Circle’s hope in the front line Breaking the dilemma of declining USDC supply in the era of rising interest rates

Circle's hope Breaking the USDC supply decline in a rising interest rate era

This article analyzes the loss of USDC supply and its impact on Circle.

Written by: Matías Andrade & Kyle Waters

The strong momentum of stablecoin growth indicates the growing demand for digital dollars on public blockchains. These platforms operate 24/7, 365 days a year, across borders and time zones. Among stablecoin giants, Circle, as the operator of the largest domestic stablecoin USDC, has made an impressive rise. However, the beginning of 2023 has brought a series of new challenges. The supply of USDC on Ethereum (which accounts for the majority of USDC’s total supply) has dropped from $41.5 billion at the beginning of the year to about $23 billion now, a decrease of 44%, as redemptions have exceeded new issuances.

In this article, we will analyze the loss of USDC supply and its impact on Circle. We will break down the current USDC supply into various categories to identify the areas of most significant decay. An urgent question still remains: is this supply contraction concerning? Furthermore, can this business model maintain its flexibility in a macroeconomic environment of rising interest rates?

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By combining on-chain analysis and off-chain financial insights, primarily from publicly available SEC filings and Circle’s verification reports, we comprehensively examine the impact not only on the blockchain ecosystem but also on Circle as a corporate entity, particularly considering Circle’s ambition to go public. Through this synthesis of off-chain and on-chain data, we evaluate issues regarding the localization of crypto assets and their broader business implications for Circle.

The missing $18 billion USDC

Although the current supply is $23 billion, the supply pattern of USDC is complex. Compared to just three years ago, this still represents nearly a tenfold increase, but it has also plummeted from a high point of over $47 billion in early 2022. The most severe phase of USDC supply loss in 2022 occurred in the first quarter, coinciding with the collapse of Silicon Valley Bank (SVB) – an event we have previously analyzed in depth. After this event, the supply of USDC decreased by a staggering $10 billion in March alone.

However, SVB is not an isolated incident; increasing government and regulatory scrutiny of domestic stablecoin operators (referred to as “Operation Chokepoint 2.0” by some) adds another layer of complexity. Overseas issuers like Tether have benefited greatly, with its supply increasing from $70 billion to $77 billion within the period of March 2023 alone.

The current pattern of rising interest rates is also an important variable. This shift brings clear opportunity costs for USDC holders. Operators of stablecoins like Circle do not directly pass on the interest generated by reserves to on-chain USDC token holders – a point we will delve into later.

However, the significant outflow of USDC supply seems to be slowing down, as shown in the chart below. However, the daily trading volume of redemptions and issuances is still far below the levels before SVB’s collapse.

The contraction of USDC supply in 2023 presents a multifaceted narrative, but several trends stand out. Here, we divide the supply into different categories:

Divided by EOA and smart contracts

First, we compare the USDC held in smart contracts with the USDC held in ordinary Ethereum accounts (also known as externally owned accounts or EOA in Ethereum terms). Currently, around $7.6 billion USDC, about one-third of the total, is held in smart contracts. This marks a 44% decrease from the $13 billion at the beginning of 2023. EOAs have also experienced a similar contraction, decreasing from $28 billion to $15 billion. Interestingly, since the direct aftermath of the SVB crisis has eased, a larger proportion of the supply loss comes from smart contracts.

Divided by address balance scale

We can also divide the USDC supply by various wallet sizes. As expected, the largest segment with the most significant losses has a larger market size. Currently, wallets holding over $10 million USDC account for $12.5 billion, compared to $22.5 billion earlier this year. Although this decrease is partly a function of skewed wallet holding distribution, in terms of percentages, the largest wallets have witnessed the most significant contraction. In contrast, wallets holding $100 to $1,000 USDC have seen their collective supply increase by 28% from the beginning of the year. Most of the losses in the large wallet category occurred during the SVB collapse, which makes sense for large holders’ diversified investments.

