If you have ever wondered about what a stablecoin is and where they come from, then keep reading this article.
What is a stablecoin?
Stablecoins are a form of cryptocurrency that has a stable value. They are “stable” because they are pegged 1:1 to a fiat currency or similar financial instrument. A stablecoin works on the assumption that their issuer has an equal amount of fiat currency or financial instruments to the issued amount of the respective token.
There are several stablecoins, but only a few have a higher usage and therefore higher market cap in the cryptocurrency ecosystem. Examples are USD Coin (USDC) and Tether (USDT), the largest stablecoins used.
They can be risky for users
Investors can lose their funds and trust in stablecoins. There have been incidents where stablecoins have lost their peg due to volatile price movement. This was the case with Terra (UST), an algorithmic stablecoin that depegged on May 7, 2022, triggering $83 billion in losses in the industry.
Stablecoins are a building block of the cryptocurrency ecosystem. Without them, it would be impractical to trade on cryptocurrency exchanges and there wouldn’t be any decentralised finance.
So how do the companies that issue stablecoins make money? What’s in it for them? Are there future opportunities for these companies to improve their business models?
Why are stablecoins important?
From the five cryptocurrencies with the most trading volume, three of them are stablecoins: Tether (USDT), Binance USD (BUSD) and USD Coin (USDC).
Anytime you trade on a crypto exchange (buying or selling), you’re either selling into a stablecoin to lock in profits or buying into the crypto from a stablecoin.
Stablecoins are important for exchanges and for decentralised finance. If you’re loaning 100 USDC, a stablecoin, you will want to know that when that loan gets repaid, your 100 coins are the same value as when you lent them out.
Having a stable value asset is essential to the cryptocurrency ecosystem. What is the incentive, then, for companies to issue stablecoins?
How do stablecoins make money?
There are two ways stablecoin issuers can make money:
- Lending (fractional reserve): similar to traditional banking;
- Interest on reserves: fully backed models (win-win).
Let’s look at each one.
1. Lending (fractional reserve models)
Lending is one of the ways stablecoin issuers make money, also known as the fractional reserve model. This is similar to how fractional reserve banking works and for that reason it’s not popular in cryptocurrency, but some companies may operate this way.
Let’s go with a practical example.
Suppose I am the stablecoin issuer and you come to me asking for 100 in stablecoin dollars. I issue that amount of stablecoins and give it to you in exchange of your $100 in real cash, fiat money.
This is where it can get tricky. I know that not everyone I issue these stablecoins to are going to redeem them right away, so I will start lending some of the money you gave me.
2. Interest (fully backed models)
This is the more accepted way, by using a fully backed model, trading liquidity for interest, and earning interest on the reserve assets that back the stablecoin.
This sounds confusing, so let’s break it down.
Circle is the company behind the USDC stablecoin. From the total amount of USDC in circulation, which is $42.1 billion, around 75% of its reserve assets are held in U.S Treasuries ($32.2 bn) and 25% are held in cash ($10.1 bn).
When Circle issues a stablecoin they know not everyone is going to redeem it at the same time. The 25% of assets held in cash are usually enough to allow people to redeem stablecoin for dollars when they do.
So what about the other 75%?
Circle is earning yield in those 75%, as they’re U.S. Treasuries, considered one of the safest investments. If more people need to redeem, Circle sells those treasuries for cash, so customers can redeem their stablecoins for cash.
Over 100 million per year
Circle has 3rd party auditors reporting on their USDC reserves. For example, in their September 2022 report audited by Grant Thorton, they show a breakdown of their U.S. Treasury securities owned.
By the time you’re reading this article, these securities may have expired or been redeemed, but the important thing to take from this is that you can verify the information.
From the Cusip, which is shown in the left column in the image, let’s take one of the values: 912796X61 (4th from the bottom). We look up that Cusip number and see that indeed it is a treasury bill from the US government.
That doesn’t tell us much though. We don’t know its yield, the important metric to understand how they make money.
For that, you’ll need to use your broker to search for a Cusip number. Here we’re using Fidelity, but you can use any broker. If you’re not a customer, you may be able to see this information if you sign as a guest.
Back to our search. We search for 912796X61 and get this result. This is a US treasury bill with ann expiration date of December 08th, 2022.
The important bit of information is the yield.
Circle is getting a ~3.4% yield on that specific treasury bill. That’s just one bill. They have 13 in that report. These bills are short-term treasuries with each having their own yields and different amounts in each treasury.
We know that in total, for that month’s report, that they owned around $38.26 billion worth of treasury bills (in some months they owned more). In the example above, that specific bill is getting a 3.445% yield. Let’s round it down to a 3.3% yield (interest rate) to make our calculation easier.
38.26 billion × 3.3% = 126,258,000
Multiplying the total amount of treasuries (38.26) by an average interest rate of 3.3% gives us 126 million $US dollars.
Circle is earning that much money per year, gaining yield from these assets. They are literally making money from issuing stablecoins.
