Circle's glimmer of hope: Breaking the dilemma of declining USDC supply in an era of rising interest rates

Original Authors: Matías Andrade & Kyle Waters

Compiled by: Deep Tide TechFlow

The strong momentum of stablecoin growth indicates a burgeoning demand for digitized dollars on public blockchains—these platforms operate 24/7, 365 days a year, crossing borders and time zones. Among the stablecoin giants, Circle, as the operator of the largest domestic stablecoin USDC, has seen an impressive rise. However, the start of 2023 has brought a series of new challenges. The supply of USDC on Ethereum (which constitutes the majority of the 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 outpaced 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 accurately pinpoint the areas where the decline is most pronounced. An urgent question remains: is this supply reduction concerning? Furthermore, can this business model remain resilient in a macroeconomic environment of rising interest rates?

By merging on-chain analysis with off-chain financial insights, primarily from public SEC filings and Circle's verification reports, we take a comprehensive look at the implications not only for the blockchain ecosystem but also for Circle as a corporate entity, especially considering Circle's vision to go public. Through this synthesis of off-chain and on-chain data, we assess issues related to crypto localization and the broader business implications for Circle.

The Missing $18 Billion USDC

Despite currently standing at $23 billion, the supply dynamics of USDC are complex. Compared to just three years ago, this still represents nearly a tenfold increase, but it has also significantly declined from a peak of over $47 billion in early 2022. The most severe phase of USDC supply loss occurred in the first quarter of 2022, coinciding with the collapse of Silicon Valley Bank (SVB)—an event we have previously analyzed in depth. Following this event, USDC supply dropped an astonishing $10 billion in just March.

But SVB was not an isolated incident; the escalating government and regulatory scrutiny of domestic stablecoin operators (referred to by some as "Operation Choke Point 2.0") added another layer of complexity. Offshore issuers like Tether have benefited significantly, with their supply increasing from $70 billion to $77 billion during the period in March 2023.

The current pattern of rising interest rates is also an important variable. For USDC holders, this shift brings a clear opportunity cost. Existing operators of stablecoins like Circle do not directly pass on the interest generated from reserves to on-chain USDC token holders—this will be explored further later.

However, the massive outflow of USDC supply seems to be slowing, as shown in the chart below. Nevertheless, the daily trading volumes of redemptions and issuances remain far below the levels prior to the SVB collapse.

The structure of USDC supply contraction in 2023 presents a multifaceted narrative, but several trends stand out. Here, we categorize the supply by different segments:

1.

By EOA and Smart Contracts

First, we compare the USDC held in smart contracts with that held in regular Ethereum accounts (also known as externally owned accounts, EOA, in Ethereum terminology). Currently, about $7.6 billion of USDC, roughly one-third of the total, is held by smart contracts. This marks a decline of 44% from $13 billion at the beginning of 2023. EOAs have also experienced a similar contraction, dropping from $28 billion to $15 billion. Interestingly, since the immediate aftermath of the SVB crisis has eased, a larger proportion of the supply loss has come from smart contracts.

2.

By Address Balance Size

We can also categorize the USDC supply by various wallet sizes. As expected, the largest wallets have seen the most severe losses. Currently, wallets holding over $10 million in USDC account for $12.5 billion, down from $22.5 billion earlier this year. While this decline is partly a function of the skewed distribution of wallet holdings, the largest wallets have witnessed the most significant contraction in percentage terms. In contrast, wallets holding between $100 and $1,000 in USDC have collectively increased their holdings by 28% year-to-date. Most of the losses in the large wallet category occurred during the SVB collapse, which logically aligns with the diversification strategies of large holders.

3.

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, likely due to USDC being funneled into decentralized exchange pools 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 dynamics of USDC in 2023 are complex but primarily driven by two overarching trends: the migration of USDC to offshore stablecoins post-SVB and the rising interest rates incentivizing capital to chase higher yields. While supply may be shrouded in uncertainty, the rising interest rates are bolstering Circle's business operations.

Circle's Treasury

One advantage of stablecoin design is supply transparency, which can be audited in real-time (at least concerning on-chain data). However, if we also consider Circle's financial statements and monthly verification reports, we can begin to construct a model of Circle's USDC treasury and how it operates, particularly regarding its profitability.

If we look at BlackRock's Circle reserve fund, we find that it lists the portfolio segmented by the maturity dates of investment assets, with all assets maturing within 2 months, and 65% of the assets maturing within 1-7 days. This estimate is based on a constant proportional allocation of overnight reverse repos and 4-week Treasury bills, at 70% and 30%, respectively.

The estimated size of the portfolio aligns closely with the current USDC supply, which may not fully represent Circle's treasury operations, especially regarding redemption operations, but should be proportional and consistent. However, this should constitute a rough estimate of the expected yield on these investments, as it ignores transaction costs, roll-over costs, and management fees that would occur 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 overnight reverse repo investments and the 4-week Treasury bill rate to estimate the yield on the remainder of these assets, at 70% and 30%, respectively.

As shown in the chart above, daily returns are highly correlated with interest rates. Although USDC supply peaked in early 2022, the estimated daily income actually peaked in early 2023—after a supply reduction of nearly $7 billion. Even today, with the supply down $18 billion from earlier this year, interest income remains far higher than it was in 2021, when USDC supply was comparable to current levels. This illustrates the business model of fiat-collateralized stablecoins well, indicating that interest rate sensitivity is increasingly becoming a decisive factor driving their profitability.

Using the quarterly data from the chart above, we can compare this data with the reserve interest income disclosed by Circle in its financial reports. We can see that they reported interest income of $274 million for Q3 2022, which is similar to our estimate of $240 million—however, when we consider all data and redemptions for the current year, this simple model seems to fall short. The lack of publicly available financial statements after 2022 hinders our model validation. Nevertheless, it is worth noting that Circle reportedly generated more revenue in the first half of this year (considering all of Circle's businesses) than in the entire previous year, at $779 million compared to $772 million.

Even with the news surrounding PayPal's stablecoin stimulating interest in stablecoins, the structural factors driving stablecoin adoption are changing, with rising interest rates being the most significant factor. The increasing opportunity cost of holding cash may drive stablecoin users to shift towards yield-bearing investments like money market funds, which offer substantial returns exceeding 5%, compared to annualized yields of less than 2% in recent years. Additionally, yield-bearing stablecoins like sDAI and sFRAX are beginning to gain adoption, and Coinbase is also offering a 5% yield on USDC.

Conclusion

The dramatic fluctuations in USDC supply in 2023, including the aftermath of the SVB crisis and increased regulatory scrutiny, have created a challenging environment for business. Despite a significant decline in supply, Circle has successfully leveraged the very same interest rate dynamics to bolster its business operations. The evolving macroeconomic conditions and the changing landscape of stablecoins, represented by yield-bearing stablecoins, highlight the need for adaptability and innovation. Circle's strategic partnership with Coinbase, which offers competitive returns on USDC, underscores the necessity of taking proactive measures in this rapidly evolving environment. As Circle considers going public, its ability to navigate these turbulent waters will demonstrate its business acumen and vision for the future of digital currency.