Here at Castle, we have received questions from investors lately about investing in so-called “stablecoins,” such as USD Coin (“USDC”), Tether (“USDT”), and Dai (“DAI”). Generally, these virtual currencies seek to maintain a value of approximately $1.00 USD. The mechanisms for maintaining this value vary by coin but rely typically on various incentives designed into their minting, burning, and collateral management processes to keep the value of the coin close to the $1 “peg.”
Stablecoins continue to attract investors; for example, the research firm Messari.io reports that the value locked in the USDC stablecoin is up roughly 700% for the seven months ended July 31, 2021. In addition to the custody, valuation, illiquidity, and other risks applicable to any virtual currency investment, we believe that investors considering stablecoin investing should consider, at a minimum, the following questions:
Who or what is backing the stablecoin?
How difficult is it to convert the stablecoin back to USD or other currencies? ● What drives demand for the coin?
Backing Stablecoins: Institutions and Collateral
As of July 31, 2021, there are few regulations governing the issuance of stablecoins, including the requirement that each coin issued be “backed” by assets having a value equal to or greater than the number of coins outstanding.
However, the market for stablecoin dollars is competitive, and the issuers of USDT and USDC have in recent months been issuing reports showing the value of their “reserves” as of certain dates, as verified by third-party accounting firms.
This approach differs from the “decentralized autonomous organization” issuing the DAI stablecoin, which uses a computerized “smart contract” to maintain reserves of various virtual currencies, such as Ethereum and Bitcoin, with a value roughly equal to the number of DAI issued.
Following the financial crisis of 2008, which stressed the money-market mutual fund industry, the Securities and Exchange Commission made several rule changes requiring managers of those funds to stress test their portfolio valuations and report the composition of their portfolios timely to the regulator. No such regulations yet exist for stablecoin reserve portfolios. Accordingly, investors should consider carefully whether these reserve assets are sufficient to
support the value of the coins in circulation and whether the reserves are invested in a way that could fund substantial liquidations in times of market stress without significant losses.
Liquidity and Convertibility
Ultimately, the market determines the price of a stablecoin, regardless of the value of the reserve portfolio. In addition to any premium or discount to these reserves, the technology behind the coin (blockchains, lending and staking applications, etc.) can have a significant impact on the returns investors can expect from their stablecoin holdings.
When comparing stablecoins, investors should consider:
Transaction costs involved in the purchase and sale of the coin (for example, the distributed exchange SushiSwap currently charges 0.05% to exchange USDC for USDT);
Any costs associated with moving the coin between wallets and applications (for example, “gas” fees on Ethereum); and
Restrictions which brokers for that stablecoin may apply due to your jurisdiction; for example, an investor in the US may not wish to purchase the Binance stablecoin BUSD without certainty that Binance will permit trading in their account.
Assessing Demand and Uses for Stablecoins
The market for stablecoins continues to evolve, but as of August 2021 we believe that the majority of stablecoins are purchased for the following purposes:
Facilitating transactions in other virtual currencies: we believe that more than 60% of current market volumes have a stablecoin on one side (such as the BTC-USDT pair rather than BTC-ETH);
Lending stablecoins to other market participants to facilitate their trading strategies; and ● Depositing into interest-bearing accounts offered by agent lenders such as Compound Prime or Circle Yield.
Each of these use cases has its own risks of loss, including the risk of losing stablecoins due to hacking of the lending protocols or failures to repay loans on demand. While lending protocols typically automatically liquidate collateral immediately in times of market stress, there can be no guarantee that the liquidated collateral will yield enough cash or stablecoins to fully repay the lent coins.
Summary
Stablecoins seek to maintain a value of $1.00 USD per coin, backed by pools of reserve assets ranging from bank deposits to other virtual currencies;
The value of a stablecoin is ultimately set by the market, and can be impacted by regulatory restrictions, transaction costs, and blockchain movement charges; and
Lending stablecoins may present attractive yields relative to traditional bank deposits or CD’s; however, there are additional risks of loss which investors should consider carefully before depositing.
Dan Hoover is Director of Product Analytics, Compliance, and Distribution at Castle Analytics LLC, a digital-asset-focused asset manager and commodity pool operator based in the San Francisco Bay Area.
LinkedIn (http://www.linkedin.com/in/danhoover)
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