This article was written and published on March 22, 2022. Republished with permission of Ken Chia, author of Bridging Bitcoin. Ken is currently Head of APAC at Abra with a focus on HNW and institutional adoption of cryptocurrencies as an asset class.
Stablecoins are cryptocurrencies without the volatility ⏤ They represent access to USD fiat on public blockchains like Ethereum.
Stablecoins have received growing institutional attention due to their high return opportunities at 8-10% pa (not degen) ⏤ high single digit annual returns without the volatility of crypto plus the added benefit of liquidity.
In comparison, in the fiat world, the US dollar yields between 0% (bank) and ~2% (30-year Treasuries).
ask: Where are these high returns on stablecoins coming from?
In this article we will unpack:
- the history of stablecoins;
- the structural scarcity of the stablecoin market; and
- the rise of the crypto lending market
History of stablecoins
Stablecoins have only been around for less than 8 years (since late 2014).
Still, stablecoins have surpassed $180 billion in market cap today and are showing no signs of slowing down.
The history of stablecoins can be divided into three phases:
- Pioneer phase (2014-2019)
- First expansion phase (2019-2020)
- Expansion and maturation phase (since 2021)
Source: ken-chia.com
Pioneer phase (2014-2019)
Welcome back to 2014.
BTC was below $1,000. The crypto market was either BTC or non-BTC (altcoin). Ethereum did not exist yet.
During this time, crypto was very experimental. Hundreds of stablecoins have been issued, including those backed by valuable commodities (gold, silver, etc.). Many of these projects are no longer active today.
Most notably, Tether was issued in 2014 ⏤ the first dollar-backed stablecoin on the market.
(non-exhaustive) stablecoin launch schedule
First expansion phase (2019-2020)
The ICO bubble of 2018 had just burst. A three-year bear market aka crypto winter ensued.
However, the builders in the industry continued to build. During this time, two main catalysts led to the initial growth of stablecoins:
- the emerging crypto derivatives markets; and
- the growing demand for dollar-backed stablecoins from China and East Asia
1. Emerging derivatives market
In hindsight, it’s relatively easy to explain why the crypto derivatives markets boomed during this period.
As the market entered the extended crypto winter of 2018, market participants looked for ways to hedge/short in the face of falling prices.
The growth of futures markets came from the need to short the market:
increasing % of the volume of derivatives
But with the emergence of new derivatives trading platforms (like FTX, Binance Futures)[…] both market makers and traders require huge USDT sums to get involved[…] The derivatives market denominated in USDT is becoming increasingly dynamic.” ⏤ Longhash, why Tether has grown faster than Bitcoin and Ethereum
2. Tether: Big in China and East Asia
In late 2017, the Chinese government banned the direct exchange of the yuan into cryptocurrency. Chinese investors then began adopting USDT as a replacement for the yuan.
By 2019, China dominated global demand for Tether (USDT).
increasing dominance in % of global demand from China
Tether’s first extension
As a result of these two major catalysts, Tether grew from zero to $4 billion and doubled very quickly, then tripled to over $10 billion in market cap.
Tether dominated until 2020, using its first mover advantage.
The stablecoin offering has been expanding rapidly starting in 2020
Expansion & maturation phase (from 2020)
In hindsight, Tether was just the beginning ⏤ the stablecoin market started booming from mid-2020:
Although Tether is still the leading issuer by market cap, its dominance has sharply decreased from ~100% to 45% of the market today, followed by Circle (USDC) at 25%.
Blessed by the OCC and acquired by Visa, USDC drastically lowered its perceived regulatory risks versus USDT:
source
The structural lack of stablecoins
Sources: FRED, Federal Reserve Bank of St. Louis; SIFMA; CoinMarketCap; Bridgewater Associates, “Our Thoughts on Bitcoin”; Raoul Pal
In relative terms, the stablecoin market is still in its infancy: at $180 billion, stablecoins represent only 10% of the total cryptocurrency market and less than 1% of the M2 money supply and most major financial asset classes i.e. gold, stocks and bonds etc.
Crypto markets are still nascent. Financial primitives (liquidity, lending, risk and arbitrage) are still evolving.
Most notably the crypto lending market.
The Crypto Lending Market
Crypto Loans 101
Crypto lending arises from a natural market between three main counterparties: borrowers, depositors and lending platforms:
- borrower: Sophisticated investors looking to borrow stablecoins for arbitrage opportunities; HNW investors / crypto miners looking for USD liquidity without selling coins (borrowing more tax efficient than selling)
- depositor: Opportunity to finance these loans for high returns
- lending platforms: Ensuring loans are adequately secured, managing and mitigating counterparty risk, performing financial analysis, ongoing loan monitoring, etc
Very similar to traditional bench models.
How big is the crypto lending market?
The crypto lending market has grown exponentially over the past four years. As a proxy, Genesis Trading cumulatively generated >$150 billion in Q4 2021:
Source: Genesis Trading, Market Observations Q4 2021
Why? Due to the structural lack of stablecoins relative to its ever-growing demand, we have seen an exponential rise in crypto lending markets led by natural market forces (depositors wanting access to high-yield USD opportunities; sophisticated borrowers looking for as much as possible to take advantage of arbitrage opportunities)
Traditional investors enjoy these types of arbitrage opportunities that give them access to double-digit annual returns (basis trades during bull runs) with minimal volatility and drawdown (market neutral). These opportunities simply do not exist in traditional financial markets.
Crypto lending is just a source of income
There’s a growing list of reasons why sophisticated investors are borrowing and why mainstream hedge funds are pouring billions of dollars into crypto, including names like Alan Howard and Paul Tudor Jones.
Let’s recap
The stablecoin market is still nascent with a history of less than 8 years. An emerging market offers opportunities, leading to a great demand for arbitrage and exploitation of these opportunities. Stablecoins are highly preferred over USD fiat due to their limitless transfer capabilities, ease of use and speed of transactions. Big demand for stablecoins leads to big loan demand ⏤ a growing crypto lending market.
A large loan demand coupled with the structural lack of stablecoins (demand > supply) leads to a market with high funding rates.
Although the crypto lending market is still nascent today, it will one day play a significant role in the global financial system, beyond crypto, as one of the four financial primitives:
What we are witnessing in crypto today is similar to the futures markets in the 70’s ⏤ evolving rapidly, then later far surpassing their agricultural and commodity origins and has a enormous effect to important markets (e.g. the interest rate swap market)
For those who like Tweetstorm threads, here’s one I put out as a quick synopsis:
source
For now, the stablecoin lending market continues to absorb more fiat dollars ⏤ like a magnet.
[…] it won’t go away until there is enough cash in the crypto market to make up the difference in price ⏤ Jeff Dorman, Arca
Disclaimer: I only recommend services that I would use myself. Nothing written on ken-chia.com is financial advice.
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