The Interchange: You can get +8% yield on USDC. Why? Follow the flow

Quick Take

  • This piece unpacks the lending economics around USDC markets.

This post first appeared in Ryan Todd's The Interchange column on July 31st, and has since been republished in front of The Block Research paywall.

I tend to subscribe to the maxim that most books should be essays, most essays should be blog posts, most blog posts should be tweets, and most tweets should be deleted.

Sure, there are exceptions to the rule. Some may even follow an inverse process flow through this principle. For example, Frank Chaparro's mustache montage tweet clearly deserved a book deal.

There also was a question posed in a tweet this week that I originally tweeted an answer to, that I now believe warrants a column. So, here we go.

"What is the best explanation targeted at a mainstream consumer audience on why you can earn a significantly higher yield on crypto dollars like USDC than you can on traditional dollars in a bank account?"

We get this question a lot both internally and externally when talking about the success of BlockFi, the uptick in stablecoin borrow rates in hunting for yield(farming) opportunities, the swelling of Genesis' originations  -- the whole lot: "How is it that you can get +8% on USDC deposits? What's the catch?"

I actually addressed this very question more than a year and a half ago in the second publication of this column, only that time it was in response to BlockFi's initial roll-out of its 6.2% bitcoin interest product. Back then, I used the analogy that the mechanics of a high "teaser" yield rate is no different than every other fintech deposit grab strategy to fund customer acquisition. The more I think about it, the more I believe it's the easiest starting point explanation for an 8% yield on digital cryptodollars to your everyday mainstream consumer audience. But it's not the full answer as to why it's been able to last for so long. And it certainly doesn't explain how it's still profitable for everyone involved with the market.

To start, similar to how credit card issuers compete for your spend by passing you the interchange fees they collect on transactions in the form of rewards, stablecoin lenders and deposit institutions/protocols compete for your deposits by passing you yield as a cost for them to acquire.

For most coin lenders, the current cost to acquire USDC deposits can be quite high -- as high as 8% at BlockFi for example. However, unlike traditional bank deposits, stablecoin lenders can afford this higher cost of funding for USDC deposits due to the ability to lend the coins at potentially even higher borrow rates.

Even if the borrow rate isn't as high as the juicy 8% yield offered on the cost of USDC deposits (generating a negative net interest margin on the USDC book) these lenders are well-funded venture-backed businesses that can afford to pass on this net cost as "marketing spend" for customer acquisition. We've seen examples in the past of stablecoin issuers like Libra earmark intended association member fees to help "bootstrap the network," and the recently self-dubbed "Robinhood of crypto," Dharma, subsidize lower borrow rate loans on its own platform last year.

Source: DeFi Rate

But this really is only one piece of the puzzle, the front-end so to speak, of delivering this yield to consumers. The back-end reason as to how deposit-taking institutions and protocols can pass on consumer deposit flow to the borrow side at potentially even higher rates is arguably more important. 

Even if the 8% does feel "too-good to be true," the reality is there currently still exists outsized demand from institutional investors to borrow dollar or USDC to buy bitcoin spot and capture basis arbitrage trades between spot and derivative exchanges. Enough demand that actually outstrips the total cash supply available to market-makers to take advantage of these opportunities themselves.

Take it from the head of the largest institutional crypto lending desk (Genesis), Matthew Ballensweig, who sits on the front line of passing this USDC deposit flow to institutional borrowers and highlights in this tweet that:

"capturing basis, by borrowing cash or USDC to buy BTC in the spot market and short the near-dated future or perpetual product on any derivative exchange [to] capture the premium or funding rate is ONE example that is yielding 15%+ annual right now with no market risk. In other words, the forces driving the magnitude and cadence of these arb opportunities is greater than the cash supply available to marker-makers and prop shops to squash these arb opportunities."

So in other words, simple supply and demand amid attractive risk-reward opportunities is helping to drive these higher yields. But there's also another subtle difference to point out that persists in this market, relative to traditional dollar funding markets.

The ability for digital bearer assets to settle almost instantly actually changes the liquidity profile around lending the asset out. Bitcoin is harder to borrow not only because of its programmed scarcity, but because it settles within minutes. Considering predominant demand in the market to borrow crypto is to go short or play arbitrage opportunities, the lack of players soaking up this demand combined with the near-instantaneous transfer of title when settling the asset has led to a supply imbalance which in turn naturally pushes lending rates up.

What's the easiest way to hunt these higher rates as a lender? Pay up for more supply. If market participants can make 15% annualized playing basis trades, paying 10-12% to borrow USDC still provides arb. And from the deposit taker paying the consumer 8% yield on USDC, a positive net-interest margin (NIM) on the book.

Yesterday's news of Genesis Trading inking a fresh $25 million investment into Circle to help "focus on Circle's USDC yield and lending services," is all you need to know of the success to date of this symbiotic relationship. From Circle CEO Jeremy Allaire:

"I think the really critical thing here is that the rapid growth and evolution in USDC borrowing and lending, which is really key," said Allaire. "And that's accelerated right alongside the nearly two hundred percent growth in USDC circulation that's happened over the last six months as well."

Stepping back for a second, one of the sweeter ironies I continue to find with this space is the general consensus to promote "open-permissionless-free markets", while still holding deep-rooted suspicions surrounding the exact market forces that come with such markets. The market is still in the early days of figuring out how to rationally price and sell counterparty risk, but to be fair, the pricing and selling of risk is what ultimately helps drive the net benefit of price discovery, deeper liquidity, and ultimately maturation of a market. All good things, to be sure.

If a holder of USDC doesn't think a depository institution (BlockFi) or smart contract protocol (Compound or Nuo, for example) appropriately prices for risk of giving up private keys or trusting smart contract code with the title to the asset for 6%-8% yield, then they won't send BlockFi or the protocol their cryptodollar. That's fine. If the growth in USDC deposits is any indication of actual interest in the yield, then I’m sure others will step in and fulfill this capital allocation role.

One of my favorite aspects of covering this industry is the perpetual hardening of understanding the core fundamentals behind capital markets and financial structured products. Yielding 8% on USDC isn't a "scam," it's a function of risk/reward, and supply/demand.

Following the flow gives you what you need to know.

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