This is Part 1 in a four part series in which we will explore the market for stablecoin issuers, its trend towards fragmentation and how unification can develop to improve mass adoption.
Part 1 will dispel the idea that stablecoins are a winner take all model and explain why there is a market gap that will be filled by an Aggregator-Distributor (AD).
Part 2 will describe CENTRE, an attempt to create a centralized Aggregator-Distributor (CAD) and how its emergence mirrors the history of credit card companies.
Part 3 will describe CementDAO a Decentralized Aggregator-Distributor (DAD) and its advantages over the centralized model.
Part 4 will explore the role of issuers in a fragmented market, and how they can carve out defensible, profitable market niches, despite producing a commodity product.
Part 1 — Stablecoins are not Winner Takes All
It is commonly believed that stablecoins are a winner-take-all market. The idea is that money enjoys important network effects — specifically, money is most useful, when money is most widely accepted. This view is a special case of the once prominent view that a single winning cryptocurrency (eg. Bitcoin) would emerge. In this essay we will explore why this view is most likely mistaken.
Let’s start with why it is expected that one coin will emerge the winner. The idea is that money has an inherent network effect. A user will find the most utility in a money that is most broadly accepted and recognized as money. As money gains adoption, there is a positive feedback loop, whereby users gravitate to what is most broadly accepted as a MoE (medium of exchange). As a result, this coin will also attract the deepest liquidity further increasing its utility. At some point, this money becomes a standard and very difficult to dislodge. This effect, it is hypothesized, is amplified in programmatic money. Smart contracts will find it easiest to manipulate a standard unit of account (UoA) and medium of exchange (MoE).
The above idea borrows heavily from the network effects that have played out repeatedly in software, that have created successive waves of tech behemoths.
A common objection to this idea is that money is not like proprietary software or data. It is hard to build a monopoly around a network for money, which is easily traded and exchanged for other types of money. Someone can, at very little cost, go from the dollar to the euro (cost is measured in PIPs — tiny fractions of 1%) and programmatic money should make this type of routing even easier. Indeed, we have never seen a single money dominate globally — not gold, not Bitcoin, not the Dollar. We have, however, seen ‘money monopolies’ form regionally, but always with the force of law behind them.
Stablecoins are Commodities
Up until very recently, there was little interest in stablecoins, and when interest did emerge, it was driven by a single large exchange’s inability to secure banking, prompting the creation of Tether. However, once Tether emerged as an important part of the crypto-ecosystem, it became apparent that stablecoins had an extremely important role to play. Indeed, it might be that stablecoins become the primary UoA and, by extension, MoE of the crypto space, used for everything: cross-border transactions, payments to dapps, saving, lending, etc.
With this realization we have seen a proliferation of new stablecoins (220 projects at last count — and growing). Most investments in these projects are based on a belief that users will desire the most commonly accepted stablecoin. Exchanges will choose to list that stablecoin, it will have the deepest liquidity and eventually the market will consolidate around it as a winner. Partly, this expectation is pattern matching from the experience of Tether. However, the stablecoin space is currently very much in its infancy. Our mental model should attempt to account for the rapid increases in complexity in the ecosystem that we are starting to see and the unique ways in which stablecoins are different from other proprietary, digital services.
A key difference is that stablecoins, by design, are a commodity. Let’s take the example of dollar-pegged stablecoins. Right now we have multiple different stablecoins all competing to be exactly the same thing: a dollar represented on blockchain. They literally become more successful the more commoditized and fungible for other dollars they become. They also have no differentiation in terms of the payment rails they employ, as that infrastructure is the publicly available blockchains on which they run.
Stablecoin issuers cannot seek to gain competitive advantage in terms of their core functionality and features. Instead they must look elsewhere for competitive differentiation, they have five options:
Reliability (trust that they won’t fail)
Issuance (how easy it is to create new coins)
Transactability (how easy is it to transact in the coin)
Brand (GUSD vs. USDT)
Reliability is a very powerful potential differentiator, if any coin were able to establish itself as the most trusted, it would almost surely win. However, since this is a forward looking prediction, it is almost impossible to objectively prove, especially over any near-term timeframe. As a result, all such assessments will be, at least in part, subjective — and will be subject to differences of opinion. As a result, reliability offers limited competitive advantage over the near and medium term. As an example, is Tether reliable?
Issuance is about how easily supply can match demand and how easily new user can obtain their stablecoins. Different users obtain stablecoins in different ways. For example, holders of ETH can convert holdings to DAI, while customers of USDT can wire money to a US bank. However, most users of a stablecoin will not be the ones to whom it was issued at origination. Most users will obtain their stablecoin on the secondary market. For example, customers of an exchange can buy any stablecoins it lists.
