rewrite this title Circle’s IPO Ushers in Golden Stablecoin Era – Nanalyze

Warren Buffett loves insurance companies because these business models generate money in two ways. First, when people pay for their policies, this creates a large pile of cash (called a float) that can be invested to show a return. Second, you write policies such that you’re highly likely to pay out less than people have paid in. The result is a profitable business provided you invest wisely and don’t take on too much risk. Turns out stablecoins offer a similar appeal without the need to hire any actuaries.

Crash Course on Stablecoins

Our recent video on the dangers of crypto wasn’t all doom and gloom. In fact, we believe the momentum behind institutional participation in cryptocurrencies – including the emergence of crypto ETFs beyond just bitcoin – means we ought to start paying attention to this space. Specifically, we want to follow the lead of institutional investors like ARK Invest which recently stated that, “stablecoins are one of the most transformative and high-growth sectors in the digital asset space.”

A stablecoin is labeled “stable” because it provides equivalent exposure to an underlying asset, largely U.S. dollars. Unlike most of the crypto coins that have ever existed, stablecoins typically have measurable intrinsic value. Over 98% of stablecoin market cap represents coins that are pegged to the dollar. One coin equals one U.S. dollar. Now folks in the crypto world can transact using the dominant global reserve currency. This begs the question. Why hold a coin that represents a US dollar when you can just hold a U.S. dollar? Well, because it’s much easier to transact across the crypto world when using stablecoins instead of U.S. dollars. Anytime you want to convert those stablecoins into dollars you can give them back to the provider who is expected to have equivalent U.S. dollars backing said stablecoins. That’s the basic idea.

When looking at the total number of stablecoins out there, we see five leaders representing 90% of total stablecoin market cap.

The largest name in the list – Tether – accounts for 60% of all stablecoin market cap and is the single biggest, most obvious, weak link in the blockchain until they get formally audited. We’ve been talking for years about how Tether might cause the entire cryptocurrency ecosystem to collapse should ecosystem participants believe they’re not holding the reserves they claim they are. That concern only goes away when they’re audited by a large reputable accounting firm.

As for the second name in the list, USDC, that’s a stablecoin being offered by a soon-to-be publicly traded company – Circle – which plans to trade under the ticker CRCL following their planned IPO.

The Circle IPO

It’s understandable why you’d want to invest in dollar-backed stablecoins. Not the coins, of course. Those will always just be worth a dollar. (Never more than a dollar, but perhaps less than a dollar if people discover they’re not actually backed by an equivalent amount of dollars.) What we want exposure to are the firms that are raking in the dough off the float. If Tether (allegedly) brought in roughly the same level of income last year ($13 billion) that Mastercard generated with ~35,000 employees, then that’s a business model that prints money.

So, when the second-largest stablecoin provider decided to have an IPO, we naturally wanted a closer look. Turns out that nearly all of Circle’s revenues come from simply generating interest on the $60 billion in cash that’s backing their $60 billion stablecoin – what’s referred to as “reserve income.”

The strong growth looks good until we see “Distribution, transaction, and other costs” which is basically their cost of goods sold. If this business model is supposed to be printing money, then why has their gross margin been declining to reach a dismal 39% in 2024? For a company with no physical products, that number is pathetic. The reason relates to a crypto infrastructure play we’ve been quite fond of lately.

Circle and Coinbase

Coinbase (COIN) and Circle have been working together since 2018 with the current relationship evolving around a commercial agreement (said to expire in 2029) that heavily favors Coinbase. In 2024, Coinbase earned $908 million from USDC-related activities – about 14.5% of net revenues – and these numbers are reported in their financials under “Stablecoin revenues.”

The Circle S-1 filing document shows Coinbase earning 100% of the interest on USDC held on its platform, and 50% on USDC held elsewhere. With the supply of USDC held on Coinbase’s platform now at 20% and growing (up from 5% in 2022), it’s hard to see why Circle would have made such a deal unless they really needed Coinbase to succeed. For investors in Coinbase, you can track these detailed payments in their quarterly financials.

We love extremely profitable business models, but Circle isn’t one of them because of their heavy reliance on Coinbase.

