2018 has been a big year for stablecoins. From concerns around Tether’s insolvency to a proliferation of transparency-oriented “Tether-killers”, to discussions around the viability of crypto-native stablecoins, the topic has found consistent mindshare in the crypto community. A considerable amount of research and writing has been dedicated to examining the stability mechanisms that each of these stablecoins employ (some great overviews here, here and here), so I’ll focus on an aspect that hasn’t received as much attention: the business behind stablecoins.
It turns out that stablecoin issuance can have significant upside across a range of mechanisms for capturing value. This upside is driven by seigniorage.
While there are diverging definitions in the literature, at a high level, seigniorage is the net revenue derived from money creation and the introduction of this money into the economy. Historically, seigniorage was the difference between the purchasing power of commodity money and the cost to produce it (e.g. the profits earned from issuing metal coins at a price above their melt value) and represented a significant source of income for monarchs and governments.
In modern economies, the majority of money is created by commercial banks through the act of lending. Commercial banks produce revenue primarily from functioning as financial intermediaries and money creators. While the lines are blurred with respect to the revenue attributable to each function, it’s generally understood that money creation is the primary income driver, as it allows commercial banks to lend in excess of their deposits. Without getting lost in semantics, commercial bank seigniorage can be thought of as some (likely majority) portion of the interests earned on banknotes held less interests paid on account deposits.
Stablecoin issuers, on the other hand, function exclusively as money creators and the seigniorage they earn depends on their issuance mechanics and network growth. Thus, when investors back a stablecoin project, seigniorage potential is a key valuation driver. Let’s explore this potential across the three major categories of stablecoins and discuss possible competitive implications.
Fiat-backed stablecoin systems accept fiat currency or other non-crypto assets as collateral, store it with custodians and issue tokenized IOU vouchers (stablecoins) on a 1:1 basis. The issuing company can generate revenue as a function of outstanding stablecoin supply, fiat collateral-base or transaction volume (on-chain or on exchanges). The following are the main ways these types of stablecoins capture value in practic
Issuers that employ this model charge a fee for issuing and redeeming their stablecoins in exchange for underlying fiat collateral. Revenue here is a function of the in/out flow, which is driven by changes in demand — primarily for access to crypto markets, with stablecoins serving as a major on/off ramp. Interestingly, fees in this model are limited by nature of the stability mechanism, as the spread between the stablecoin price and the underlying collateral must be greater than the fee to create arbitrage opportunities for traders. To encourage a tight spread, the issuer must limit its revenue potential from this strategy, which may explain Tether and TrueUSD’s choice of a 0.1% issuance/redemption fee (Tether actually has higher fees for redemptions, on the order of 0.4–3%). Assuming annual in/out flow of $10B and 0.1% issuance/redemption fee, this strategy could generate $10M in revenue.
Engage in market-making on exchanges, earning as a function of the bid/ask spread and exchange volume facilitated by the issuer’s trading desk. The bid/ask spread reflects the depth of order books on exchanges and depends on liquidity provided by the company, traders and other 3rd party market-makers. Importantly, bid/ask spreads tighten with increased trade volume and can be lower than 0.01% in a sufficiently liquid market. It’s also worth noting that market-makers run by the issuer are not differentiated from other market-makers, suggesting that this is not a primary monetization strategy as much as it a necessary function for the wellbeing of a stablecoin ecosystem.
Invest a portion of collateral-base in short-term treasuries and money market funds. This strategy is driven by the size of the collateral-base, interest rates on short-term investments and the reserve ratio — the ratio of reserves held as fiat vs productive assets. 1-month treasuries currently yield 2.2% annually, making this an attractive strategy. With a stablecoin market cap of $10B and a reserve ratio of 50%, this strategy would yield ~$110M in annual revenue. Note that this is an order of magnitude more lucrative than charging fees on issuance/redemptions, provided that annual in/out flow is comparable to market cap (not necessarily a fair assumption).
By no means do the above strategies encompass all possible ways to capture value in fiat-backed models — they are just the strategies I’ve seen employed so far. Of the above, short-term lending on a fractional reserve seems to be the most lucrative strategy. It’s important to note that fiat-backed stablecoin issuers can engage in multiple monetization strategies at the same time, though not all types of issuers share the same incentives to monetize their stablecoin systems.
Fiat-backed stablecoins are used most on centralized exchanges, serving as a desirable trading pair, safety asset and onboarding tool. Because exchanges receive meaningful utility from fiat-backed stablecoins, they could in theory justify issuing them without needing to monetize directly. This makes it challenging for non-exchange issuers to compete on user-imposed fees with Tether, USDC, GUSD, etc. For this reason, market-making and short-term lending may be the only viable long-term monetization strategies for fiat-backed stablecoins.
Crypto-backed stablecoins move away from centralized custody and provide a decentralized alternative that still maintains claims on collateral. As we depart from the simpler implementation of the fiat-backed approach, the design space expands and monetization strategies become more complex. In addition to the stablecoin that they issue, crypto-backed projects typically feature a second cryptoasset — a “volatility-coin” — that is intended to incentivize behaviors that benefit the system. While the issuing company or DAO maintains the flexibility to engage in market-making activities, the volatility-coin tends to be the asset of interest from an investment perspective.