Issuance, therefore, is mostly an important differentiator to a special class of users: originators. Originators are the users who first obtain the stablecoin before making it available on secondary markets. Originators are depositors in the case of asset-backed stablecoins. They are ‘Shareholders’ in the case of algorithmically generated coins.
Originators are highly heterogeneous, making it hard to appeal to all of them. Thus, USDT can dominate the market for high-net-worth US originators but completely fail to meet the needs of Venezuelans seeking to convert Bolivars to USD. DAI can dominate the market for sophisticated ETH holders who want USD exposure but prove too complicated and limited to scale to global issuance demand. Issuers are actually one step removed from the secondary market users, as they are reliant on their originators for this. Stablecoins compete not just with each other but also with their own originator, who become middlemen and who can provide a more convenient way for most users to buy stablecoins. Issuance is, therefore, not a scalable decommoditizer.
Transactability is the ease with which stablecoins can be transacted between users. Since stablecoins share free, public infrastructure for this they cannot easily gain an advantage here. They can, however, succumb to disadvantages based on regulatory requirements. Blacklists, whitelists and other AML requirements could easily limit the potential market and scale that any given stablecoin project can properly address alone. Transactability is not a good decommoditizer, but it can lead to fragmentation in the market, especially for fiat-backed stablecoins.
What about Brand? Can a stablecoin, despite not having a scalable way to differentiate itself on a global basis from other stablecoins build enough good-will with users globally to become the winning stablecoin? Can it become a synonym for money in the same way that Google became a synonym for search? We have reasons to be skeptical. No commodity has ever become a global monopoly through force of brand. Coca Cola has Pepsi, RC Cola, and sundry competitiors. Stablecoins have it even worse than most products. They are always a secondary brand. What will always be a more powerful brand than USDT? USD.
Perhaps Distribution can provide stablecoin issuers the competitive advantage they need to dominate a market? Can a stablecoin project grow the number of places their coin is accepted such that it reaches a tipping point and everyone switched to it? Unfortunately, being an issuer in and of itself confers no advantage when it comes to distribution. Indeed, issuers are at a disadvantage to almost every other player in value chain, as they have no direct relationship with the majority of users. They only have a direct relationship with originators — unless they have a pre-existing customer base from some other business (such as an exchange). It might be possible for an aggregator-distributor (AD) to gain such a monopoly. This AD might be a stablecoin issuer that hits upon a powerful distribution strategy (a possible example is CENTRE, which we analyze in Part 2). It might just as well be a pure-play AD, since as we have already demonstrated, being an issuer, in-itself, provides no such advantage.
Stablecoins are not Vertically Integrated
Right now, most people imagine stablecoins as a fully integrated offering across the stablecoin value chain. Issuer X, mints the branded coin USDX, builds a distribution network of last-mile providers (exchanges, wallets and dapps) for USDX, and has a trusted relationship with USDX users. In this fully integrated model, the ‘X’ brand is important and it is conceivable that Coin X needs to become the winner-take-all. However, let’s break apart that value chain and see if it needs to be integrated.
The value chain includes; (1) issuance, (2) origination, (3) distribution, (4) last-mile services and (5) end-users.
Issuers control origination, distribution and brand. Last mile providers have to contend with numerous issuers, leading to high costs and dilution of brand. The ecosystem cannot support a large user base as this value chain does not provide fungibility. The lack of users leads to less origination for issuers, restricting growth of the market.
End-users ultimately drive demand and they just want (commodity) USD for all their spending, saving and speculating needs. Last-mile providers such as exchanges, wallets, dapps and payment systems have a direct relationship with end-users. They want simplicity and ease of use for these users. Currently they are incentivised to support as many stablecoins as possible, in order to allow holders of any coin to use their service. However, they don’t want the overhead of maintaining all these coins or managing exchange and liquidity for all of them. They struggle with the shallower liquidity that results from liquidity being fragmented across multiple coins. Perhaps even more importantly, they want to provide simple, intuitive user experiences. Having multiple coins is a nuisance.
As a result, we have already begun to see the emergence of attempts to simplify and aggregate. For example, Huobi will accept several different stablecoins but represent them to the user as HUSD on their exchange. Issuers create the coins, but Huobi owns the brand and the user relationship. Similarly, some wallets are exploring methods to show all stablecoins simply as ‘USD’ or ‘EUR’, making the underlying stablecoin transparent to the user. In doing so, they too are stripping stablecoins of their brand and disintermediating their direct relationship with end-users. These solution are not perfect, because stablecoins are not perfectly fungible yet — but even so, it makes sense for last-mile services to do this.
