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Hi friends ​​👋, 

Happy Thursday! 

As the dust has begun to (hopefully) settle on the crypto crash, people have begun sorting through the rubble to figure out which products from this last cycle were useful and real, and which were hypes and ponzis. I’ve thrown my hat into this ring too many times, including two pieces on web3 use cases: Today and in the Future. 

One category that seems to be unanimously viewed as useful, outside of the most skeptical skeptics, is stablecoins. It’s one of the use cases I highlighted a month ago. And among the stablecoins, the consensus seems to be that USDC is the stablest of them all. 

Stablecoins are sneakily fascinating because they’re both a digital currency and a sort of platform on top of which new applications can be built, or old ones improved. But to achieve that promise, they need to actually be stable. A dollar-denominated stablecoin, like USDC, needs to be redeemable for a good ol’ fashioned US Dollar, every time, everywhere. 

If a stablecoin can be trusted to perform that foundational obligation, then developers can begin to build financial products on modern digital rails. Sometimes, they’ll build entirely new applications, like DeFi protocols. Others, they’ll rip out pieces of old, creaky financial infrastructure and replace them with newer rails. 

The revolution does not need to be total to be impactful. Circle is a case study in compromise. It’s a centralized company facilitating the growth of a decentralized financial system. It’s used by web2, web3, and web2.5 companies alike. It’s happy to sit in the background, facilitating fast, cheap, global payments and loans while others build shiny interfaces and sturdy guardrails on top. 

After seeing USDC’s outperformance during the bear market – its market cap has grown as the overall market has shrunk – and seeing a lot of people I respect point to USDC as a gold standard, I decided to team up with Circle to tell the story via a Sponsored Deep Dive. You can read more about how I choose which companies to work with on Sponsored Deep Dives here. In this case, I realized that I didn’t know nearly as much about stablecoins as I should, and I was pumped that they were willing to work with me to help understand and then explain. 

As always: this is not financial or investment advice. I’m an idiot, and I’m learning as I go – you would be foolish to allocate your cash based on anything I write. Do your own research. But I hope that it’s an entertaining and informative look into one of crypto’s key building blocks. 

Let’s get to it. 

Circle & USDC: Building a Stable Platform

(Click the link to read the full thing online)

Yes, I know. This newsletter is called Not Boring. But I’m going to start this essay off by showing you the Most Boring Chart in All of Crypto. 

That’s the 1 year price chart of USD Coin (“USDC”), the fiat-backed, fully-collateralized, dollar-denominated stablecoin issued by Circle. I dare you to find me a more boring chart. 

For the entire past year, as prices of other crypto assets rollercoastered up and down and up and very down, USDC hugged the $1 line tightly. 🥱

For stablecoins, boring is good. Boring is the goal. And being the most boring stablecoin results in a chart that isn’t very boring at all: 

That’s USDC’s market cap since its inception in October 2018, which represents the total USDC in circulation. At the time of writing, July 20th, 2022, that number stands at $54.8 billion. Circulating USDC has more than doubled in the past year, after growing 25x between July 2020 and July 2021. Since its price is pegged to $1, increases in market cap mean that there’s more usage of USDC (the inverse is also true – the market cap declines when people redeem their USDC for Dollars).

Boring is a feature, not a bug. It’s key to Circle’s first product value proposition – digital dollars – and it’s key to Circle’s mission: To raise global economic prosperity through the frictionless exchange of financial value. 

If you’ve heard of Circle, it’s likely because of USDC. That’s the company’s first killer product. Recently, it announced that it’s launching a second, Euro Coin (EUROC).

But thinking about USDC and EUROC as just stablecoins misses the company’s ambitions to become:

• The platform on top of which developers build a new financial system

• The digital currency of choice institutional investors leverage for trading and settlement

• A tool that enables the frictionless, borderless exchange of value

It’s an ambitious bet in a competitive space, and one dogged by both valid and invalid concerns, many of which we’ll cover in this piece. Circle is trying to differentiate on trust, the necessary foundation for its ambitions. Increasingly, it seems to be working.

I didn’t give much thought to stablecoins until Luna’s UST blew up a couple of months ago. But as I’ve dug in, I’ve realized that they’re one of the most solid use cases in web3 today, and a fundamental building block in the much bigger visions entrepreneurs in the space are building towards. Once the idea of programmable, permissionless money worms into your brain, it’s hard to see where stablecoins wouldn’t provide an improvement over the status quo. 

