Jul 15, 2022
Is USDC in Trouble? Not obviously so.
Summary:
- Allegations on Circle collapsing
- Does Circle lend out its reserves? (No)
- Are Circle’s reserves indirectly being lent out?
- Is Circle paying Silvergate/Signature 5% on deposits? (Almost certainly not)
- Overall assessment of Circle’s USDC
Allegations on Circle collapsing
@CoinInsider recently raised some strong allegations about USDC in a Twitter thread:
Geralt Davidson @CryptoInsider23
The core allegations being made are:
- That Circle indirectly lends its reserves out in risky ways like was done by Celsius.
- That Circle is currently paying the banks at which it deposits USDC about 5% interest.
Both allegations seem implausible to me, but they do raise some new questions in my head.
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Does Circle lend out its reserves? (No)
Circle shares a monthly attestation by auditing firm Grant Thornton that shows the amount and type of reserves backing USDC. The May report shows that the reserves are at least as much as the outstanding USDC, and that reserves are either cash or short dated US treasuries.
For the first time, Circle has disclosed an (unaudited) summary of its detailed holdings which shows that about three quarters are in US Treasuries and the rest is in cash at various US banks. The average maturity of the holdings is 43.9 days.
It makes sense that Circle would heavily weight towards US treasuries because they are interest bearing, and generate income for Circle. Cash, of course, doesn’t generate any yield. As a technical note, short dated treasuries are quite cash-like. In fact, I understand there are conditions under which one may pay US taxes with treasuries.
So, if you believe the audit report, Circle is not directly lending out its reserves.
Are Circle’s reserves indirectly being lent out?
Is it possible, somehow, that the reserves are indirectly being loaned out?
The cash portion of Circle reserves is held at various banks, which are not precisely specified, but stated by Circle to include BlackRock and BNY Mellon. Looking at the SEC filings, one can see that there are partnerships with Silvergate and Signature Banks, but it is unclear what portion of the cash reserves, if any, is deposited with these two banks. My guess is either none or else a small amount, but I don’t know.
Any bank holding the cash portion of Circle’s reserves can, and I assume does, lend out these funds. That’s what regulated banks do, they lend out deposits and hold a partial reserve. This isn’t any different than how, if my non-crypto business deposits $1M into a US bank, the bank will use those funds for lending. Of course, the lending out would be in fiat US dollars, not in USDC.
This brings us to the question of whether there is a risk that banks holding the cash portion of Circle reserves might suffer a bank run or heavy losses. In the case of Blackrock and BNY Mellon, the level of assets they have on their balance sheet is far in excess of the cash portion of Circle’s reserve. My understanding is that neither of these banks do much business in crypto — so I don’t see how they would have much exposure to failing crypto companies. In the case of Signature Bank and Silvergate, my guess is that those banks have more exposure (lending) to crypto businesses. However, it’s unclear whether much, if any, of Circle’s cash reserves are at those banks.
Even if Signature and/or Silvergate run into liquidity issues and had a lot of Circle’s cash reserves, one would need to assume that the Fed would allow depositors at a US regulated bank to get burned. Perhaps that’s not impossible, but it doesn’t seem likely.
All in all, I don’t see a clear way in which Circle’s reserves are being used as the basis for crypto lending, directly, or indirectly.
Is Circle paying Silvergate/Signature 5% on deposits?
There is a pretty wild claim by @CryptoInsider23 that Circle is losing money because it is paying 5% interest to banks like Silvergate/Signature to hold their deposits.
Not only based on where reserves are actually held (mostly in treasuries, and the cash is maybe largely at Blackrock and BNY Mellon), but also based on Circle’s SEC filings of accounts, it seems unlikely that Circle is paying 5% to banks for reserve deposits. This much above market rate for US dollar deposits (which banks usually don’t charge to hold). Let’s take a look through Circle’s accounts for the first quarter of 2022:
As can be seen in the revenue section, Circle is making money from its reserve (see “USDC interest income” . Not only that, but its incoming sharing of interest is only about one quarter of its interest income.
Very roughly (excluding income share), Circle made about 19 million USD in 1Q2022 on about 51 billion USD of deposits. That’s an annualised interest rate of about 15 basis points. Federal funds rates were at 25 basis points for Q1, so a return of 15 basis points suggests that Circle had over half if its reserves in US treasuries back then. I would expect interest income to rise significantly in the coming quarters. For example, at an interest rate of 250 basis points, Circle might make (at a 75% treasuries-cash split of the reserve) revenue of $150M per quarter. This is the classic story of why rising interest rates are good for financial businesses.
Moving further down on the Operating Statement, there is lots more room for concern:
- There were losses of $64M from digital asset impairments, which seem to be related to losses on collateral that was received due to borrower liquidations in the Circle Yield program. I would expect this number to get worse in the second quarter. It seems there is about $200M outstanding in this program, so may be that provides some kind of limit on the possible losses. That may be wrong though because $200M in total makes the $64M million impairment for Q1 (which wasn’t that terrible a quarter) look bad as a percentage. It seems there are lots of derivative contracts mixed into the SEC filing, making it hard to understand exposures.
- There is a huge “Other income (expense), net” line item causing a loss of $731 million. Digging in, it looks like this is associated with the conversion of convertible debt into equity — at significant cost to the company. It looks like most of the convertible debt has been converted, so this may be a one off. That said, during 2Q2022 the company may have been under pressure for cash and needed to find other ways to raise cash.
In summary, Circle certainly doesn’t seem to be paying Silvergate/Signature 5% on all of its reserves. Circle seems to make a gross profit on its reserve deposits, rather than them being a cost. Actually, with interest rates rising, Circles reserves seem to be a source of growing revenue. The risks to the business seem to come from Circle’s yield program and also from a mix of derivatives that are hard to understand, plus from short term needs for cash until interest rates risk.
Indeed, there may not be any cases in which Circle is paying Silvergate/Signature 5% for anything. @CryptoInsider23 seems to misunderstand Circle’s business model and also how bank deposits work.
Overall assessment of Circle’s USDC
I have the following concerns about Circle’s USDC:
- Circle only recently decided to limit reserves to cash and short dated treasuries. Before that, Circle had other assets in the reserves, which makes me question why Circle previously thought that would be safe.
- Circle’s statements about being regulated are correct, but misleading. As I understand, Circle is regulated as a money transmitter. However, USDC is not regulated in what must constitute reserves, and government agencies do not audit USDC. This is a clear difference from what the New York Department of Financial Services considers a regulated stablecoin like USDP or BUSD.
- Even though Circle’s reserve would be ring-fenced in the case of bankruptcy, it’s obviously important that Circle be healthy financially as a company for USDC to be sustainable. Circle’s financial statements show that the company remains reliant on funding (debt or equity), which may become more expensive depending on market conditions. Perhaps rising interest rates will provide a saviour, but Circle’s business health is not without risk.
On the plus side:
- Circle has moved to pure cash+treasury backing for USDC.
- Circle is become more transparent by sharing details of its specific holdings.
- Interest rates (and Circle’s interest income) are rising.
That’s it for this piece folks, please comment below if there are errors to be corrected above.
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