Stablecoins: Yield Opportunities, Risks, and DeFi Dynamics
In recent weeks, yields on stablecoins like Tether (USDT) and USD Coin (USDC) have surged, catching the attention of investors familiar with the once record-high risk-free returns on short-term U.S. Treasury bonds. With the anticipation of spot ETFs for not only Bitcoin but also Ethereum, where much of DeFi resides, stablecoin holders find themselves with newfound options to deploy their capital.
DeFi’s Rise and Stablecoin Dynamics
The summer of 2020 witnessed the explosive growth of decentralised finance (DeFi), driven by innovative concepts like yield farming introduced by Compound’s governance token. Yield farming, a speculative practice of earning rewards by depositing tokens in various DeFi protocols, led to a substantial capital influx into the DeFi ecosystem, reaching $175 billion by November 2021. Notably, Aave and Compound, the leading lending protocols, had nearly 40% of their deposits in stablecoins.
Stablecoins, digital representations of a dollar on blockchains like Ethereum, became crucial sources of liquidity across the crypto space, constituting a $127 billion industry. Tether’s USDT ($88 billion) and Circle’s USDC ($24 billion) dominate this sector.
However, the stability of returns came into question in mid-2022 with the collapse of the TerraUSD stablecoin ecosystem. As $50 billion vanished within days, investors withdrew funds from DeFi protocols, leading to the downfall of major industry players like Celsius and Voyager. Loss of trust in centralised custodians and the allure of on-chain Traditional Finance (TradFi) solutions fueled the demand for alternatives.
Commenting, TIDEX CEO Eric Ma, says: “The fall of Luna’s algorithmic stablecoin, TerraUSD, was detrimental to the entire ecosystem and led to a chain reaction of failures in other institutions. The failures certainly played a big part in extending the bear market at the time. It also heralded the end of algorithmic stablecoins and refocused people’s attention to the importance of stablecoin collateral.”
Tokenised Treasuries and Growing Trends
In response to the changing landscape, tokenised treasuries gained prominence, witnessing a surge in investments from $104 million to $675 million. While these figures still represent a fraction of the $23 trillion Treasury market, the trend is still quite a stark one.
On-chain/off-chain Treasury yields are expected to remain high due to factors like the ongoing inflation cycle and the potential impact of pandemic-related stimulus measures still kicking in as markets develop.
As DeFi continues to evolve, stablecoin demand is anticipated to persist, driven by investors seeking long positions in cryptocurrencies like Bitcoin and Ethereum.
For investors, the decision between consistent returns from TradFi-based products and the volatility of DeFi returns requires careful consideration. Options include reputable custodians like Coinbase offering interest rates on USDC comparable to national banks, tokenized treasuries offered by Franklin Templeton, and DeFi solutions such as those provided by Maple Finance.
However, investors engaging with DeFi protocols should monitor loan and borrowing rates daily, recognizing the potential impact of external events, such as SEC approvals of Bitcoin or Ether ETFs, thefts or hacking attacks, and regulatory actions. Established and secure DeFi lending protocols like Aave and Compound remain primary choices for those entering the DeFi space.
Commenting, Eric says: “DeFi allows everyone to participate in earning interest and stablecoins play a huge part in this ecosystem as the top token to stake. For the space to continue growing we will need to see a rise in TVL and improvements in security.”
In essence, the discrepancy in interest rates between stablecoins and actual dollars is attributed to the constant demand for stablecoins, primarily fueled by their utilisation in DeFi lending and staking pools. As DeFi’s derivatives pyramid grows, stablecoins are increasingly locked up in vaults, contributing to their high interest rates. Stablecoin issuers, like Tether and USDC, find it challenging to control interest rates, emphasising the fundamental conflict in stablecoins’ dual roles.
Concluding, Eric says: “There’s no doubt another DeFi season will be here. But what will it look like? A new rendition of yield farming? Or perhaps the gamification of DeFi? Whatever it is, the narrative for the next bull run is being developed as we speak. Whatever it is, we should all be ready and be a piece of it all.”
