Thoughts On Stablecoins, Borrowing & Lending Platforms, Earning Yield, Leverage, Risks, & Regulation

Jun 30, 2021 • 7 Min Read

In this Crypto Weekly, instead of discussing our usual views on the market, we’re going to talk about something a little different – our thought on stablecoins, borrowing & lending platforms, earing yield, leverage, risks, and regulation.

We think it’s worth discussing these areas to expand on our notes from last Friday and Monday on leverage in the crypto lending space and given the House Financial Services Committee holds a hearing on Crypto today.

Thoughts On Stablecoins, Borrowing & Lending Platforms, Earning Yield, Leverage, Risks, & Regulation

Source: C-SPAN

Why do stablecoins matter in crypto?

Stablecoins are becoming a big part of the crypto economy with the total value of stablecoins outstanding now at ~$108B. These digital assets offer a lot of innovation and are enabling new use cases on top of them.

Thoughts On Stablecoins, Borrowing & Lending Platforms, Earning Yield, Leverage, Risks, & Regulation

Source: The Block

Are stablecoins digital dollars or digital debt?

Most think about stablecoins as digital dollars. The reason is because these assets (pegged stablecoins only; crypto backed and algorithmic are different) are usually backed by dollars as collateral held by the issuer at a regulated bank.

But we think these assets look a lot more like digital debt than digital dollars in a few ways. In the finance world, these instruments somewhat resemble debt with the following illustrative terms:

  • Liability: USDT
  • Face Value: $1
  • Maturity: Perpetual
  • Yield To Maturity: 0%
  • Interest Coupon: Zero Coupon
  • Issuance Price: Par (100% Face Value)
  • Optionality: Immediately Puttable At Par
  • Instrument Form: Digital Barrer Certificate
  • Collateral Type: USD, Money Market Instruments, Other Debt
  • Collateralization Ratio: Fully or Partially Collateralized
  • Counterparty: Tether Limited, Etc.
  • Seniority: Unsecured Claim

These are a generalization, there will of course be different legal structures, but at a high level this pretty much holds. Let’s walk through this (not in the same order as above):

  • Users are giving stablecoin issuers dollars and getting digital receipts of those dollars which they can trade. 
  • Stablecoin issuers hold the purchasers deposited cash: sometimes it’s in a bank earning interest or sometimes those dollars are used to purchase money market instruments or other fixed income securities.
  • The issuers are not obligated to give the stablecoin holders any form or periodic interest payments (note this is different than a situation where these stablecoins are lent out to others through lending platforms).
  • The issuer only promises to give the stablecoin holder back an equivalent amount of dollars when they redeem them, which can generally happen at any time (with some exceptions).
  • Since these stablecoins don’t pay any interest and they are issued at par, and redeemable at par, holders get a 0% effective interest (note if bought on the secondary market returns could differ; buying above $1 = -yield & below $1 = positive yield).
  • The users could leave their dollars with the issuer indefinitely if they chose.
  • The main risk to users is that the issuer does not have the collateral to meet redemptions when requested by the stablecoin holder.
  • These assets are generally guaranteed by the issuer holding the collateral and if the value of the collateral assets is not enough to cover the face value of the stablecoin liabilities the issuer owes the holder.

Are we worried about stablecoins like Tether?

Tether is a topic we get questioned about very often. Many in the crypto community have been concerned for years that the value of Tether is not backed by sufficient dollars to cover the outstanding USDT tokens. While we don’t know for certain the details about Tether’s reserves, we’re not as concerned about the stablecoin as many others are. From our perspective most concern around Tether has much to do with the mislabeled or misunderstood representation of its reserve assets.

Thoughts On Stablecoins, Borrowing & Lending Platforms, Earning Yield, Leverage, Risks, & Regulation

Source: Tether

Although they don’t have a large enough cash position to cover the USDT liability, Tether is essentially a big credit fund with a pool of debt assets of their own that they say cover the value. They say most of their assets are in money market commercial paper, which if true would be relatively low risk assets. If they are lying about this, my gut is the NY DA would have found out during their probe and have a problem with it (but I really don’t know). If they took a loss on their debt investments, their affiliated exchange, Bitfinex, is a sizeable business and I’d guess they could bail out USDT again to keep the machine going.

One thing is certain, crypto lenders have been willing to give Tether $60B+ of the best type of financing with the lowest cost of capital and most unrestrictive covenant lite borrowing terms anyone could ever ask for.

Is USDT a fairly priced debt token? That’s another story.