Top holders

We further examine the top holders of USDC. The top 1% and top 10% of addresses now account for a larger proportion of the total USDC supply than they did at the beginning of 2023. This concentration peaked around the SVB crisis, possibly due to USDC being pooled into decentralized exchanges or exchange wallets. However, the total number of accounts holding USDC has increased from 1.6 million to 1.8 million this year.

The supply pattern of USDC in 2023 is complex but driven mainly by two overarching trends: the migration of offshore stablecoins after SVB and rising interest rates incentivizing capital to chase higher yields. Despite potential uncertainty on the supply side, the rising rates are boosting Circle’s business operations.

Circle’s Treasury

One advantage of stablecoin design is supply transparency, which can be audited in real-time (at least in terms of data on the blockchain). However, if we also consider Circle’s financial statements and monthly attestation reports, we can begin to build a model of Circle’s USDC Treasury and how it operates, particularly its profitability.

If we look at BlackRock’s Circle Reserve Fund, we find that it lists the portfolio segmented by investment assets’ maturity date, with all assets maturing within 2 months and 65% of assets maturing within 1-7 days. This estimate is based on a constant proportion allocation of overnight repo and 4-week treasury bills, at 70% and 30% respectively.

The estimated size of the portfolio happens to be the current supply of USDC, which may not fully represent Circle’s Treasury operations, especially redemption operations, but it should be proportionate and consistent. However, this should constitute a naive estimate of the expected daily yield of these investments, as it ignores transaction costs, rollover costs, and management fees that would be incurred in managing this portfolio.

Based on FRED data, we can estimate the yields these securities would generate, using the effective federal funds rate to estimate the yield on the overnight repo investments and the 4-week treasury rate to estimate the yield on the remaining portion of these assets, at 70% and 30% respectively.

As shown in the above graph, the daily return is highly correlated with interest rates. Despite the USDC supply reaching its peak in early 2022, the estimated daily income actually reaches its peak in early 2023 – after a decrease in supply of nearly $7 billion. Even today, with the supply $18 billion lower than earlier this year, interest income is still significantly higher than in 2021 when the USDC supply was at a similar level. This nicely illustrates the business model of fiat-collateralized stablecoins and indicates that interest rate sensitivity is increasingly becoming a determining factor of their profitability.

Using the quarterly data from the above graph, we can compare these figures to the reserve interest income disclosed by Circle in their financial statements. We can see that they reported interest income of $274 million for Q3 2022, which is similar to our estimate of $240 million – however, this simple model appears to fall short when considering all the data and redemptions of the current year. The lack of publicly available financial statements after 2022 hinders the validation of our model. Nevertheless, it is worth noting that Circle reported revenue for just the first half of this year (considering all of Circle’s business) exceeding the full-year revenue of the previous year, at $779 million compared to $772 million.

Even with the recent excitement around LianGuaiyLianGuail stablecoin news, interest in stablecoins is growing, and structural factors driving stablecoin adoption are changing, with the most important factor being rising interest rates. The opportunity cost of holding cash is increasing, which may push stablecoin users towards yield-generating investments such as money market funds that offer substantial returns exceeding 5%, compared to less than 2% annualized returns in recent years. Additionally, yield-bearing stablecoins are gaining adoption, such as sDAI and sFRAX, and Coinbase is also offering a 5% yield on USDC.

Summary

The dramatic fluctuations in USDC supply in 2023, including the consequences of the SVB crisis and intensified regulatory scrutiny, have created a challenging environment for the business. Despite a significant decrease in its supply, Circle has successfully utilized the same interest rate dynamics to boost its operational activities. The ever-changing macroeconomic conditions and evolving stablecoin landscape have highlighted the adaptability and innovation required, with yield stablecoins as representative alternative solutions. The strategic partnership between Circle and Coinbase, which provides competitive returns for USDC, demonstrates the necessity of taking proactive measures in this rapidly developing environment. As Circle considers going public, its ability to navigate through these turbulent times will prove its business acumen and vision for the future of digital currencies.

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