But let’s start with the basics and build up from there: 

• What are stablecoins? 

• How do stablecoin issuers generate revenue? 

• Why are stablecoins a valuable primitive? 

• How are USDC and Circle a platform? 

• What is Circle’s competitive advantage? 

• What would a new financial system built on Circle’s rails look like? 

What Are Stablecoins?

If you’ve followed the crypto markets recently, you might’ve heard the word “stablecoin” and chuckled. “Stablecoin, huh?” you’d quip, “Not very … stable 😂.” It’s a funny joke. 

In May, UST (Terra’s stablecoin) lost its peg to the dollar (translation: it became worth less than $1). It flushed hard, bringing the entire Luna ecosystem down with it. Ultimately, it brought down crypto hedge fund Three Arrows Capital (“3AC”) which contributed to the downfall of Celsius, BlockFi, Voyager, and other Centralized Finance (“CeFi”) lenders. Friend of the newsletter Jon Wu wrote a great thread / Not Boring essay on Terra-Luna and UST, and Arthur Hayes wrote the definitive piece on the 3AC collapse in case you want to read more gory details. 

The UST situation brought to light something that was apparent to anyone who dug into the math or simply walked through the logic: not all stablecoins are created equal. Not all stablecoins are … stable. 

The goal of a stablecoin is to stay pegged to its reference asset. For most stablecoins, that’s the US Dollar. So one (1) USD stablecoin – like USDC – should be worth $1. As Alex Danco wrote in 2018: 

The crucial test that any stablecoin must pass for the market to actually trust it is: if a user wants to redeem their stablecoins for genuine dollars, under any reasonable circumstance, can they do so?

“Reasonable” is doing a lot of work here. People should always be able to redeem their stablecoins for genuine dollars. There are three main models stablecoin issuers pursue to make that happen: 

1. Fiat-Backed

2. Cryptocurrency-Backed

3. Algorithmic

We’ll start last, first. Algorithmic stablecoins, like UST, aren’t backed by dollars, a basket of cryptos, commodities, or anything, really, outside of what they create themselves. 

Instead of explaining this insanity myself, I’ll turn it over to the inimitable Matt Levine:

Here is how an algorithmic stablecoin works:

1. You wake up one morning and invent two crypto tokens.

2. One of them is the stablecoin, which I will call “Terra,” for reasons that will become apparent.

3. The other one is not the stablecoin. I will call it “Luna.”

4. To be clear, they are both just things you made up, just numbers on a ledger. (Probably the ledger is maintained on a decentralized blockchain, though in theory you could do this on your computer in Excel.) 

5. You try to find people to buy them.

6. Luna will trade at some price determined by supply and demand. If you make it up on your computer and keep the list in Excel and smirk when you tell people about this, that price will be zero, and none of this will work.

7. But if you do a good job of marketing Luna, that price will not be zero. If the price is not zero then you’re in business.

8. You promise that people can always exchange one Terra for $1 worth of Luna. If Luna trades at $0.10, then one Terra will get you 10 Luna. If Luna trades at $20, then one Terra will get you 0.05 Luna. Doesn’t matter. The price of Luna is arbitrary, but one Terra always gets you $1 worth of Luna. (And vice versa: People can always exchange $1 worth of Luna for one Terra.)

9. You set up an automated smart contract — the “algorithm” in “algorithmic stablecoin” — to let people exchange their Terras for Lunas and Lunas for Terras. 

10. Terra should trade at $1. If it trades above $1, people — arbitrageurs — can buy $1 worth of Luna for $1 and exchange them for one Terra worth more than a dollar, for an instant profit. If it trades below $1, people can buy one Terra for less than a dollar and exchange it for $1 worth of Luna, for an instant profit. These arbitrage trades push the price of Terra back to $1 if it ever goes higher or lower.

11. The price of Luna will fluctuate. Over time, as trust in this ecosystem grows, it will probably mostly go up. But that is not essential to the stablecoin concept. As long as Luna robustly has a non-zero value, you can exchange one Terra for some quantity of Luna that is worth $1, which means Terra should be worth $1, which means that its value should be stable.

“All of this is,” Levine writes, “quite straightforward and correct, except for Point 7, which is insane.” $UST and $LUNA rose in tandem, and they fell in tandem. 