It probably should not be thought about as cash. But again, no stablecoins should be really, some just have higher quality collateral pools, but even debt securities that are fully cash collateralized usually trade at a slight discount to par in the real world. Question is what risk premium and discount to par should USDT trade at? Is it BB grade credit, CCC, etc.?

Remember how buying below par and putting to issuer is a positive yield? This is why buying Tether FUD in the past when it had traded down to 95% on the dollar had been a highly profitable trade. And it may be a good reason for a smart trader to keep the uncertainty going.

It’s worth noting that default risk here is not mechanically different than folks who are relying on lending platforms as a counter party to give them back their BTC, etc. (although the issuer quality may be different).  In some ways, since Tether isn’t obligated to pay its depositors interest and the liabilities it can take on are (at least they claim) mostly in money market assets, meaning their collateral may even be safer than some lenders who must go out on the risk curve making crypto loans to meet depositors promised interest rates.

How do stablecoins change the banking system money supply dynamic?

Stablecoins do something interesting to the money supply that didn’t exist before. It used to be that you deposited your dollar in a bank, you owned the account and the bank’s liability to you as an asset, then the bank would lend that money out through the fractional reserve process and earn a return that it paid back to you.

Stablecoins change this dynamic by giving the depositor both the ability to earn interest on the dollars sitting in the bank account being lent out in the real economy and the ability to take these digital debt receipts and lend them out again in the crypto economy and earn interest there as well – effectively taking the same dollar and lending it twice.

It’s a brave new world in some way – essentially, people are now willing to pay others high rates of interest to borrow their lower risk debt.

This is not a bad deal for the issuers and one reason the supply of stablecoins is likely to continue rising until regulators stop it – if they ever do.

How do holders earn interest on their stablecoins?

Coinbase announced yesterday that it would offer users 4% APY on USDC deposits with the largest crypto exchange, adding to the list of lenders like BlockFi and others have been taking users crypto deposits and offing interest in return.

Thoughts On Stablecoins, Borrowing & Lending Platforms, Earning Yield, Leverage, Risks, & Regulation

Source: Coinbase

We don’t know the exact legal structure Coinbase has this wrapped in, but 4% might not be a bad rate for accessing the debt markets if it falls under the camp of an unsecured liability of the company. But many users will rightfully view Coinbase as a highly credit worth borrower and find the ability to “lend to them” attractive.

It’s also interesting to note how this changes the debt capital markets financing model. It’s no longer only major institutions that can directly (without intermediaries like money market funds) access the money markets and lend to borrowers like Coinbase – now you and I can do in a crowdfunding form.

Do all borrowing & lending platforms carry the same risks on their deposits?

It’s reasonable to say that not all counterparties will be as credit worthy as Coinbase. But users who are willing to lend to these platforms can earn higher returns by taking on higher risk. And we want retail clients to better understand these risks. As an example, here’s a description of the business activities from the Celsius February 2021 financials to give folks a better understanding of how the business model operates.

Thoughts On Stablecoins, Borrowing & Lending Platforms, Earning Yield, Leverage, Risks, & Regulation

Source: https://find-and-update.company-information.service.gov.uk/company/11198050/filing-history

For example: the crypto lender Celsius lends the assets deposited on its platform to centralized and decentralized exchanges and other borrowers, sometimes on an undercollateralized basis, who are then counterparties to the company. The firm also does discretionary trading to generate excess returns. We’re not claiming there’s any problems with this, simply explaining the mechanics. These activities are fine as long as borrowers have material defaults, the discretionary trades don’t generate massive losses, and they can earn enough excess return to cover borrower interest payments or the platform itself has a strong enough balance sheet to meet liabilities.  

But the reason some crypto lending platforms must take on more risk is to meet high rates of returns they promise their deposits.

Thoughts On Stablecoins, Borrowing & Lending Platforms, Earning Yield, Leverage, Risks, & Regulation

Source: Celsius

But if the lenders assets become impaired somehow during a sell off where liquidated collateral doesn’t cover loans issued, or during a hack lose funds, or due to the default of an uncollateralized counterparty, or due to improper management of the business – users can lose a substantial portion of their funds since these types of institutions are not regulated like banks. Are we claiming this is the case with Celsius? We don’t know what the company’s recent financial condition looks like so no we’re not. But we want folks to understand the type of risks they are taking on with them and others.

Reports you may have missed

Get invaluable analysis of the market and stocks. Cancel at any time. Start Free Trial

Articles Read 1/1

🎁 Unlock 1 extra article by joining our Community!

You are reading the last free article for this month.

Already have an account? Sign In