Stablecoins are non-fungible, bank deposits are fungible

On Twitter/X, I recently suggested that the network effects of the stablecoin market are massive. Tether, which has four times more wallets than all other stablecoins, is locked-in as the stablecoin lingua franca, just like English has been locked-in as the global language of business. 

In case you've missed the trend, stablecoins are fiat money (primarily U.S. dollars) that are issued on a new type of database called a blockchain. The total value of stablecoins in circulation has grown from $0 to over $200 billion in a decade, with Tether dominating at $138 billion.

When I said at the outset that the stablecoin market is governed by network effects, what I meant is that a positive feedback loop exists whereby the value that a network (i.e. languages or stablecoins) provides to users increases as more users join the network. Once a given stablecoin has entered into this virtuous loop, other issuers cannot join in, and will have troubles competing. It's a winner take all market that Tether and its stablecoin USDt (and perhaps smaller competitor USDC, issued by Circle) have already won.

Larry White, a monetary economist who I've mentioned a few times on my blog, asked me why I think network effects are present in the stablecoin market. We don’t see network effects with other U.S. dollar payment media like checkable deposits, Larry points out (and I agree), so it's not clear why we should see this with stablecoins.

Here's my logic.

Stablecoins aren't fungible, bank deposits are

The key is that while U.S. dollar stablecoins—Tether's USDt, Circle's USDC, PayPal USD, etc—are pegged to the dollar, and thus seem to be alike, they are not actually completely alike. That is, they are not fungible with each other. 

Fungibility is one of my favorite words, and I write about it quite often on this blog. It means that members of a population are interchangeable, or perfectly replaceable with each other. All grams of pure raw gold are interchangeable. Not all grams of pizza are alike—pizza is non-fungible.

U.S. dollar bank deposits (say Well Fargo dollars and Chase dollars) are fungible with each other. Rather than being independent, they are fused together as homogeneous and singular U.S. dollars. A Chase dollar is just as good as a Wells Fargo dollar for the purposes of making payments.

That's not the case with stablecoins, which are like pizza. Or better yet, in the same way that Chinese yuan and UAE dirham are pegged to the dollar but remain independent currencies, each U.S. dollar stablecoin is pegged to the dollar but functions as its own distinct non-fungible currency. For the purposes of making payments, one stablecoin is not as good as another one, just like how dirham balances aren't perfect replacements for yuan.

The reason behind this difference is that U.S. banks cooperate with each other by accepting competitor's money at par on behalf of their customers. For instance, I can take a Wells Fargo check to my Chase branch and Chase will accept it 1:1 even though it represents a competing bank's dollar. Or I can send an ACH payment directly from Wells Fargo to Chase, and Chase will accept that Wells Fargo dollar at par and convert it into a Chase dollar for me. 

The effect of this reciprocal acceptance is that all U.S. banking dollars are tightly knit together, or interchangeable. A fungible standard has been created.

I can't perform these same actions with stablecoins. I can't send 100 USDC to Tether to be converted into 100 USDt, nor send 100 USDt to Circle, which issues USDC, to be converted into 100 USDC. Stablecoins issuers are loners. They've chosen to avoid banding together to weave a unified U.S dollar stablecoin standard.

This lack of standardization explains some weird things in the stablecoin market, like why there are so many markets to trade USDt for USDC (see below). Notice that the clearing price in these stablecoin-to-stablecoin markets is never an even $1, but always some inconvenient price like 0.991 or 1.018.

Some of the multiple markets for trading USDt for USDC, all at varying prices Source: Coingecko

 

There is no equivalent trading market for Chase-to-Wells Fargo balances or TD-to-Bank of America dollars. These banks' dollars are perfectly compatible and don't require such markets.

The advantages of a single dollar standard

Harmonization is useful. Anyone can walk into a McDonald's and purchase a Big Mac for $5.69 with whatever brand of bank dollar they want. Money held at small banks is just as useful as money at massive ones: the Bank of Little Rock may only have five branches, but its dollars are accepted at McDonald's all across the world, on par with those of Chase, America's largest bank.

McDonald doesn't accept stablecoins, but if it did, it would have to offer multiple prices for a Big Mac: i.e. 5.73 USDt and 5.68 USDC. Each stablecoin serving as its own particular unit of account is inconvenient, both for McDonald's and its customers. PayPal USD probably wouldn't even be accepted at McDonald's: it's too small.