After UST’s collapse, the market for algorithmic stablecoins will likely be muted for a long time, so we don’t need to spend more time here. 

Cryptocurrency-backed stablecoins are backed by a basket of cryptocurrencies and are typically overcollateralized, meaning that the dollar value of cryptocurrencies in the reserve exceeds the dollar value of stablecoins outstanding. They achieve this by requiring each user to deposit more in another token, like ETH or BTC, than they pull out in stablecoin. 

The leading example here is MakerDAO’s stablecoin, DAI, with a $7.2 billion market cap.

Here’s how it works: 

1. A user who wants to take out a loan opens a Vault by sending ERC-20 tokens like ETH, Wrapped BTC, and USDC to the smart contract and receives DAI in return. 

2. DAI borrowing is overcollateralized, meaning that you need to put in a higher dollar value in your ERC-20 token of choice than you take out in DAI, with higher collateral ratios depending on the volatility and liquidity of the token you deposit. Currently, ETH has a minimum collateral ratio of 170%, Wrapped BTC of 175%, and Staked ETH of 185%. 

3. At any time, you can deposit your DAI back in and unlock the ERC-20 you’d locked up. 

4. If, however, the price of your ERC-20 of choice drops to a point that breaks the minimum collateral ratio, Maker will liquidate you, or sell your tokens. 

The disadvantage of borrowing DAI is that you need to put up a lot of collateral – currently, to borrow DAI with ETH requires a minimum collateral ratio of 170%, meaning I’d need to put in at least $17,000 worth of ETH to get 10,000 DAI. I also have to pay a Variable Annual Fee, currently at 0.50% for ETH deposits. 

Plus, if the price of ETH drops to a point that breaks that ratio – in this case, if it drops even one cent – the smart contract liquidates me by selling the ETH. That could mean that you might be forced to sell at an inopportune time.

The advantage of DAI to the borrower is that it’s completely on-chain, without the need for a centralized intermediary, and works well with your existing crypto holdings. If you want to hold onto your ETH but take out a little walking around money, you can just lock up the ETH, get DAI, and use it for any of the things you might use stablecoins for. 

The advantage of DAI as a protocol is that, by being overcollateralized and liquidating below certain thresholds, it can maintain stability and keep the promise that users can redeem their DAI for their ERC-20 tokens in any reasonable scenario. 

As a result, even during the recent turmoil, DAI has held up well. DAI’s chart isn’t quite as boring as USDC’s, but it’s pretty boring: 

At the time of writing, it’s trading at around $1.00, as designed. 

There are other crypto-backed stablecoins that are pegged to the dollar, with more launching regularly, others pegged to assets besides the US Dollar, and others still that aren’t pegged to anything at all. Some just want to be reserve currencies themselves. OlympusDAO, for example, has a mix of tokens in its reserve, backing its “Future Decentralized Reserve Currency,” Ohm. If you’ve seen the (3,3) or (something, something) meme on Twitter, that comes from the game theory behind Ohm, that it’s better for everyone if everyone just stakes their Ohm and holds. Ohm has had a bumpy ride, falling from a peak of $420 to a current price of $52. 

There are other promising crypto reserve currency projects, all vying to build an internet-native reserve that isn’t tied to the value of any fiat currency, but they’re different than stablecoins and outside the scope of this piece. 

That brings us to fiat-backed stablecoins, like USDC. 

Circle’s USDC stablecoin is the most straightforward of the major stablecoins: for every dollar of USDC in circulation, Circle holds $1 worth of straight cash and US Treasury Bills, for which there is the deepest and most liquid market of any asset in the world.

Watcher.Guru @WatcherGuru

JUST IN: Circle says they hold 80% of their $USDC reserves in US Treasury bills and 20% in cash within the US banking system.

July 5th 2022

453 Retweets3,505 Likes

If you want to redeem 1 USDC for $1, no magic needs to happen. The dollar is sitting there, either right in the USDC reserve bank accounts at BNY Mellon and other large banks, or invested in short-term Treasuries that are easier than anything else in the world to exchange into dollars. Circle posts weekly reporting and monthly attestations on its website.

To learn so much more about stablecoins, Circle, and USDC…

Continue Reading Online

Thanks to Jesse, Peter, and the Circle team for working with me on this piece, and to Dan for editing!

That’s all for today! See you back here tomorrow for some Weekly Optimism.

Thanks for Reading, Packy