is limited or market conditions are unfavorable. On the other hand, institutional users have the privilege to redeem from the protocol 1:1.

Assessment - Directly Distributed Stablecoins:

Directly distributed stablecoins prioritize decentralization and community-driven governance, aiming to empower users and democratize decision-making processes. Through decentralized governance mechanisms such as DAOs (Decentralized Autonomous Organizations) and token-based voting, all users have a voice in protocol governance and redemption procedures. This inclusive approach enhances transparency, accountability, and user trust, fostering a more resilient and equitable stablecoin ecosystem. However, direct distribution models may encounter governance challenges, such as voter apathy or conflicting interests among token holders. Additionally, regulatory scrutiny and compliance considerations may pose hurdles to decentralized governance initiatives. Despite these challenges, direct distribution offers a pathway to strengthen decentralization and governance in stablecoin ecosystems, aligning with principles of fairness, inclusivity, and user empowerment.

User Accessibility and Adoption:

Adoption and accessibility are critical factors shaping the usability and effectiveness of stablecoins in real-world scenarios. High adoption rates and seamless accessibility enable stablecoins to fulfill their intended functions as reliable mediums of exchange, stores of value, and units of account. Factors such as user-friendly interfaces, widespread acceptance, and regulatory compliance influence stablecoin adoption and accessibility across various demographics and geographic regions.

Assessment - Externally Distributed Stablecoins:

Externally distributed stablecoins often benefit from established networks, strategic partnerships, and regulatory approvals, enhancing their adoption and accessibility. Integration with major cryptocurrency exchanges, payment processors, and financial institutions facilitates widespread adoption among retail and institutional users. However, reliance on centralized intermediaries for distribution and redemption may introduce barriers to accessibility, particularly in regions with limited infrastructure or regulatory uncertainty.

Assessment - Directly Distributed Stablecoins:

Directly distributed stablecoins prioritize decentralization and community-driven adoption strategies, aiming to reduce reliance on centralized intermediaries and expand access to underserved populations. By leveraging decentralized finance (DeFi) platforms, decentralized exchanges (DEXs), and blockchain interoperability solutions, directly distributed stablecoins enhance accessibility and inclusivity. Furthermore, community engagement initiatives, educational programs, and grassroots marketing efforts foster organic adoption and user empowerment. However, direct distribution models may face challenges in gaining mainstream acceptance and regulatory approval, limiting their accessibility in traditional financial ecosystems. Moreover, user education and technical literacy requirements may pose barriers to entry for novice users unfamiliar with blockchain technology. Despite these challenges, direct distribution offers a pathway to democratize access to stablecoin technology, promote financial inclusion, and drive global adoption.

Additionally, an often-overlooked aspect of directly distributed stablecoins is the opportunity for user engagement in critical system functions. While blockchain principles emphasize user participation in consensus mechanisms, similar opportunities exist for activities essential to market efficiency, such as market making and liquidity provision. Unfortunately, current systems lack the infrastructure and tools necessary for users to readily undertake these roles. Market making, in particular, plays a crucial role, yet there's a notable absence of accessible infrastructure enabling experienced users to become market makers or liquidity providers. Addressing these gaps is vital for fostering user engagement, promoting market efficiency, and advancing the broader adoption of stablecoin ecosystems.

Why Are the Most Successful Stablecoins Externally Distributed?

The success of externally distributed stablecoins can be attributed to various factors, including convenience, accessibility, and market efficiency. While directly distributed stablecoins may offer advantages in transparency and decentralization, the trust derived from operating within an efficient market ecosystem often outweighs the confidence placed in digital systems alone. Humans, inherently economic beings, prioritize the trust radiated by efficient markets, where transactions are executed swiftly and reliably at fair prices. Therefore, while decentralized infrastructure lays the foundation for trust, the perceived trustworthiness of efficient markets plays a pivotal role in user adoption and acceptance. This nuanced understanding of trust underscores the complexity of stablecoin dynamics and highlights the importance of balancing decentralization with market efficiency for widespread adoption and success.

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