Stablecoins are one of the most used type of crypto assets, with three stablecoins in the top 10 of cryptocurrencies by market cap. Crypto traders take profit in stablecoins, and for remittances they are extremely fast and cheap. Regulators as well tend to be positive towards stablecoins, sometimes considering them a part of the future financial system. But who is on the ‘other side of the trade’? In other words, what is stable coin issuers’ business model? How do stablecoins make money? That depends on the type of stablecoin.
Stablecoins can be divided into three main camps.
- Centralized stablecoins that hold fiat collateral off-chain
- Decentralized stablecoins that hold crypto collateral on-chain
- Algorithmic stablecoins without collateral but a volatility coin to maintain the peg
| Type of stablecoin | Example | Backing | How does it make money? |
| Centralized, fiat collateralized | USDT, USDC, BUSD | Each stablecoin is backed one-on-one by a dollar or euro, off-chain | Lending on the money market, fees |
| Decentralized, crypto collateralized | DAI | Over-collateralized by other crypto assets, on-chain | Interest on borrower’s stablecoins, fees |
| Algorithmic, non-collateralized | USDD, (former) UST | Volatility coin | Arbitrage of peg difference |
Centralized Stablecoins Make Money (Mostly) by Lending
Centralized stablecoins are called centralized because they have a company behind them, with a board of directors and all. The company operates somewhat like a money market fund (more on that below). The assets that back the stablecoins the company issues are held on the balance sheet or through third parties like banks.
The prominent way in which centralized stablecoins make money is through short-term lending. The company behind the stablecoin takes a portion of their assets and lends them out to earn interest. A part of the funds are kept in dollars or whatever the currency that the stablecoin represents.
Fees for Exchanging Stablecoins
Stablecoin companies in some cases charge fees. Tether does this, for example. Circle, the company behind USDC, doesn’t. When you create Tether’s USDT stablecoins by handing over your collateral, you pay a 0.1% fee. Same if you redeem your stablecoins for the original collateral. In practice, retail investors won’t often do this. They can simply turn to crypto exchanges if they want to exchange stablecoins for dollars.
To Which Parties do Stablecoin Companies Lend?
Stablecoin companies mostly lend to traditional institutions such as the American government, which is considered the safest form of lending. Why? Because the US government is considered the most creditworthy entity in the world (one can wonder if this will stay the case though…). Also, the treasury market is – most of the time – very liquid. Meaning that stablecoin issuers that are faced with a lot of redemption demand can sell large sums of their collateral treasuries without the price dropping.
Circle, the company behind #2 stablecoin USDC, publishes its monthly attestations on its website (below are the numbers for October 2022).
As you can see from USDC’s attestation, of their 43 billion in reserve assets, the vast majority are held as US Treasuries. The rest is cash. The maturity date of the treasuries is extremely short: on average 28 days.
Tether’s Holdings
Tether, the issuer of the number 1 stablecoin in terms of market cap, is less transparent about its holdings (see below).
On the medium risk part of the spectrum, stablecoin companies loan to corporations and municipalities. Riskier than US treasuries but (hopefully) higher yields. Tether, for example, does this. As per September 2022, Tether’s holdings were:
As you can see, Tether’s US Treasury bills make up less than 40 billion of the 68 billion in market cap. A relatively large sum is invested in for example money market funds (7 billion) and unspecified ‘other investments’ (2.6 billion). Presumably, the latter are venture capital investments, which are highly illiquid – but potentially profitable.
Another potential source of lending revenue comes from the crypto sector. Stablecoin issuer Tether has lent to crypto lending platform Celsius. Needless to say, those loans proved to be much riskier than the loans to traditional financial institutions.
Similarities Between Centralized Stablecoins & Money Market Funds
Like a stablecoin issuer, a money market fund invests in debt-based financial instruments like US Treasuries. It issues shares worth $1 and, like stablecoins, it tries to keep this peg.
A difference with stablecoins is that profits are paid out as dividend payments. But the yields are not high enough to consider money market funds long term investments. Instead, they are considered safe places to temporarily park your money.
Also like a stablecoin issuer, a money market fund could find itself in a situation where it can’t meet redemption requests. This has happened on a few occasions. That’s why regulation for money market funds has become stricter: they have tight restrictions on portfolio holdings. A money fund mainly invests in the top-rated debt instruments, and they should have a maturity period under 13 months. Stablecoins regulations in the US markets are still not clear.
Decentralized Stablecoins: Fees
MakerDAO is a Decentralized Autonomous Organization (DAO) that issues stablecoin DAI. This stablecoin is backed by collateral that is a basket of crypto coins, for example Ether and USDC. This collateral, often called a collateralized debt position or CDP, is locked up in a smart contract.
How does this work? In addition to the stablecoin DAI, a crypto-backed stablecoin project like MakerDAO issues a second crypto asset: a volatility coin. In the case of Maker it is called MKR. Fees on on-chain transactions are paid to MKR holders. CDP holders also pay a so-called stability fee for generating Dai and closing their accounts. That’s how the MakerDAO makes money.
Algorithmic, Non-Collateralized Stablecoins: Peg Arbitrage
The term algorithmic can be misleading, as the category of decentralized but collateral-backed stablecoins like DAI are also automatic/algorithmic in the way they operate. Why? Because it’s software/smart contracts which determine how the vault with crypto collateral is automatically adjusted.
But in the case of algorithmic stablecoins, they have no real collateral. Instead there’s a built-in arbitrage incentive to mint or burn the stablecoin, a continuous feedback mechanism which stabilizes the price. For example, whenever the price of this kind of dollar stablecoin is slightly below one dollar, you can burn one stablecoin. This reduces the supply and makes the price go up (and vice versa). But how do people make money in this setup? For burning a stablecoin, they get one dollar worth of volatility coin in return. For example, the failed stablecoin Terra (UST) allowed people to mint one dollar worth of LUNA regardless of the exact dollar price of UST.
So the arbitrage opportunity in this case would be:
- Buy one stablecoin for 0.99 cents
- Burn it and get 1 dollar worth of volatility coin in return
- Sell the volatility coin and pocket the 1 cent profit
Non-Dollar Stablecoins
Dollar stablecoins are far more prolific than non dollar stablecoins, for example euro stablecoins. One reason is that the euro is less in demand than the dollar. The other reason is that making money on euro reserves is harder than on dollar reserves. The interest on euro bonds is lower than the interest on US treasuries.
Erik started as a freelance writer around the time Satoshi was brewing on the whitepaper.
As a crypto investor, he is class of 2020. More of a holder than a trader, but never shy to experiment with new protocols.
