Stablecoins are designed to be pegged to their underlying asset, which is the US dollar (USD) for the majority of coins. The top three stablecoins in order of decreasing market cap are USDT, USDC, and BUSD.
Historically, these stablecoins have lived up to their promise with market prices holding their peg to USD. However, we have observed temporary deviations from the peg in part due to exchanges’ steering efforts and rumors of insolvency. This volatility has caused many investors to reevaluate their stablecoin holdings.
Evidence supports diversifying across the three majors by maintaining the required USDT for trading while holding excess balances in USDC or BUSD. The paragraphs to follow provide explanation of the rationale for diversification in the context of the current stablecoin market.
The top three USD stablecoins operate on a simple model. Deposits are made into reserves in the USD in return for stablecoins issued on-chain at a rate of $1 per token. Reserves are held in USD denominated assets for future redemptions on stablecoins. The top three stablecoins were launched when interest rates on US treasuries were close to zero. Each of them has an affiliated crypto exchange:
USDT was launched in 2014 by Tether Limited, owned by iFinex Inc, which owns Bitfinex.
USDC was launched in 2018 by Centre, founded by Circle, which includes members from Coinbase.
BUSD was launched in 2019 by Paxos in partnership with Binance.
The issuance of the top three stablecoins was largely motivated by the need to facilitate trading on the exchanges. The yields on the reserves initially were not significant. However, in 2022 we have seen the interest rates on 4-week Treasury bills rise to its current level of 3.7%. With the exception of cash for immediate redemptions, the reserves can be invested in short-term T-bills.
This simple stablecoin business model has become one of the most profitable and lowest risk in the crypto industry. Each stablecoin is estimated to be generating enormous profits just assuming the risk-free 3.7% 4-week T-bill rate:
USDT has approximately $62 billion of its $68 billion reserves invested, which would generate $2.29 billion risk free annually.
USDC has approximately $36 billion of its $44 billion reserves invested, which would generate $1.33 billion risk free annually.
BUSD has approximately $20 billion of its 22 billion reserves invested, which would generate $0.74 billion risk free annually.
With fees and trading diminished due to the digital asset depreciations in 2022, it should come as no surprise that exchanges are making efforts to steer their users toward holding their affiliated stablecoins to increase deposits and profits. Binance consolidated its users' stablecoin holdings to BUSD in this summer, while as recently as last week Coinbase offered free conversions to USDC from USDT.
The latter along with some insolvency rumors lead to USDT trading 3% below peg for a period of time on Thursday December 8th; the peg was later reestablished. In an attempt to dispel rumors of insolvency and provide transparency, reserves are reported by all three of the top stablecoin issuers. Reported reserves are attested by third parties, but not formally audited.
Solvency & liquidity
USDC & BUSD
USDC and BUSD are the most sound from the perspective of solvency and liquidity. As of October 2022, both hold their reserves in cash at US regulated financial institutions and US treasuries of under 3 month duration. BUSD reserves are also held in Overnight Reverse Repurchase Agreements collateralized with US Treasuries. All of these are highly liquid and secure, giving both USDC and BUSD the ability to redeem all outstanding stablecoin effectively. BUSD has the added security of being a trust company regulated by New York State Department of Financial Services, which requires this allocation on an ongoing basis. Reports from October 2021 and October 2022 indicate reserves that equal liabilities for stablecoins outstanding. This suggests that their issuers have been taking disbursements from the yields generated by treasuries held.
Reserves for USDT as of September 2022 were reported to be greater than outstanding stablecoin valuation by a thin 0.3% margin. Approximately, $48.8 billion or 72% of USDT asset reserves are of the same quality as those of USDC and BUSD. Another $7.3 billion or 11% are reported as cash equivalent, short duration of good credit rating. However, after subtracting out $0.7 billion or 1% for other currencies and gold, the remaining $11.3 billion or 16% are reported in other investments, like commercial paper and secured loans. It should be noted that the reserve allocation in less secure assets than those of USDC and BUSD has decreased from being over 70% to 38% from September 2021 to September 2022.
However, given the thin 0.3% margin of the September 2022 report, insolvency could become an issue if the lower quality higher duration reserve assets are devalued. It is possible that devaluation could arise from increased credit risk or higher yields, decreasing longer term bond valuations. The margin as of September 2021 was 0.2% while credit risk and yields have increased dramatically over the past year. This would suggest that Tether has contributed to the reserves to maintain adequate funding. There are no reports indicating Tether’s excess funds to make future contributions and some of the valuation methodology for their assets is vague. The future solvency of USDT is more uncertain than USDC and BUSD.
More risky reserves along with other factors lead to USDT making $10.3 billion in net redemptions in 2022 according to a recent Kraken report, losing market share. The same reports indicated that USDC and BUSD both gained market share with net deposits this year of $2.1 billion and $9.1 billion, respectively. USDT has been able to make all of the requested redemptions despite the surge in requests due to the Coinbase steering efforts and recent rumors. It will likely continue to be able to meet redemption demands with its large cash holdings.
In conclusion, the top three stablecoins are running extremely lucrative risk-free business models by holding short-term treasury reserves and retaining all of the yield. Evidence suggests that all top three stablecoins are likely able to fulfill redemptions comfortably in the near-term, despite some risks that likely have been exaggerated in competition for market share.
Stablecoin issuers have little need to introduce credit risk or yield curve risk with lower credit quality and longer duration reserve assets. Tether has been reducing riskier assets held in reserves for USDT, but significant risk remains. All else being equal, this would suggest that USDT offers a less secure store of value, while at the same time it is necessary for trading operations as the dominant quote currency in token trading pairs.
These developments and recent volatility suggests that diversifying stablecoin holdings across the top three is a prudent approach, with USDC and BUSD preferred as a secure store of value and USDT held as necessary for liquidity and trading.
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