The Race for Stablecoin Transparency

The stablecoin industry is plunging into a transparency war of sorts, with stablecoin issuers tripping over each other to provide the public with ever more financial information. 

Earlier this month, the company behind the world’s biggest stablecoin by market cap, tether, began to publish verified numbers on the makeup of its reserves. Tether was reacting to last month's move by Circle, the issuer of second-biggest stablecoin USDC, to disclose its own information about the composition of USDC's investments. CoinDesk's Frances Yue provides a useful summary of the recent ramp-up in the transparency war.

Any extra disclosure is good for stablecoin consumers. But for stablecoin issuers, the transparency wars make an already-difficult business model even more complicated to execute.

When it comes to transparency, an industry standard has evolved whereby the issuer publishes regular attestation reports. In these attestation reports, the stablecoin issuer attests to its auditor how many reserves it has, and the auditor examines this claim for validity. The auditor's findings then get posted for the public to see.

Up till now, attestation reports did not disclose much about the sorts of investments held to “back” stablecoins. And so the composition of stablecoin reserves has always been mostly a matter of conjecture and rumour. With Tether and Circle now providing attested information about the composition of their assets, and not just quantity, consumers finally know what that "something" is.

In Tether’s case, its biggest reserve asset is commercial paper, most of it rated A-1 or A-2. And USDC’s preferred backing asset is cash and cash equivalents, with a big allocation to Yankee certificates of deposit.

I suspect this new transparency will create beneficial knock-on effects for consumers. Equipped with more information, consumers can better shop around for the safest coins. To attract them, stablecoin issuers will have to demonstrate their backing assets are sound. That means the entire sector will be pressured to cleanse itself of dreck collateral.

This process may even satisfy regulatory hawks, who have begun to circle the stablecoin sector with concerns about the possibility of stablecoin runs and contagion effects.

In Tether's case, we've already seen an improvement in asset quality. As one of the many conditions of a February legal settlement with the New York Attorney General, Tether was obliged to provide a quarterly breakdown of its investments to the public.

To comply, Tether produced its now notorious pie chart, an information-lite graphic that raised more questions than it answered. The pie chart showed, for instance, that 24% of Tether's investments (as of March 31) were held in the form of a scary-looking assortment of assets that included secured loans, corporate bonds, funds and precious metals, and other investments.

Tether's newest attestation (dated June 30) reveals this scary grouping had fallen to just 15% of assets. Meanwhile, Tether's allocation to Treasury bills, a safe short-term form of government debt, has risen from 3% to 24%. With greater transparency comes more pressure to invest customers' funds prudently, it would seem. 

If tether stablecoins are safer than before, there's plenty of work to do. Tether should be telling users more about its corporate bond portfolio. What is the minimum rating of its bonds? What is their average maturity?

As for Circle, courtesy of its beefed-up attestation reports we now know that 61% of USDC’s investments are placed in cash and cash equivalents. Unfortunately, by consolidating these items together, Circle doesn't provide sufficient granularity. Circle should do what Tether has already done in its reporting: deconsolidate cash, the safest of backing assets, from riskier 90-day commercial paper.

Stablecoin customers are better off now than a few months ago. But what about stablecoin issuers? 

The transparency wars will only make things more complicated for Circle, Tether and the rest. To begin with, regular attestations aren't free. Auditors need to be paid. And the more complex the auditing requirements, the higher an auditors' fee.

Even worse, a transparency-induced competition to safety means lower revenue for issuers. A big portion of stablecoin revenue accrue from the interest income thrown off by a stablecoin's backing investments, which issuers keep for themselves rather than paying out to their customers. A five-year corporate bond currently yields around 1.2% per year. With increased transparency, juicier assets such as these will be increasingly out of bounds for issuers. But the alternative, safe assets like Treasury bills and bank deposits, don't yield much. These days they offer a miniscule 0.05% or so.

Stablecoin financial health has already been damaged by low interest rates. When COVID-19 hit in March 2020, global interest rates plunged and have stayed low ever since.

Here’s an example of the damage that’s been inflicted. According to Circle's recently published financial statements, there was only $520 million USDC in circulation at year-end 2019. By year-end 2020, this number had hit $4 billion. That’s an impressive growth rate. But the collapse in interest rates nullified all of USDC’s expansion. USDC made more interest income in all of 2019 ($6.2 million) than it did in 2020 ($4.4 million), despite being just 1/10th the size.

If increased transparency crimps stablecoin revenue, a boatload of other costs only adds to the complexities of turning a profit. Stablecoin issuers must fight other crypto firms for talent. Regulation is also expensive. Circle, for instance, has 44 different money transmitter licenses, each of which has its own requirements. The company has expressed an intention to become a full-reserve bank, but that will subject it to more demanding liquidity and capital requirements.

To fight for market share, stablecoin issuers sometimes split interest revenue with large customers. In the quarter ending March 30, 2021, for instance, Circle owed "USDC rebates" of $5.7 million to customers with whom it shares revenue. That's a big chunk of Circle's revenue out the window.

This combination of lower interest rates and a raft of expenses is why Circle lost $9 million in the first quarter of 2021 on revenue of $17 million. (We only know the financial health of Circle because it is planning an initial public offering, and must disclose this information.)

There is another potentially large expense on the horizon. Right now, stablecoin users limit their customer due diligence to users who want to redeem or deposit for actual U.S. dollars. Anyone in between is allowed to use stablecoins without being identified. I can receive $1 million tether and send them to you, and neither of us need to reveal who we are. This "in-between" segment comprises a big percentage of stablecoin users.

However, the U.S. President's Working Group on Financial Markets has said that stablecoin arrangements "should have the capability to obtain and verify the identity of all transacting parties, including for those using unhosted wallets." In a recent interpretive letter on stablecoin arrangements, the Office of the Comptroller of the Currency (OCC) echoed the Working Group's conclusions.

If these requirements are eventually imposed on stablecoins, that would mean they would have to collect information about all users, potentially exploding their know-your-customer/anti-money laundering (KYC/AML) budgets.

Banks can afford all of these costs because they have multiple lines of business including investment banking and insurance. Huge portfolios of long-term assets provide a solid stream of interest payments: mortgages, corporate loans, consumer credit and more. But unless they want to become banks, stablecoins can only rely on low-yield, low-yielding assets for interest income.

As for non-banks like PayPal, they rely less on interest income to generate revenue and more on transaction fees.   

If they are to survive, stablecoins probably can’t remain the plain-vanilla stablecoins they've been for the last six-or-so years. They may have to start adding bank-like products or PayPal-style fees.

Circle is already adding bank-like products. It offers customers the chance to lend their USDC stablecoins to Circle and earn interest, which Circle then lends to third parties. However, with crypto lenders BlockFi and DeFi Money Market recently running afoul of securities law for offering similar lending products, the window for extracting revenue from this business line may be narrowing.

That’s not all Circle is doing. In late 2020, it rolled out a transactional services offering that provides APIs for customers who want to use USDC accounts for salary or supplier payouts. Already this business line is beginning to bring in more revenue than the interest income harvested from USDC’s assets.

Amid already low interest rates, transparency wars and ongoing regulatory uncertainty, it remains to be seen whether new product lines are sufficient to ensure that stablecoins remain a viable payments product. One thing that is certain. The more transparency there is, the safer the product is for consumption.