Yield Bearing Stablecoins - UPDATE

Yield Bearing Stablecoins - UPDATE

Yield-bearing stablecoins are exactly that: stablecoins with interest. For a variety of reasons, stablecoins started out not paying interest.  Yields were negative or close to zero, their primary use-case as a 24/7/365 settlement unit between traders and exchanges far outstripped any interest component in a world where crypto was still largely unbankable. An interest component could have increased the regulatory scrutiny as a possible security, and given a patchy track record concerning disclosure and reserves anybody using or accepting a stablecoin like Tether was doing so out of necessity not choice.

Although Tether started trading on the Omni chain in 2014 it only became significant in terms of trading in 2018 where it grew from 10% of BTC volume to over 80% during that year.  Fast forward 5 years and Tether has become a force to be reckoned with in crypto and arguably the most profitable company on earth when measured on a per-employee basis. This is not all Tether's doing, but largely a factor of them being (i) in the right place at the right time from a jurisdictional perspective (i.e. not the US), (ii) having cleaned up their act/disclosure enough to hold onto the dominant stablecoin position when the competition heated up, and (iii) the US Government raising interest rates at the fastest rate in history and Tether now being a systemically important funder of the US treasury as a top 20 holder of US Government paper. We will argue however that this is about to change.

Given jurisdictional advances in providing regulatory clarity for stablecoins (MICAR & the US Stablecoin Bill making its way through Congress). We believe that the competitive landscape for Stablecoins is about to undergo a radical transformation, driving the adoption of stablecoins as a fully reserved global transactional settlement layer and a viable alternative to bank deposits should they also become yield-bearing.  This will drive more and more people to hold deposits on-chain and separate the function of high-velocity money as a settlement layer and SOV from credit creation.

But let's go back to basics before we jump to conclusions. There are three different types of stablecoins, each with its own way of fixing (pegging) their value.

  • Fiat / Commodity-backed / fully collateralized
  • Cryptocurrency-backed / over-collateralized
  • Algorithmic / under-collateralized

Fiat & Commodity-backed  / fully collateralized stablecoins

The most popular stablecoins in the market are ones that are fully backed by fiat, bonds, or commodity collateral. Circle (USDC) and Tether (USDT), for instance, are pegged to the U.S. dollar (USD) at a 1:1 ratio and fully collateralized by US treasury bills, bonds, and cash in the form of bank deposits. Similar stablecoins exist for the Euro, the British pound, the Japanese yen, and the Chinese RMB

Commodity-backed stablecoins are pegged to the value of commodities. Tether gold (XAUT) is an example of a commodity-backed stablecoin. XAUT is fully backed by gold reserves kept inside a vault in Switzerland. One ounce of gold is equal to one XAUT.

Because the price of these stablecoins is pegged to the unit of collateral being held, whether that be the USD price of an ounce of gold or the USD price of a T-Bill there is no need for over-collateralization other than to guarantee liquidity and/or show positive reserves to compensate for counterparty risk.

Multi- or over-collateralized stablecoins

Without getting too meta, crypto-backed or multi-collateralized stablecoins are pegged to a currency but collateralized with one or more established cryptocurrencies. For instance, MakerDAO issues DAI one of the most popular dollar-pegged multi-collateralized stablecoins against ETH, BTC & other stablecoins. It uses smart contracts to maintain a safe level of over-collateralization relative to the value of the more volatile underlying collateral so that the collateral held always exceeds the value of the stablecoins in issue (borrowed into existence against the collateral).

Algorithmic stablecoins

Not backed by any “real-world” financial assets,  commodities, or established crypto assets, this category of stablecoins uses algorithms to regulate the supply to maintain a price peg. In short, these algorithms automatically burn (permanently remove coins from circulation) or mint new coins based on the fluctuating demand to maintain the peg for the stablecoin at any given time.

A lot of trial and error has gone into the quest to create algorithmic stablecoins, as they are deemed by many to be a holy grail for crypto.  To date, however, the yield on such algo's has been mostly inflationary. The epic failure of Terra's UST stablecoin and others before it seems to suggest that algorithmic stablecoins are more akin to fractionally reserved banks than any holy grail.

What are yield yield-bearing stablecoins?

So back to yield-bearing stablecoins. Now that interest rates have gone up globally, assets, including non-yield-bearing stablecoins, fiat currencies (bank deposits), and government bonds can all be used to generate yield which should (at least partially) accrue to stablecoin holders just like they would to holders of bank deposits or shares in a money market fund.