A riskless business model?
Stablecoins issuers are close to what is considered a riskless (no risk) business model. They’re not riskless, but they’re close when compared to other enterprises, as there is less risk involved.
Why is it (almost) riskless?
- Demand payment equal to stablecoin value. A stablecoin issuer is not putting any upfront capital. Someone wants $1000 USDC, they ask for $1000 in cash first.
- Create from thin air the equivalent USDC/USDT etc. Only after receiving people’s money do they issue the stablecoin equivalent amount. The stablecoin issuer’s only obligation is to redeem those coins for dollars.
- Buy treasuries and year yield on them. Not everyone will be redeeming dollars for stablecoins at the same time, so they take the cash people gave them and buy treasury bills, one of the safest assets, and earn yield from them.
- Reinvest into new treasuries. They issue these coins to users, who trade them with other people and exchanges (buy bitcoin with them or put them in a DeFi protocol), but don’t usually redeem back for dollars. They use the $1000 we gave them and continually reinvest in treasuries as the older ones expire.
Somewhat worst case scenario
Suppose that suddenly lots of people want to redeem their stablecoin for dollars. We know that they have around $9 billion dollars in cash at hand, which they will use for these redemptions.
Remember they have $9 billion in cash (25%) and $38 billion in U.S. treasuries (75%) for a total of $47 billion.
In the event that the redemptions are in such large amounts that their $9 billion in cash are used up, they will just sell enough from their treasuries to compensate for the excess redemptions, and still keep whatever is left.
From a business perspective, this is a low risk venture. We’re not investing in a 20 million/billion tech startup, we’re not buying real estate, we’re not creating a product until we’ve already got that money and we’re making money off of a safe asset (government treasuries).
Stablecoin issuer goals
The stablecoin business is reasonably easy to scale once they get adoption and momentum for their product. The goal of a business is to ultimately make profit, and with that in mind, stablecoin issuers have three main strategies:
- Maximise coin issuance to buy more treasuries. U.S. Treasuries are short-term debt securities backed by the US government. They can’t increase the interest rate given by the government, but they can get more volume. They will want to issue a billion stablecoins because they can scale it well.
- Rate remains the same, but profit increases. They can maximise the issuance of coins by getting more people to trust their cryptocurrency and wanting to use it over their competitors. The interest rate may remain the same but the profit in dollar terms increases.
- Competition for customers. Issuers want more people using their stablecoin. They can prove their level of trustworthiness by releasing clear reports, comply with the government and sponsor industry events.
Tether, the issuer behind the USDT stablecoin, has had trouble showing enough transparency and accountability. It had ties to Bitfinex, a crypto exchange which was hacked for 31 million in 2017, and was sued by the New York Attorney General for $18.5 million.
Despite these issues, Tether still has lots of people using their USDT, but over the years it lost a significant market share to other stablecoins, such as Circle’s USDC or Binance’s BNB.
Someone, at some point in time, decided to use a certain stablecoin, with resulting network effects increasing stablecoin adoption exponentially. Having people using your stablecoin for the first time is important, but so is having them keep using it.
Here is one strategy that stablecoin issuers could use.
Stablecoin auto yields
What if, as a stablecoin issuer, you were earning 3.3% interest rate on all those treasuries, and gave a portion back to people? Users would receive a smaller interest rate on their stablecoins.
This isn’t far-fetched as there are decentralised exchanges where users can swap, lend and even leveraged yield farming with auto-compound.
Suppose you issue 100 million coins for receiving $100 million from users. You put that amount in treasuries. At a 3.3% interest rate, you’d get $3.3 million per year.
100 million issued × 3.3% = $3.3M
That’s what Circle is doing with USDC.
But what if you go an extra step and offer customers a 1% kickback to holders? You’d be rewarding users for holding your stablecoin over your competitors. Instead of getting 3.3%, you’d get 3.3 - 1 = 2.3% because you’re giving away 1% to users, from the 3.3 down to 2.3%.
100 million issued × 2.3% = $2.3M
You would still make $2.3 million per year on those 100 million coins, and gain big thanks from users who would get the other 1%.
How many more people would start using your stablecoin?
With the added incentive, many more users would use your stablecoin and you would exponentially increase your profits even with the 1% you’re giving back, due to the sheer amount of volume you’re making from the increased user base.
Stablecoins are a fundamental part of the cryptocurrency ecosystem. It would be impractical to trade on exchanges and there would be no decentralised finance. There are several stablecoins, a few of which are in the top 5 of market cap of cryptocurrencies, like Circle’s USDC and Tether’s USDT.
Companies issuing stablecoins have a low risk business. Coins can be issued after they receive the equivalent amount in cash from users. A portion of these funds are kept in cash, for when users want to redeem their stablecoins for dollars. Another part is invested in government treasuries, earning yield on those amounts.
Finally, stablecoin adoption is dependent on networking effects. We have also shown a way on how issuers could incentivise their stablecoin usage, giving back to holders.