2018 has been a big year for stablecoins. From concerns around Tether’s insolvency to a proliferation of transparency-oriented “Tether-killers”, to discussions around the viability of crypto-native stablecoins, the topic has found consistent mindshare in the crypto community. A considerable amount of research and writing has been dedicated to examining the stability mechanisms that each of these stablecoins employ (some great overviews here, here and here), so I’ll focus on an aspect that hasn’t received as much attention: the business behind stablecoins.
It turns out that stablecoin issuance can have significant upside across a range of mechanisms for capturing value. This upside is driven by seigniorage.
While there are diverging definitions in the literature, at a high level, seigniorage is the net revenue derived from money creation and the introduction of this money into the economy. Historically, seigniorage was the difference between the purchasing power of commodity money and the cost to produce it (e.g. the profits earned from issuing metal coins at a price above their melt value) and represented a significant source of income for monarchs and governments.
In modern economies, the majority of money is created by commercial banks through the act of lending. Commercial banks produce revenue primarily from functioning as financial intermediaries and money creators. While the lines are blurred with respect to the revenue attributable to each function, it’s generally understood that money creation is the primary income driver, as it allows commercial banks to lend in excess of their deposits. Without getting lost in semantics, commercial bank seigniorage can be thought of as some (likely majority) portion of the interests earned on banknotes held less interests paid on account deposits.
Stablecoin issuers, on the other hand, function exclusively as money creators and the seigniorage they earn depends on their issuance mechanics and network growth. Thus, when investors back a stablecoin project, seigniorage potential is a key valuation driver. Let’s explore this potential across the three major categories of stablecoins and discuss possible competitive implications.
Fiat-backed stablecoin systems accept fiat currency or other non-crypto assets as collateral, store it with custodians and issue tokenized IOU vouchers (stablecoins) on a 1:1 basis. The issuing company can generate revenue as a function of outstanding stablecoin supply, fiat collateral-base or transaction volume (on-chain or on exchanges). The following are the main ways these types of stablecoins capture value in practic
Issuers that employ this model charge a fee for issuing and redeeming their stablecoins in exchange for underlying fiat collateral. Revenue here is a function of the in/out flow, which is driven by changes in demand — primarily for access to crypto markets, with stablecoins serving as a major on/off ramp. Interestingly, fees in this model are limited by nature of the stability mechanism, as the spread between the stablecoin price and the underlying collateral must be greater than the fee to create arbitrage opportunities for traders. To encourage a tight spread, the issuer must limit its revenue potential from this strategy, which may explain Tether and TrueUSD’s choice of a 0.1% issuance/redemption fee (Tether actually has higher fees for redemptions, on the order of 0.4–3%). Assuming annual in/out flow of $10B and 0.1% issuance/redemption fee, this strategy could generate $10M in revenue.
Engage in market-making on exchanges, earning as a function of the bid/ask spread and exchange volume facilitated by the issuer’s trading desk. The bid/ask spread reflects the depth of order books on exchanges and depends on liquidity provided by the company, traders and other 3rd party market-makers. Importantly, bid/ask spreads tighten with increased trade volume and can be lower than 0.01% in a sufficiently liquid market. It’s also worth noting that market-makers run by the issuer are not differentiated from other market-makers, suggesting that this is not a primary monetization strategy as much as it a necessary function for the wellbeing of a stablecoin ecosystem.
Invest a portion of collateral-base in short-term treasuries and money market funds. This strategy is driven by the size of the collateral-base, interest rates on short-term investments and the reserve ratio — the ratio of reserves held as fiat vs productive assets. 1-month treasuries currently yield 2.2% annually, making this an attractive strategy. With a stablecoin market cap of $10B and a reserve ratio of 50%, this strategy would yield ~$110M in annual revenue. Note that this is an order of magnitude more lucrative than charging fees on issuance/redemptions, provided that annual in/out flow is comparable to market cap (not necessarily a fair assumption).
By no means do the above strategies encompass all possible ways to capture value in fiat-backed models — they are just the strategies I’ve seen employed so far. Of the above, short-term lending on a fractional reserve seems to be the most lucrative strategy. It’s important to note that fiat-backed stablecoin issuers can engage in multiple monetization strategies at the same time, though not all types of issuers share the same incentives to monetize their stablecoin systems.
Fiat-backed stablecoins are used most on centralized exchanges, serving as a desirable trading pair, safety asset and onboarding tool. Because exchanges receive meaningful utility from fiat-backed stablecoins, they could in theory justify issuing them without needing to monetize directly. This makes it challenging for non-exchange issuers to compete on user-imposed fees with Tether, USDC, GUSD, etc. For this reason, market-making and short-term lending may be the only viable long-term monetization strategies for fiat-backed stablecoins.
Crypto-backed stablecoins move away from centralized custody and provide a decentralized alternative that still maintains claims on collateral. As we depart from the simpler implementation of the fiat-backed approach, the design space expands and monetization strategies become more complex. In addition to the stablecoin that they issue, crypto-backed projects typically feature a second cryptoasset — a “volatility-coin” — that is intended to incentivize behaviors that benefit the system. While the issuing company or DAO maintains the flexibility to engage in market-making activities, the volatility-coin tends to be the asset of interest from an investment perspective.
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