There exists, therefore, a gap in the market for an aggregator-distributor of stablecoins; an AD layer will provide last-mile services and end-users what they desire, a fungible commodity. The AD will provide value by doing one or more of the following:
Provide a single interface that allows last-mile services to accept many coins from many users
Make exchanging between stablecoins simple and easy, providing fungibility
Mitigate the exposure to the idiosyncratic risk associated with any specific issuer or method of issuance
Create an aggregated ‘USD’ that can help avoid the confusion of competing ‘USDX’ brands.
With few or a single AD feeding into last mile providers, costs are reduced and the importance of brand is reduced. A larger user base feeds into the origination that can support many more issuers creating a reinforcing dynamic that grows the market.
Now, without getting into the specifics of how an AD could accomplish the above (we will cover that in Part 3) — let’s imagine what the value chain looks like with such an AD.
Issuers no longer need to concern themselves with having a direct relationship with all users. Instead they focus on a specific class of user; originators. Their business model does not change, however they no longer need to fight for distribution but also can’t expect to dominate the market.
Once issued, new stablecoins become inputs to the AD, and gain access to the full network of last-mile services integrated with the AD. In this respect, the AD business model has similarities to a marketplace — matching stablecoin holders with the services they wish to use and facilitating the exchange of whatever stablecoin the user has with whatever stablecoin the service accepts. The business model can include exchange fees and fees for providing risk protection against the idiosyncratic hazards inherent to specific issuers.
Last-mile services, gain simpler integration and maintenance. Additionally, if they aggregate all stablecoins under one symbol (eg. ‘Dollar’, ‘USD’) they have access to much deeper liquidity and can offer their users a much simpler interface. For last mile services, any added complexity is unwanted friction for the user. Having one winning stablecoin would also allow them to accomplish this, but a working AD is far preferable since they would not be beholden to one dominant player.
Market Dynamics Make One Winner Unlikely
The number of stablecoin issuers (including smart contracts like MakerDAO) that will exist, is the result of an equilibrium between countervailing forces for consolidation and fragmentation:
We have already explored the market forces pressing for consolidation: network effect, liquidity effect and brand power. Countervailing them out are forces driving fragmentation:
Returns to Specialization: different financial markets are highly idiosyncratic, with very different regulations, social mores and market conditions. There are strong returns to players that can specialize in meeting these needs. We explore this further in Part 4.
Low Barriers to Entry: For fiat backed stablecoins, almost any regulated entity can issue a stablecoin with little to no adjustment of their regulatory mandate. The barrier to entry for crypto-backed or algorithmic entrants is even lower. Any project can be forked at will. New projects, with new structures are constantly being invented.
Commodity Product: As already described, stablecoins are commodities and fungible in their most important feature — their adherence to a peg.
Lack of Returns to Scale: Most issuers do not earn substantially improved margins as they scale. For example, fiat-backed USD stablecoin issuers can earn an interest rate in money markets for their AUM (assets under management). This interest rate does not improve as AUM grows (in fact, the opposite is likely true, yield is often lower with scale). Some projects are experimenting with revenue models, such as transaction fees or seigniorage shares which might be able to see returns to scale but these projects might be the most vulnerable to being undercut by new entrants if they ever attempted to extract greater rents.
In the absence of one or more ADs, it might be that the balance between these forces would tip in favor of consolidation, leading to a increasing dynamic consolidation over time. However, an AD changes the market structure, reducing or eliminating the need for stablecoins to achieve scale to gain wide network acceptance and deep liquidity.
Issuers cannot easily take steps to prevent their aggregation by an AD without collateral damage. To do so introduces whitelisting of addresses by the issuer, which drives fragmentation rather than consolidation and also reduces the utility of the issuer’s coins vis a vis other coins. However, stablecoins can benefit from working with an AD. Not only can they leverage the distribution and liquidity to become more competitive, all stablecoin issuers are incentivised to support ADs if any other stablecoin appears to be gaining enough traction to become the single winner. Since ‘winner-takes-all’ also implies ‘loser takes nothing’, ADs become a powerful defensive play for the any stablecoin issuers that are not the current leader — in other words, for the majority of stablecoins.
Regardless of the expected long term market equilibrium, it is clear that in the near term we will see growing proliferation of stablecoin issuers. The same dynamic has been observed in blockchain protocols and exchanges, where most observers assumed we would see consolidation but instead have only seen continued and growing fragmentation. In the stablecoin space, this means that the opportunity for winners to ever emerge through consolidation is small. ADs will emerge long before the trend towards consolidation takes hold. Ultimately, this is to the benefit of the stablecoin space as a whole and will specifically benefit issuers. Effective ADs will help grow stablecoin adoption, growing the pie for all issuers, and at the same time will reduce the overhead costs associated with being an issuer as they will gain distribution for free. The issuers that are best able to take advantage of ADs will be best position to benefit. A question arises, will ADs not be able to use the market power they gain to replace the issuers or grow at their expense. In Parts 2 and 4, we will examine this question and how issuers can preserve their market power.