A Battle of Stablecoins

Last week Coinbase asked its users to switch from USDT to USDC. In September Binance converted most stablecoins held by users into its own one, BUSD. Why did exchanges attack rival stablecoins? And what stablecoin is the safest?

A Rise of Stablecoins

Stablecoins have become hugely popular in the last 2 years. The total market cap of stablecoins rose from just $28 billion at the end of 2020 to $142 billion. Even Terra (UST) collapse this year did not shake market confidence in stablecoins, as there were no major outflows from the largest stablecoins.

Stablecoin Market Cap (USD)

The stablecoin market cap gains were despite the broader crypto market cap being about 10% lower than it was 2 years ago. The crypto total market cap is $800 billion now compared with $875 billion at the end of 2020.

Crypto Total Market Cap (USD)

The largest stablecoin, USDT (Tether), steadily increased its dominance, reaching about 8% of the entire crypto market cap and becoming the third largest cryptocurrency (after Bitcoin and Ethereum). Three stablecoins (USDT, USDC, and BUSD) are now among the 6 largest cryptocurrencies (with USDC being fifth and BUSD being sixth).

USDT Dominance

Stablecoin Reserves

Given persistent worries about stablecoins’ ability to support a peg, their governing bodies disclose reserves backing the stablecoins. The two largest currencies, USDT and USDC, publish a detailed breakdown of their assets and even an independent verification by a reputable third party. As a positive sign, Tether changed its third-party verifier from a relatively unknown entity to a large auditor (BDO) this year. Circle is verified by a large auditor too (Grant Thornton).

The reserves of both USDT and USDC look good (at least on paper). USDC reserves consist of cash and short-term US Treasuries. USDT reserves are more diversified, probably because of its multi-currency offering.

USDT Reserves as of September 30, 2022

However, the quality of the reserves held by USDT and USDC does not guarantee their creditworthiness. Both Tether and Circle do not disclose their balance sheets, so no one knows the exact amount of liabilities held against the reserves.

The third largest stablecoin, BUSD supported by Binance, published a reasonable reserve report too, showing full backing by US Treasuries. It goes as far as disclosing specific securities held in the reserves. However, BUSD's connection with Binance suggests that it should be treated like a Binance obligation rather than an independent currency.

Among the three largest stablecoins, I subjectively rank USDC as the safest and BUSD as the riskiest. USDC is backed by Coinbase, which is the only major crypto company having adequate disclosures. Coinbase is a public company traded on US exchanges, so it provides complete financial statements (including all its liabilities). It even has a relatively good credit rating. Tether seems less risky than Binance because its business is far simpler and is focused mostly on supporting transactions. In my view, both Tether and Binance have long-term regulatory issues because of lax controls (AML, KYC, etc).

However, even Coinbase is a very risky entity (or at least the bond market thinks so). Its bonds maturing in 2028 are traded at about 14% annualized yield, implying a credit risk of about 10% per year. I think that the market is worried about the current profitability issues of Coinbase, so USDC, which is like a separate and very profitable business segment partly owned by Coinbase, should have significantly lower credit risk.

Competition for Stablecoin Profits

I believe that the increased competition between stablecoins is explained mostly by the cash flows stablecoins started to generate. Stablecoins have become a way more profitable business this year thanks to much higher short-term USD rates paid on reserves. In January short-term risk-free yield was near zero, but now it’s above 4%. It means that most stablecoin reserves generated almost no yield in January, but provide a very nice one now. For example, current USDC reserves of $43.2 billion would provide an annualized yield of about $30 million in January compared with about $1750 million now!

3-month US Treasuries yield (%)

Current market cap of Coinbase, which co-founded USDC’s Circle, is $9.1 billion, so the annualized yield of USDC reserves equals about 20% of Coinbase value. I believe that a share of the current Circle profit is very significant for Coinbase. Coinbase discloses only a total interest income, including both the main platform and its share of Circle. The total interest income of Coinbase skyrocketed to $102 million in the third quarter from $8 million in the same period a year ago, while Coinbase's revenue in the third quarter plunged to $346 million from $1022 million a year ago. That’s particularly important given the business issues of Coinbase, which reported big losses in the last few quarters. Its stock price is down 83% year-to-date.

USDT's current USD reserves are $66.6 billion, generating an annualized yield of about $2.7 billion. Tether has likely become one of the most profitable crypto companies in the world.

Conclusion

Much higher rates this year make stablecoins a very lucrative business. Given crypto winter and lower revenues from other crypto businesses, stablecoin providers push for wider use of their own currencies and try to undermine competitors.

Among the three largest stablecoins, I subjectively rank USDC as the safest, USDT as riskier than USDC, and BUSD as the riskiest one. However, all stablecoins, including USDC, have a very significant credit risk. For long-term holders, I would prefer the volatility of Bitcoin and Ethereum prices to the credit risk of stablecoins.

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