The short but extremely complex, fast-moving world of DeFi is being created in real-time, with a new trend, innovation or challenge popping up on an hourly basis. One of the most discussed innovations is the emergence of Treasury-backed stablecoins. These digital assets are collateralized by US Treasury securities. They’re being hailed as a safer, more reliable alternative to existing, more opaque stablecoins. However, are they really the safe haven that DeFi has been yearning for, or are they simply another overhyped craze? Let's explore the details.

In theory, Treasury-backed stablecoins are only meant to be worth a dollar, or whatever the coin is pegged to. Unlike other stablecoins which may use a mix of assets for collateral, these are uniquely backed by US Treasury securities. They incorrectly claim that they use Treasury bills as their primary form of collateral. The result is that for every stablecoin issued, there’s an equal amount of Treasury securities backed and held in reserve. As our partners at the Treasury Borrowing Advisory Committee (TBAC) remind us, this is a very good thing for Treasury financing. Today, about $120 billion in Treasuries back stablecoins. Major payment stablecoins are 1-to-1 backed by high-quality, liquid assets—primarily U.S. Treasury bills and cash—held in transparent, audited reserves.

The attraction of Treasury-backed stablecoins, to the extent that they have any appeal at all, is their safety and stability. US Treasury securities are the safest assets in the world. They are issued by the US government and are backed by the full faith and credit of the US government. This backing is supposed to provide stablecoin users with more confidence. It’s an important mechanism that reduces the risk of “de-pegging,” a fate that befalls all stablecoins when one loses its intended value. In 2023, Circle’s USD Coin recently lost its dollar peg for a few days. This came just weeks after the company revealed that it had kept some of its reserves at the now-failed Silicon Valley Bank. No users ever had to worry about avalanches causing them to be locked out of redemptions. Their peg mostly rebounded within days as they had incredibly safe underlying collateral. This recent incident reinforces the idea that sound collateral and transparent, robust reserves are crucial to the stability of a stablecoin.

The Potential of Treasury-Backed Stablecoins in DeFi

The second issue, the effect of Treasury-backed stablecoins on the DeFi ecosystem, is much larger in potential scope. Here's how they could revolutionize the space:

  • Increased Stability: By being backed by US Treasuries, these stablecoins offer a degree of stability that other stablecoins may lack. This stability can attract more users to DeFi, as it reduces the risk of significant losses due to price fluctuations.
  • Enhanced Trust: The transparency and security associated with US Treasury securities can enhance trust in stablecoins. This trust is crucial for the widespread adoption of DeFi, as it encourages users to participate in various DeFi protocols and applications.
  • Regulatory Compliance: As stablecoins gain traction, regulatory scrutiny is likely to increase. Treasury-backed stablecoins may be viewed more favorably by regulators due to their perceived safety and compliance with existing financial regulations. Proponents of stablecoin regulation argue that clear rules will spur further stablecoin activity and support a growing sector of buyers of short-term U.S. government debt, or T-bills, that are typically considered cash-equivalent securities.
  • Revenue Generation: The dominant source of revenue for stablecoin issuers is the yield they earn on their reserves, often in bank deposits or short-term treasury bills. This revenue can be used to further develop and improve the stablecoin ecosystem.

Demand for these Treasury-backed stablecoins is expected to soar, with market estimates putting it as high as $2 trillion by 2028. While this growth would be hugely positive for the DeFi ecosystem, it would help backstop Treasury financing even further.

Risks, Limitations, and Centralization Concerns

While the advantages described above would be welcome, Treasury-backed stablecoins are not without their dangers and shortcomings. It's crucial to consider these factors before jumping on the bandwagon:

  • Business Model Risk: The core business model of firms issuing stablecoins backed by reserves may face sustainability challenges in environments with lower interest rates.
  • Deviation from Par Value (De-Pegging): While Treasury backing provides a degree of stability, stablecoins can still deviate from their pegged value, which can lead to a loss of trust and confidence.
  • Bank and Exchange Intermediation Risks: Users need to open an account at a cryptocurrency exchange that connects to their bank, which can create risks related to exchange and bank intermediation.
  • Overseas Challenges of Dollarization and Sanctions Evasion: The use of USD stablecoins can perpetuate US dollar usage abroad, which can lead to challenges related to dollarization and sanctions evasion.
  • Treasury Market Strain: Material Treasury bill demand from stablecoin issuers could strain the existing supply of Treasury bills, potentially leading to increased costs for the Treasury Department.
  • Centralization: The centralization of stablecoin arbitrage can impact the stability of stablecoins in the DeFi space, as shown in a study on stablecoin runs and the centralization of arbitrage. Tether and Circle hold a combined $166 billion in U.S. Treasuries, highlighting the concentration of power in a few key players.

Wide-ranging differences in approaches to stablecoin regulation could balkanize the global digital finance ecosystem. This will necessarily result in the development of divergent regimes in the US, EU, and elsewhere. To do so, the US must set an example by encouraging a free and open discussion. This is the best way to ensure that regulators lay the groundwork for responsible, ambitious monetary innovation. Stablecoins operate on a two-tiered market. While some issuers may be more concerned with innovating new payment mechanisms rather than old legacy systems, these systems are still needed for reserving and monetary creation.

The Future of Treasury-Backed Stablecoins

The increasing value of stablecoins has raised eyebrows among regulators both here and abroad. Accordingly, they find themselves now writing and debating regulations in the United States, United Kingdom, and European Union. Markets are moving, and the regulatory environment is evolving just as quickly. Look for clearer, stricter rules and standards on the issuance of stablecoins and their use—particularly those pegged to Treasuries.

Whether Treasury-backed stablecoins become DeFi's safe haven or remain an overhyped trend depends on how these risks and limitations are addressed. Without clear and consistent regulation, this welcome trend could stall. It, coupled with creative remedies to centralization worries, will set free the complete promise of these digital possessions. Stay tuned with us at ThrowingToken.com as we bring you expert analysis on DeFi insurance, impermanent loss solutions and more! Plus get exclusive deep-dive DEX reviews and revolutionary NFT marketplace analysis to help you stay ahead and cash in on this changing landscape.