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Academy Industry Analysis Article
Stablecoin Institutional investment USDT

Hedge, Arbitrage, Invest: Stablecoin Demand in a Zero Interest Rate Economy

2020.04.14 Robbie Liu

Since mid-February, the market value of Bitcoin (BTC) has fallen by more than 30 percent. At the same time, the total value of stablecoins in circulation is now over $8.2 billion. That’s an increase of more than $2.2 billion (or 33 percent) since March 11 — the day before Bitcoin’s steepest decline in 11 years, per Dapptotal data

The market value of Tether (USDT), the most ubiquitous — and infamous — stablecoin, has grown from $5 billion to $6.68 billion since March 11. USDT also currently accounts for more than 80 percent of the stablecoin market, according to Dapptotal data

Meanwhile, the circulating supplies of other popular USD-pegged stablecoins, such as USD Coin (USDC) and Paxos Standard (PAX), have also been rising rapidly. Since mid-March, the total circulating supply of USDC rose from 209.21 million to 255.94 million, and PAX’s rose from 467.47 million to 712.77 million.

Total circulating supply of stablecoins. Source: dapptotal.com

Stablecoins benefit from market volatility

First and foremost, the inflow of funds into stablecoins makes a lot of sense as a hedge against volatility in the crypto markets. This is much like how stock investors seek money market funds to park their cash in during market instability. 

The collapse in the price of crypto since February — when Bitcoin hit over $10,000 per coin — has prompted many people to sell crypto for stablecoins as a hedge, and others to obtain stablecoins in order to be able to buy crypto at the bottom. For either purpose, the demand for stablecoins is notably strong. 

In general, every time the crypto market fluctuates dramatically, it stimulates the issuance of stablecoins. In 2019, Tether added 400 million new USDT to its network in the space of 10 days — on July 2, 4, 8 and 10. Before the issuance, the price of Bitcoin had risen from $8,000 to $14,000 within two weeks.

USDT premiums and arbitrage

The demand for additional stablecoin issuance is also used in arbitrage. After the mid-March market crash, USDT — the cryptocurrency with the highest monthly trading volume per CoinMarketCap data — was trading at a high premium (meaning the price of USDT was slightly over $1). 

Many traders and arbitrage firms thus try to benefit from arbitrage between USD and USDT. For example, buying large amounts of USDT in the short-term and aiming to sell it when USDT’s price is pushed up by demand. 

We have also seen a huge USDT premium in over-the-counter (OTC) trading in the Chinese market recently, according to the Chainext USDT OTC Trading Premium Index. The index is calculated by the USDT/CNY OTC price divided by the offshore Chinese Yuan exchange rate and multiplied by 100. As we can see from the chart below, a the USDT premium has decreased recently but it went as high as 6 percent in March 2020. 

USDT OTC Premium % vs BTC Price. Source: Chainext & OKEx

According to a Coindesk report, after China effectively banned fiat on-ramps for local crypto exchanges in 2017, Chinese traders have continued to be heavily involved in the crypto market by using USDT. Since 2017, Coindesk reports, the percentage of overall crypto trading against the yuan dropped severely, reportedly from 90 percent to 1 percent of trades. 

A Morgan Stanley report  published in November 2019 noted that USDT's share of Bitcoin transactions began to soar in the second half of 2017, coinciding with China’s ban of local fiat-to-crypto gateways. 

Proportion of Bitcoin trading by currency/asset(%). Source: Morgan Stanley

Almost all of the additional issuance of USDT has had strong market demand behind it. Tether provides effective liquidity to crypto investors who do not have a direct fiat gateway. 

USDT’s not so great reputation

Despite its overwhelming dominance among stablecoins — and its spot as the fourth largest cryptocurrency by market cap — Tether is generally criticized for its inability to provide regular public audits of the funds allegedly backing the coin. 

The question of whether or not the circulating supply of USDT is actually backed 1:1 by USD — as the company previously claimed — has been a continuous point of contention in the crypto community. 

As of April 2019, Tether’s lawyers revealed that the stablecoin USDT was in fact backed by “cash and cash equivalents […] representing approximately 74 percent of the current outstanding tethers.”

Stablecoin investment in a falling interest rate environment

The surge in the issuance of stablecoins — ostensibly in response to demand — can be explained by several factors. First of all, stablecoins can be relatively easily purchased, unlike many traditional financial instruments. They can be especially useful as a hedge in countries whose currencies are currently dramatically weakening against the dollar. Additionally, in the current economic environment of falling interest rates, stablecoins could potentially generate more income for holders than fiat savings.

This month, the U.S. Federal Reserve cut interest rates to near zero in an effort to mitigate the effects of the coronavirus (COVID-19) pandemic on the economy. This move is concerning for a number of reasons, including that real U.S. yields, as measured by the “Treasury Inflation Indexed Long-Term Average Yield,” have fallen back into negative territory after a brief recovery at the end of March. 

Treasury Inflation Indexed Long-Term Average Yield. Source: FRED

To illustrate the situation for investors, the best savings rate currently available, for example, in a PNC bank account using Certificates of Deposit is 0.15 percent over 12 months with a balance of $25,000 or above. 

The situation is even worse if you are in countries that currently have negative interest rates, such as Switzerland and Japan. 

As a general rule, central banks around the world are keeping interest rates low to stimulate investment, but the cost of doing so is that people are forced to sacrifice gains on their savings. 

PNC Bank Fixed Rate Certificate of Deposit. Source: PNC

For real yields, stablecoins seem to currently be able to offer a better deal. As of April 13, OKEx’s Earn Program offers more than 0.8 percent APY to users who move their USDT into an OKEx savings account. 

OKEx USDT savings rate. Source: OKEx Earn

According to a report from The Block from late March, even in the current environment, all major USD stablecoins issuers said they would keep their coins pegged 1:1 with USD. 

DeFi lending interest rates 

In the world of decentralized finance (DeFi), potential earning is even more pronounced.  Launched at the end of 2017, DAI is the largest crypto-collateralized stablecoin and can be lent to investors via DeFi protocol MakerDAO. 

As of April 13, the interest rate of DAI lending on the two largest decentralized money markets in existence, Compound and dYdX, is 2.66 percent and 0.456 percent respectively per Defipulse data. 

However, the price of the crypto-collateralized stablecoin proved more volatile than other stablecoins during mid-March market instability. 

DAI Lend Rates last 7 days. Source: Defipulse


Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involve significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.

Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involve significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.

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