The returns on stablecoins like USD Coin are rising, but they are not without risks
Just as investors became accustomed to the record-high risk-free returns on short-term U.S. Treasury bonds, yields on stablecoins like Tether (USDT) and USD Coin (USDC) have skyrocketed in recent weeks. As cryptocurrencies begin to move as investors prepare for spot ETFs not only for Bitcoin but also for Ethereum, where the majority of DeFi resides, stablecoin holders suddenly have multiple options to put their money to work.
Loan yields for USD Coin are increasing on Aave
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DeFi grew in popularity in the summer of 2020, largely due to the innovative concept of yield farming first introduced by lending protocol Compound’s governance token. Yield farming, a speculative, high-risk, high-reward practice of earning “free money” by depositing tokens in various DeFi protocols, sparked a massive capital inflow into the DeFi ecosystem, reaching the $175 billion mark in November 2021 reached US dollars. The most famous decentralized system Aave and Compound lending protocols have almost 40% of deposits in stablecoins.
During the 2021 boom, more than $180 billion worth of cryptocurrencies were locked in DeFi.
In the background, stablecoins are digital representations of a dollar that reside on a blockchain such as Ethereum, Tron, BNB Smart Chain and many others. Their fungibility has made these assets important sources of liquidity across the crypto space. Dollar-pegged stablecoins are a $127 billion industry, with the two biggest players being Tether’s USDT ($88 billion) and Circle’s USDC ($24 billion).
The unsustainability of these returns became starkly apparent in mid-2022 with the collapse of the stablecoin ecosystem TerraUSD, which relied on its own DeFi lending project called Anchor to encourage people to lock up tokens. As $50 billion disappeared from the Terra ecosystem in a matter of days, investors began withdrawing funds from yield farming protocols on all blockchains. Centralized custodians like Celsius and Voyager also advertised double-digit returns on stablecoin deposits, which they then lent to trading desks or contributed to the DeFi ecosystem. These practices declined significantly when the market crash exposed the misuse of customer funds. This led to the ultimate bankruptcy of both companies as well as many other well-known industry participants such as FTX and Genesis Global Trading, among others.
Loss of trust in centralized custodian banks coupled with decades of high interest rates in the US has increased demand for on-chain TradFi solutions that provide returns to stablecoin holders but give them the ability to trade on crypto markets as they wish. One solution is tokenized treasuries, whose investments have increased from $104 million at the start of the year to $675 million today. Admittedly, these numbers still represent a very small percentage of the $23 trillion Treasury market, but the trend is increasing.
The table below shows Ethereum protocol Aave’s current lending yields for popular cryptocurrencies and stablecoins.
Current Ethereum protocol Aave loan yields for popular cryptocurrencies and stablecoins
Outlook and implications
On-chain/off-chain Treasury yields are expected to remain high at their current levels due to a number of factors. For one thing, the inflation cycle initiated by pandemic-related stimulus measures is not yet fully felt, which would preclude interest rate cuts next year. But that doesn’t mean that the target interest rate will change from 525 to 550 basis points, because it would be difficult for the supposedly apolitical Fed to raise interest rates again in an election year.
It is more difficult to predict future DeFi prices for stablecoins, which, like any other product, are based on a balance between supply and demand. From a demand perspective, industry insiders suggest that the new demand drivers for stablecoins are focused on investors looking to take long positions in cryptocurrencies, particularly Bitcoin or Ether. Spencer Hallarn, head of OTC trading at market maker GSR, says many traders looking to bet on Bitcoin, which is up 120% this year, are turning to DeFi markets as a cheap and relatively easy source of stablecoins to to advance these bets.
Another market participant suggested that traders use stablecoin pools on DeFi to take long positions on Ether with leverage. You can deposit Ether into a lending pool on a DeFi protocol like Compound to take out more stablecoins, exchange them back for Ether, and repeat the cycle over and over again. While Ether has underperformed Bitcoin so far this year, investors taking this approach are betting on a surge next year after spot Bitcoin ETFs begin trading and then Ether fund applications led by one of the world’s largest Asset manager, BlackRock, is under review by the Securities and Exchange Commission. This trend suggests that demand for stablecoins will remain high. But given the high volatility of cryptocurrencies, their prospects are likely to be riskier than that of US Treasuries.
Bitcoin has gained against Ether throughout 2023
One final point: It is important to note that while stablecoins are intended to be fungible, the risk profiles of different assets depend on their issuer. For example, Boston-based Circle Financial Ltd, the issuer of USDC, claims to embrace regulation and positions its asset as the safest stablecoin possible. Market leader Tether, on the other hand, has been plagued by controversy since its inception, has never submitted an audit and refuses to name its banking partners. However, this does not necessarily mean that USDC is “safe” and USDT is “unsafe.” During the banking crisis in March, it was revealed that Circle had $3.3 billion in unsecured deposits with Silicon Valley Bank, while Tether was unaffected.
The purpose of this discussion is to point out that stablecoins in DeFi can be lent/borrowed at different interest rates. However, as you can see in the chart below, where borrowing rates for USDC and Tether have changed over the last three months, there is no consistent pattern between the two. Hallarn says there is typically a lot of “noise” in these markets. Another possible explanation for these fluctuations is that traders are arbitrating the spreads between these assets in order to make additional profits with their existing trading strategies.
USDC and USDT returns throughout 2023
Investors looking to stake cash on-chain must decide whether they want the consistent returns of a TradFi-based product or want to experience a roller coaster ride of DeFi returns.
There are several excellent options for investors who want to stay in stablecoins and save their dry powder for the next bull market, which may just be beginning. Reputable custodians like Coinbase offer interest rates on USDC comparable to those offered by national banks. In the world of tokenized treasuries, Franklin Templeton is a leader in the TradFi space. Over $300 million is now invested in the Franklin OnChain US Government Money Fund, which was launched on the Stellar Network.
The net expense ratio is a reasonable 20 basis points and the yield is currently over 5%. For the DeFi purists, a cash management offering from Maple Finance has attracted $20 million in assets. The pool accepts USDC deposits on Ethereum and invests in US treasuries through an affiliate. 50 basis points are charged and an effective annual interest rate of just under 5% is achieved. It is also worth noting that these projects provide daily liquidity to investors who want to convert their holdings back into stablecoins for trading.
If you choose to run your assets on DeFi protocols, be sure to check loan and borrowing rates daily, as they can suddenly change in one direction or the other in the short term. Potentially positive stimulus could be news of the SEC’s approval of a Bitcoin or Ether ETF, while on the other hand, unexpected thefts or hacking attacks on a DeFi protocol or regulatory action against DeFi itself or the key tokens it supports could weaken demand. The two most established and secure DeFi lending protocols are Aave and Compound. Therefore, investors looking to participate in DeFi for the first time may want to look into these options first.
Ultimately, investments should suit your time frame and risk tolerance. When a bull market is coming, it is always better to be early than late. The biggest profits are made at the beginning of the cycle. If your digital assets are not for speculation and may be used in the real world, don’t be afraid to enjoy the higher returns and even some TradFi products.
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