We already see Coinbase as a great way to play the growth of increasing institutional participation in cryptocurrencies. Circle’s success is becoming increasingly tied to Coinbase whose CEO said that he wants to make USDC “the number one stablecoin in the world” displacing Tether’s dominant position. And now we’re seeing why the rumored acquisition might make good sense. Coinbase could acquire Circle and immediately bolt on the second most popular stablecoin. However, one problem with incredibly lucrative business models is that everyone wants a piece of them.

The Stablecoin Business Model

A bog standard stablecoin backed by the U.S dollar doesn’t have any barriers to entry. The provider needs to be more creative than the competition for their stablecoin to be an industry standard. It’s mind boggling why Tether is the leading stablecoin when they might be one of the shadiest things we’ve ever seen. Since when has “one of the most profitable businesses ever” still not had a proper audit to ensure the (checks notes) $150 billion they were given is backed by equivalent amount of liquid assets? Perhaps everything gets audited and Tether is kosher. Then what?

ARK thinks that stablecoins will increase in size from around $250 billion today to $1.4 trillion by 2030. It probably comes down to how much “float income” the stablecoin issuer agrees to share in the form of “incentives” to gain or steal market share. So, it’s a race to the bottom. That’s still fine because during that race there’s a ton of money to be made. Just returning three percent on $1.4 trillion is a $42 billion run rate.

Napkin math shows a 4.75% return on $60 billion is around $2.85 billion, about what Circle could generate from their float without taking any risk on. The problem arises when interest rates fall (this is their expected direction these days). It then becomes more costly (in terms of risk) to sustain these yields (revenues). It can be very tempting to take on excessive risk, especially if you’re not being formally audited. There’s also pressure from competitors who may be willing to sacrifice most their reserve income for market share. PayPal recently offered their own stablecoin and plans to pass on most of the reserve income to people who hold it.

ARK says, “yield-bearing stablecoins are the fastest-growing category in the stablecoin market,” and that “Circle and Tether are unlikely to follow the trend until absolutely necessary.” Once they start losing market share, they’ll be forced to. (You can monitor stablecoin market share here.)

We’d like to understand more about adjacent revenues streams that come off stablecoins unrelated to float income. For Circle these are classified as “Other revenue” and they represented less than 1% of total revenues last year. They talk about developer and integration services (these don’t seem scalable) and tokenized funds (again, no barrier to entry). A company like Coinbase is likely to have more creative ways to extract money from stablecoin use cases given they operate a holistic platform and are catering to institutions (where we believe the real crypto opportunity lies).

Systemic Risk

It’s mind boggling how the biggest player in a space known for catastrophic failures and scammers can skate by without being audited and nobody really bats an eyelash. Par for the crypto course. We’re hoping this year Tether gets audited by a large consulting firm and those concerns are alleviated. They have the dominant leadership position right now and that’s easier to cement when legitimate concerns are addressed.

If Tether does fail, then this will be a double-edged sword. On one hand, all that usage will likely migrate to Circle and their float will explode in size. Industry participants will all stress the importance of basic auditory requirements and everyone will have forgotten about it several years later. On the other hand, the industry would likely see massive downside volatility similar to what we saw when Luna failed. Whenever the crypto industry has a setback, then platforms seem to suffer which would represent a buying opportunity.

Expect current participants and new entrants to continue fighting to capture stablecoin market share with consolidation over time as economies of scale triumph over innovation.

Conclusion

We already see these profitable “reserve income” business models being challenged. It’s easy to see why Circle would look for an exit while times are still good. And all the greater fools who made crypto popular will likely bid up any crypto IPO with no consideration at all. Whether the Circle IPO trades at a premium or not is irrelevant. We would never want to hold any business whose entire success hinges on a relationship where the counterparty has all the leverage. Just look at how favorable the contract terms are for Coinbase.

Crypto is a market that is increasingly driven by institutional adoption. That’s precisely when we want to start thinking about exposure, and Coinbase is still looking like the best publicly traded digital asset infrastructure company out there. In a coming video, we’ll take a closer look at ARK’s recent research on the stablecoin opportunity as we continue exploring ways investors might – in the safest way possible – get exposure to the growing digital asset space.