The resistance to sharing the underlying yield by the incumbents (USDC & USDT) can probably be ascribed to their need to appease regulators not wanting to accelerate what is colloquially referred to as the "slow walk" (as opposed to the revered "bank run") of deposits out of the banking system and into money market funds and other higher-yielding alternatives.

Other stablecoin initiatives however are paving the way to share the underlying yield. Ondo Finance through its onchain counterparty Flux Finance is allowing whitelisted users to lend/borrow stablecoins against tokenized treasury holdings allowing them to generate yield/leverage on the treasury collateral they own.  Mountain Protocol (USDM) and others have figured out how to maintain a fully collateralized treasury of US government securities against which they issue yield-bearing stablecoins to non-US citizens. Angle.Money a multicollateralized EUR-denominated stablecoin issuer has pionered utilizing BAKKT tokenized institutional EU money market product to provide yield in the form of staking rewards and made the staked (receipt) token as liquid as the original non-yield-bearing multi-collateralized agEUR stablecoin, another innovative manner of layering yield on stablecoins. The above are examples of players using the jurisdictional/regulatory arbitrage to shift the boundaries of what a stablecoin can be.  The last one I want to mention in that regard is Ethena.fi, an attempt to create a stablecoin based on a delta-neutral hedging strategy around staked ETH which in turn has embedded ETH staking yield. This may be a semi-algorithmic stablecoin that could actually work.

To date, a lot of the DeFi and stablecoin activity has been Ethereum-centric but high gas fees and scaling issues have restricted adoption and caused fractionalization.  During the bear market part of the crypto cycle, Tron actually became a major settlement layer for USDT transactions.  Solana showed some traction early in the cycle, but post-EIP 1559, the Ethereum L2s are effectively all at the same level in terms of cost, so we would argue gas fees and scaling issues are no longer a real constraint.

What is the source of the yield?

There are different ways to generate yield for/on stablecoins. The first one to be built was ideologically pure, through decentralized lending.  Allowing stablecoin or other crypto collateral to be deposited into a smart contract, which then lends out this collateral to borrowers. Borrowers must pay interest & over-collateralize their loans, making them rather inefficient means of generating leverage.  That said, these protocols worked pretty much as intended throughout the last two crypto cycles and distributed yield to the collateral providers without meaningful defaults, sometimes at the cost of liquidation. Successful examples of such include MakerDAO, Aave & Compound.

The success of these decentralized lenders was followed closely by centralized/custodial attempts at providing leverage to the HF-trading and other crypto native players, most of which ended in tears when the cycle turned and it turned out credit & collateral was not managed in accordance with the underlying volatility of crypto borrower creditworthiness.

Next in line are attempts at using other yield-bearing assets, ie. Liquid Staking Derivatives, to issue loans against collaterals that have embedded or rebasing yield. This approach enables holders to leverage the asset further in DeFi protocols and loop or ‘compound’ the yield of the principal through composability. Unfortunately, a lot of this so-called "yield" has historically been in inflationary tokens that died with the end of DeFi summer.  It will be interesting to see the next incarnation of these ideas when the Eigenlayer type of re-staking yields becomes a reality.

The last approach has been to bring off-chain yield on-chain and simply distribute that yield to holders. Historically this was deemed difficult to execute due to regulatory constraints, but lately, it has gained a lot of traction and interest from the TradFi community. It is one of the main drivers of the RWA narrative, and some even go as far as calling it the engine that will ‘take DeFi to a Trillion Dollar Marketcap’.

Why do yield-bearing stablecoins matter?

Taking a step back it is clear that properly constituted/collateralized yield-bearing stablecoins are superior to their non-yield-bearing brethren.  What is more important, however, is that they are superior to traditional alternatives, namely bank deposits or money market funds. First, they offer an effective & efficient mechanism for holders to earn interest on their cash holdings without ceding control/custody of their balance (only the underlying collateral). Their issuance and collateralization can be made transparent on-chain (through audits/oracles/proof of reserves), alleviating dependence on jurisdictions/regulators to "police" such matters, elegantly putting an end to the abuse of fractional reserves and/or implicit government guarantees by those deemed too big to fail.  Stablecoins are natively digital and therefore globally applicable, thus less dependent on jurisdictional limitations. All of these pros have serious cons when perceived from a TradFi/incumbent's perspective. Still, it should be clear to all who spend a few minutes thinking about this topic, that once the initial cold start problems of the current yield-bearing stablecoins are overcome, they will be unstoppable because the demand from them will overwhelm whatever TradFi/jurisdictional limitations remain to capture deposits at subpar yields, especially in inflationary currencies. So much so, that I believe CBDC's (should they remain non-interest bearing as currently envisioned) will be more like food stamps than actual money.