The lack of standardized stablecoin market becomes even more awkward in asset markets. If you want to buy $1 million bitcoins on, say, Binance, there's a whole array of different U.S. dollar stablecoin markets available, including bitcoin-to-USDt, bitcoin-to-USDC, and bitcoin-to-FDUSD. (FDUSD refers to First Digital USD, a medium sized stablecoin.)

The table above shows the prices of bitcoin and ether on Binance, the world's largest crypto exchanges. Notice that liquidity in both Binance's bitcoin and ether trading market is compartmentalized into different stablecoins rather than being fused into a single homogeneous US dollar-to-bitcoin market. Source: Coingecko

You can forget about easily buying bitcoins with PayPal USD stablecoins. No crypto exchange offers that trading pair; PayPal USD is too small to be worth the hassle.

This has the effect of fragmenting the liquidity of the stablecoin market into different buckets. Instead of stablecoins-in-general having a certain level of marketability, each individual stablecoin has its own distinct liquidity profile in asset markets.

In contrast, the liquidity that a Wells Fargo dollar, a Bank of Little Rock, or a Chase dollar provides to their owner in the context of asset markets has been unified into a collective whole. If you want to buy shares of Blackrock's iShares Bitcoin ETF, there isn't a separate market for Wells Fargo-to-bitcoin or Chase-to-bitcoin. As for Bank of Little Rock dollars, they are just as fit for bitcoin purchases as its much largest competitors.

A winner-takes-all market

Now we can understand why network effects dominate the stablecoin market.

If you want to start using stablecoins to trade crypto or buy stuff, you will always be arm-twisted by market logic into choosing the largest most liquid stablecoin. And your decision to go with the largest one makes that stablecoin a little more liquid, thus solidifying its pole position.

Selecting a smaller stablecoin like PayPal USD makes little sense. McDonald's will never accept it, and there are many crypto assets that you won't be able to buy with it. Even when certain PayPal USD trading pairs are available, the bid-ask spreads will be wide, imposing much larger costs on you than if you simply went with a larger stablecoin. Thus network effects, working in reverse, repel uptake of PayPal USD.

The unsafe stablecoin is the largest

Tether remains the largest stablecoin, despite being one of the most unsafe stablecoins. (USDC does not get top marks for safety, either.) Network effects explain this.

Stablecoin rating agency Bluechip awards Tether a D rating, noting that it is "less transparent and has inferior reserves... USDT is not a safe stablecoin". Under normal conditions (i.e. those not characterized by network effects) the safest stablecoins would have long-since displaced Tether from its leading spot. But in stablecoin markets, the safest stablecoins—Gemini USD, PayPal USD, and USDP, all rated A or A- by Bluechip—remain insignificant players. The virtuous circle in which Tether is locked dominates all other factors.

These are the best-ranked fiat stablecoins according to Bluechip. But they are also tiny, with market capitalization below $1 billion. There appears to be no point trying to be a safe stablecoin, since the network effects arising from liquidity completely dominate any safety concerns that users might have.

Eyeing Tether's profits, new competitors are entering the stablecoin market. But this is a game they probably shouldn't bother playing. PayPal arrived last year with PayPal USD, but to date it remains mostly irrelevant, despite huge growth in the overall stablecoin market over the same period. Ripple and Revolut are also slated to bring out their own products. They're also destined to mediocrity, because they're too late to make the jump into the virtuous loop that Tether and (to a lesser extent) Circle occupy. 

(There is one caveat. Should one of the two leaders eventually be shutdown for money laundering offenses or sanctions evasion, one of these also-rans could be vaulted into their spot.)

Might the stablecoin sector eventually migrate over to the unified fungible standard that characterizes banking deposits? 

No, that's probably not going to happen. For a fusion to occur, Tether and runner-up Circle, which issues USDC, would have to start accepting their competitors' stablecoins at par. But they won't go down this path, since that would kill off the network effect that gives them their unrivaled dominance over the rest of the pack. No, it's in the interests of the leaders for chaotic non-fungibility to continue. 

Alas, this lack of standardization may limit the stablecoin sector's broader potential to serve as a cohesive global payment alternative to the better-organized banking standard. Sometimes a bit of cooperation trumps competition.