The world’s largest crypto exchange Binance is all set to convert three stablecoins — USDC, Pax Dollar, and True USD — to Binance USD. The move by Binance is not surprising but is an indicator of what’s coming next: the battle for stablecoin supremacy. Why? Because there’s some serious money to be made in stablecoins.
At their core, stablecoins are like checking accounts. They are tokens on various blockchains with a value that tracks a fiat currency, usually the US Dollar.
The reason they exist is simple: stablecoins are the lubricant of the crypto machine. Moving money from crypto to fiat and the other way around is clumsy. It takes lots of time and transaction costs add up, especially if you are trying to transact on different exchanges. For example, if you sell on Binance but decide to buy on Coinbase or on different chains. Or if you hold Ethereum but want to interact with a project built on Solana. In such cases, you must have a fiat-to-crypto or crypto-to-crypto conversion facility. Stablecoins solve this problem elegantly. Moving money on-chain (without the value being tied to crypto but to fiat) is a huge convenience.
Types of stablecoins
There are three types of stablecoins. They can be backed by fiat like USDC and USDT; by crypto like DAI or by an algorithm like UST Terra.
- Fiat-backed stablecoins are the largest and use deposits in banks and holdings of liquid bonds (like US Treasury bills) to enable easy two-way convertibility between stablecoins and fiat.
- Crypto-backed stablecoins use crypto collateral (like Bitcoin and Ethereum) and an algorithm/smart contract to enable fiat-like returns.
- Algorithmic stablecoins (the most famous of which was UST Terra) try to maintain their peg to fiat through an incentive system of arbitrage with another token (LUNA in the case of Terra).
Combined, stablecoins are valued at over $150 bn and are the fastest growing part of the crypto market. As a percentage of the crypto market, they have grown from 3.6% in Jan 2021 to 15% currently i.e they have quadrupled in less than 2 years!
What does the crystal ball say?
Since the segment has grown rapidly very recently, data is limited. However, Circle’s income statement sheds some light on the economics of stablecoins. Circle along with Coinbase founded the consortium that manages USDC, one of the largest stablecoins. Coinbase is the second largest crypto exchange in the world after Binance.
When Circle issues a USDC in exchange for $1 of fiat, the $1 is deposited in a bank account used to buy assets that yield interest. This reserve interest income is a major source of revenue. Some of this revenue is shared with the exchanges that give Circle more business and help boost USDC issuance.
Fed funds rate which drives interest rates for USD assets has been close to zero between April 2020 to March 2022. As a result, issuers of fiat-backed stablecoins like Circle didn’t earn much from their investments. From March 2022 onwards, the Fed has started hiking rates greatly increasing profitability.
Sample this: For the quarter ending June 2022, Circle had $81.3 mn of reserve interest income and $21.85 mn of income sharing and transaction costs from its USDC stablecoin business. That is a gross income of about ~$59.5 mn. The USDC stablecoin business had balances of $55.7 bn. These balances earned ~0.64% per annum for Circle. With the Federal Reserve interest hike, funds rates for the period January to March 2023 are predicted to be in the range of 3.75-4%.
Assuming a balance of $55 bn for the January to March 2023 period, at 3.75% earnings, the USDC business could generate over $500 million of revenue for Circle. If the revenue share proportion with distribution platforms (exchanges like Coinbase) is similar, Circle could earn a gross profit of over $350 million in just one quarter with over $150 million being distributed to its exchange partners! Of course, other revenue streams come with being a stablecoin issuer but they pale in comparison with the reserve interest. If you extrapolate it to the whole industry, with over $150 bn of stablecoins currently outstanding, issuers can generate over $5 bn of revenue over the next 12 months.
An annual revenue pool of $5 billion with relatively limited barriers to entry is likely to result in new entrants entering the market. The core construct of stablecoins may also change with some issuers sharing revenue with the holders (in addition to the exchanges). Of course, these are subject to regulatory changes like becoming labeled securities.
We expect some global asset managers, which already manage $8 trillion of AUM of money market funds, to start issuing stablecoins leveraging their brand, and regulated status and expertise. Over time, stablecoins can become the bridge for traditional financial institutions to enter crypto. Ergo, stablecoin wars are coming. Or rather, it is already upon us.