The Lifeblood of DeFi: Fiat-backed Stablecoins

Written By endless760

The 2021 collapse of the UST stablecoin is on the minds of many crypto investors and the unfortunate event reinforced the importance of understanding a stablecoin’s volatility potential; specifically, volatility to the downside. However, evaluating the risk of a stablecoin goes beyond merely looking at a stablecoin’s collateralization ratio. The type and mix of reserve assets is an important detail that cannot be overstated. The mix of assets in a stablecoin’s reserve will define a reserve’s liquidity schedule, speak to the risk tolerance of the governing body, and help investors evaluate a stablecoin’s overall risk of insolvency. This article covers the basics of fiat-backed stablecoins and takes a closer look at the reserve assets of a few popular fiat-backed stablecoins. This is the second article in a series. For a high-level overview of stablecoins, take a look at the first article.

Fiat-backed Stablecoins

Continuing with USD stablecoins as an example, fiat-backed stablecoins mint one coin in exchange for one US dollar. In regards to eliminating risk to the collateral that maintains a coin’s USD peg, the most secure form of a stablecoin is called a true stablecoin where the dollars received in exchange for coins are solely used to backstop the full market cap of stablecoins in circulation. The deposited dollars are not used to purchase a different asset, nor lent out to generate additional income. Meaning, the cash is essentially placed into a bank account creating a 1:1 reserve-to-issuance ratio that can support a hypothetical buyback of all minted coins at any time. The downside of this low-risk approach to holding reserve assets stems from the missed opportunity to generate higher yield from riskier investments.

TUSD

According to an independent and transparent audit from November 2022, the TrueUSD (TUSD) stablecoin has a 100.5% collateralization of USD escrowed in third-party bank accounts that can be exchanged for the minted TUSD stablecoin at any time. Similarly, USD can be exchanged for TUSD at any time in a process called minting. The deposited USD serves as collateral to the TUSD and is held in reserve bank accounts.

TUSD Chain of Custody
Source: TUSD Website

In line with a true stablecoin, TUSD generates revenue from the interest TUSD reserves collect while sitting in third party holding banks, which is about as low risk as it gets compared to revenue-generating alternatives pursued by other types of stablecoins.

USDT

Let’s take a look at the most widely-circulated stablecoin: Tether, or USDT. As of late October 2022, there were more than $69 billion USDT issued worldwide. It is supported on Ethereum, Solana, OMG Network, Tron, Algorand and EOS blockchains, and trades on various layer-2 solutions secured by Bitcoin and Bitcoin Cash. For more info on layer-1 blockchains vs layer-2 scaling solutions, checkout the previous article that provides an overview and then dives deeper into planned Ethereum layer-1 and layer-2 upgrades.

Tether self-reports issuance and reserve holdings daily via their website, and on 10/30/2022 it showed $69.29 billion of USD collateral backing $69.10 billion of issued USDT, resulting in a reserve ratio of 1.002. In dollar terms, Tether is over-collateralized by $190.9 million representing 2/10ths of one percent of overall supply.

Tether Stablecoins in Circulation on October 30, 2022

The most recent audit performed in June 2022 showed approximately $66.41 billion in collateral backing approximately $66.22 billion of total liabilities in the form of either USDT, EURT (Euro coin), CNHT (Renminbi coin), and XAU (gold-backed coin). The amount of each coin in circulation as of 10/30/2022 is shown in the figure.

A closer look at the audited reserves shows a broader mix of reserve holdings compared to USDC’s reserve mix. The bulk, about 80%, of USDT reserves are spread as follows with about: 43.45% as short-term US Treasury bonds, 12.65% as A-rated corporate bonds or CDs, 10.25% as money market funds, and 8% as cash deposits. The remaining ~20% of reserves are either lower grade loans, corporate bonds, or crypto holdings.

Description: USDT Reserve Audit June 30, 2022

The main takeaway is that only about 18.4% of reserves are liquid in the form of money market holdings or cash deposits. Meaning, if all USDT holders wanted to redeem their USDT for US dollars, only ~18% would be supported. After 120 days, the short-term US Treasury bonds could be liquidated into cash, and the remaining cash out depends on when the corporate bonds come due.

USDC

USDC is another USD-backed stablecoin supported on various layer-1 blockchains including Ethereum, Stellar, Solana, Algorand, and Tron. As the number two stablecoin in terms of issuance volume, USDC differs from TUSD in terms of how the reserves are put to work. In addition to retaining a portion of reserves as cash, the vast majority of reserves are converted to short-dated US government bonds.

The exact mix between bonds and cash is disclosed on a weekly basis and the reserve accounts are audited monthly. The March 2022 USDC reserve audit showed 51,388,555,903 USDC in circulation and USD-denominated assets “at least equal to” $51,388,555,903. Therefore, the auditors disclose a reserve ratio of at least 1:1. The reserves are held in US banking institutions and are not commingled with other corporate accounts.

Asset Mix of Reserve Holdings

In addition to monthly reserve audit reports, on a weekly basis the Circle site publishes the cash/bond mix of reserve holdings, and the amount of minted and redeemed USDC over the previous week. The October 27, 2022 cash/bond mix of USDC reserves is shown in the figure below.

Description: USDC cash/bond mix on October 27, 2022

For comparison, a snapshot of the May 2022 cash/bond mix is shown below:

Description: USDC cash/bond mix on May 20, 2022

A comparison of the May and October 2022 cash/bond mixes shows that Circle shifted to holding a higher percentage of reserves as cash. More specifically, between May to October 2022 Circle increased from ~23% to ~30% of cash holdings as a percent of total reserves.

Issuance Rate

The last, interesting data point we will look at is the weekly issuance vs redemption rate of USDC. In October 2022, the net change in circulation USDC was -0.1B as shown in the snippet below.

USDC Issuance from October 20-27, 2022

Looking back at the May 13-20, 2022 issuance and redemption report, we can see a net positive change in weekly issuance.

USDC Issuance from May 13-20, 2022

There are many factors that influence stablecoin issuance rates, especially with a handful of stablecoin options that crypto investors can move between. Another point of relevance is the timing of the TerraClassicUSD collapse. TerraClassicUSD (formerly Terra Luna’s USD stablecoin, UST) fell from its $1.00 peg to 0.12 cents between May 6th to May 13th, then ended the following week at 0.06 cents on May 20th. Therefore, it’s easy to deduce that the net inflow of $2.3 billion into USDC in May 2022 was largely driven by investors fleeing USDT.

Wrapup

In terms of governance, USDC issuance, redemption and reserve management is centrally managed by the Circle organization.

Comparing reserves of the top two stablecoins, USDT and USDC, my opinion is that simple is better. Tether and Circle both invest reserve holdings to generate revenue from their holdings, but Circle’s USDC coin keeps it simple by investing in the lowest risk debt as commonly agreed upon by the international community — US government bonds.

The next article in this stablecoin series focuses on non-fiat asset backed stablecoins. They build a bridge between DeFi and traditional hard assets.

endless760
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