Instead of banks earning the yield on the treasuries they bought with your deposits and then earning additional yield through rehypothecation of those same treasuries and leveraging them through their fractionally reserved balance sheets, individuals will accrue the "safe" treasury and/or liquid staking yield and have the choice to further increase that yield by using the yield-bearing stable as collateral for more risky lending or alternate DeFi activity. Thus decentralizing credit creation and reducing the systemic risk of too-big-to-fail financial institutions. But, I hear you think, what will happen to all those overleveraged players... Nothing, they will slowly bleed deposits and collateral to this new/better decentralized system on crypto rails, and this, in turn, will lead to a financial renaissance akin to what was seen when the Medici propagated the use of double-entry accounting and birthed traditional banking and financial services as we know them today. Regulators and central banks across the world are fully cognisant of the need for change, what they are a bit slow to realize is that this revolution will not be led by them and it will not be televised as it is already underway, and it's here to stay.

Risks of yield-bearing stablecoins

Yield-bearing stablecoins come with risk, namely that the underlying collateral of the stablecoin is not sufficient to maintain its value/peg. This recently happened to USDC when part of their reserves that were held at Silicon Valley Bank were in danger of being compromised due to SVB's demise.  Luckily Circle's reserves were more than adequate and Circle's bank deposits at SVB were ultimately recovered. What was interesting was that the market instantly absorbed and priced all of this information without any intervention from central banks or regulators whilst depositors at SVB had to be made whole for the mark-to-market losses that were known to all but remained unaccounted for on SVB's balance sheet for quarters on end. This all goes to show that even though fully reserved banks/savings initiatives like Caitlin Long's Custodia bank are indeed fully reserved stablecoins like USDT & USDC have been resisted by regulators to protect deposits underpinning the fractionally reserved TradFi system,  they represent a better alternative in a world where money can be moved at the touch of button 24/7/365 .

Another risk is that the issuing platform or decentralized lending protocol may be hacked or exploited. This could lead to the loss of stablecoin holders’ funds. Ultimately the smart contract risk and counterparty risk play a large role here — with regular exploits plaguing the vertical regularly. This is a complex issue that to my mind does not yet have a satisfactory answer/solution. That said, as long as we regularly have failing banks and the SEC can't even secure their own Twitter/X account, it is not clear that centralization and regulation are better than decentralization & encryption.

The players to date

The biggest yield-bearing stablecoin player to date is undoubtedly MakerDAO with DAI (sprakprotocol.io). MakerDAO is a decentralized lending protocol that allows users to mint DAI, a USD-pegged stablecoin. DAI is backed by a basket of assets, including other stablecoins, fiat currencies, and government bonds. MakerDAO users can earn interest on their DAI by depositing them into the DAI Savings Rate (DSR). The DSR is a smart contract that lends out DAI to borrowers. Borrowers pay interest on the loans, which is then distributed to the DAI depositors. Sparkprotocol.io also lets you borrow DAI against your Liquid Staking Tokens (LSTs) like stETH.

In addition to DAI, there are several other yield-bearing stablecoins available. Some popular options include:

  • sUSDT (USDT Savings) and eUSDC (USDC Earn) — the two staples by Tether and Circle.
  • stEUR using tokenized BAKKT EU money market fund from Anlge.Money that acts as a Euro-denominated MakerDAO/DAI lookalike.
  • mkUSD, DUSD, eUSD, and R and CASH — backed by LSTs mostly stETH.
  • USDM, USDY, and USDR — backed by Real World Assets such as Treasury Bills and Real Estate.

So what's next? Where are the next big innovations in this space going to come from? If you listen to crypto Twitter: ‘RWAs!’ seems to be the answer everyone agrees with.

BREAKING NEWS: ‘RWAs are fueling the next crypto bull run!’

In the ever-evolving world of stablecoins, innovation continues to drive the industry forward. DeFi has been a transformative force and its evolution has led to the emergence of real-world assets (RWA) packaged as yield-bearing stablecoins. According to many, these new developments have the potential to not only revive DeFi but also fuel the next crypto bull run.

DeFi represents a shift from traditional financial systems to decentralized, blockchain-based alternatives. The beauty of DeFi applications is to enable users to access a wide range of financial services, without the need for traditional intermediaries like banks, often referred to as “money legos.” In 2022 and 2023 the DeFi space matured, and the need to bridge the gap between TradFi and crypto became evident: this is where Real-World Assets (RWA) come into play.

RWAs are fueling DeFi

Real-World Assets (RWA)

RWA refers to off-chain assets that are tokenized and brought on-chain for use in DeFi applications. Tokenization involves converting real-world assets, such as treasury bills, real estate, commodities, or even debt, into digital tokens. These tokens represent ownership and value, allowing them to be traded and used in blockchain-based financial applications. Tokenization simplifies the transfer of ownership, provides transparency, and enables fractional ownership, making it possible for a broader range of investors to participate — it democratizes access while making transactions more capital-efficient.

RWA tokens come in various forms, including equity-based, real asset-based, and fixed income-based. These tokens have the potential to significantly expand the range of assets available for DeFi use. Notable examples include Goldfinch, Centrifuge, Maple Finance, ClearPool, and Florence Finance, each offering unique approaches to RWA in DeFi. The best resource for RWAs at the moment is rwa.xyz.

The Promise of Yield Bearing Stables ("YBS")

While RWAs represent a bridge between traditional assets and DeFi, yield-bearing stablecoins add an exciting layer to the DeFi ecosystem. Yield-bearing stablecoins play a crucial role in DeFi for several reasons:

They can be generating passive income, while contributing to the liquidity of DeFi platforms by incentivizing users to supply their assets/collateral to lending and liquidity pools, thus facilitating liquidity, borrowing, and lending within the ecosystem.

Yield-bearing stablecoins also provide a way to manage risk. They offer stable value with yield, which can be used to hedge some of the volatility of other crypto assets and help diversify a user’s portfolio by holding more stable assets and/or exposure to traditional assets/RWAs (while staying within the DeFi ecosystem).

The stability of YBSs and the inclusion of real-world assets in DeFi expands its utility. As DeFi and stablecoins mature, they increasingly provide alternative solutions for traditional financial needs.  We foresee a future where people will be able to pick and choose how they want to utilize their assets/collateral to earn yield, provide liquidity, or indeed invest in riskier endeavors and DeFi will become the marketplace for a newfound abundance and diversity of such products.

Yield as a driver of liquidity

Yield-bearing stablecoins introduce a new dimension of attractiveness to DeFi.  For instance, during periods of rising interest rates, such stablecoins can offer competitive yields, making them an enticing option for investors looking for passive income as can be seen with the current craze for tokenized treasury yield.

These yield-bearing stablecoins, in turn, attract new liquidity, and given their composability within the DeFi ecosystem, they drive liquidity of the system as a whole. Liquidity is the lifeblood of financial markets, and stablecoins encourage users to provide their assets for lending or staking, which, in turn, supports borrowing and trading activities. This increased liquidity and capital inflow can be a driving force behind the growth of DeFi in the future.

As real-world assets are integrated into DeFi, we witness the potential for crypto to drive positive change in traditional finance. These developments showcase the industry’s ability to adapt and create innovative solutions that transcend the limitations of traditional systems.

Finally, the convergence of RWA and yield-bearing stablecoins in the DeFi ecosystem signifies a significant leap forward in the crypto industry. A leap that makes the benefits of DeFi clear to all — even TradFi! The inclusion of Yield Bearing Stablecoins expands the possibilities for investment while offering attractive yields, new primitives, and even new composability with DeFi.

Yield-bearing stablecoins thus offer numerous benefits and usher in a new age of blockchain finance. They allow holders to earn everything from pretty riskless folly collateralized treasury or LST-based yield and layer new RWA-based yields on top of that in an easily accessible, permissionless way.

We would argue, these benefits far outweigh the risks today already and these risks are likely to be diminished and/or better understood & mitigated over time.  Once mainstream TradFi catches up with that point of view, we could see an unseen amount of liquidity being poured back into the DeFi and crypto ecosystem-potentially reigniting interest in blockchain and thus the next cycle’s bull run.