In the era of rising interest rates, how does Circle solve the dilemma of declining USDC supply?

Originally written by Matías Andrade & Kyle Waters

Original compilation: Deep Tide TechFlow

The momentum of stablecoins' growth is a strong indication that the demand for digitized dollars on public blockchains is booming – platforms that operate around the clock, 7 days a week, 365 days a year, across borders and time zones. Among stablecoin giants, Circle's rise as the operator of the largest domestic stablecoin, USDC, is impressive. However, the start of 2023 presents it with a new set of challenges. The supply of USDC on Ethereum (which accounts for the majority of the total supply of USDC) has fallen from $41.5 billion at the beginning of the year to about $23 billion now, a decline of 44%, as redemptions outstrip new issuances.

In this article, we will analyze the USDC supply loss and its impact on Circle. We break down the current USDC supply into various categories to pinpoint the areas where attenuation is most pronounced. A pressing question remains: Is this supply shrinkage worrisome? Further, can this business model remain resilient in a macroeconomic environment with rising interest rates?

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

$18 billion of missing USDC

Despite currently standing at $23 billion, the supply landscape for USDC is complex. This still represents nearly 10x growth compared to supply just three years ago, but it is also a significant decline from a high of over $47 billion in early 2022. The most dramatic loss of USDC supply in 2022 occurred in the first quarter, coinciding with the collapse of Silicon Valley Bank (SVB) – an event that we have previously dissected in depth. After this event, USDC supply fell by a staggering $10 billion in March alone.

But SVB is not an isolated incident; Escalating government and regulatory scrutiny by domestic stablecoin operators (dubbed "Operation Suffocation 2.0") adds another layer of complexity. Foreign issuers such as Tether have benefited tremendously, with supply rising from $70 billion to $77 billion in the March 2023 time frame alone.

The current pattern of rising interest rates is also an important variable. For USDC holders, this shift comes with a clear opportunity cost. Existing operators of stablecoins such as Circle do not pass the interest generated by the reserves directly to on-chain USDC token holders - this will be discussed in depth later.

However, the massive drain on USDC supply seems to be slowing down, as shown in the chart below. However, the daily trading volume of redemptions and issuances is still well below pre-SVB levels.

! [In the era of rising interest rates, how does Circle solve the dilemma of declining USDC supply?] ](https://img-cdn.gateio.im/webp-social/moments-7f230462a9-03cb077f37-dd1a6f-69ad2a.webp)

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

Divided by EOA and smart contracts

First, we compare USDC held in smart contracts with USDC held in regular Ethereum accounts (also known as externally owned accounts in Ethereum terminology). Currently, about $7.6 billion in USDC, about a third of the total, is held by smart contracts. This marks a 44% drop from $13 billion at the beginning of 2023. EOA experienced a similar contraction, falling from $28 billion to $15 billion. Interestingly, since the direct consequences of the SVB crisis eased, a larger percentage of the loss of supply came from smart contracts.

! [In the era of rising interest rates, how does Circle solve the dilemma of declining USDC supply?] ](https://img-cdn.gateio.im/webp-social/moments-7f230462a9-961bd0799a-dd1a6f-69ad2a.webp)

Divided by address balance size

We can also divide the USDC supply by various wallet sizes. As expected, the segment with the most losses was larger. Wallets that currently hold more than $10 million in USDC account for $12.5 billion, compared to $22.5 billion earlier this year. While this decline is partly a function of the wallet holding distribution skew, the largest wallets witnessed the most significant contraction in percentage terms. In contrast, wallets holding between $100 and $1,000 in USDC have collectively held a 28% year-to-date increase in USDC supply. Most of the losses in the large wallet category occurred during SVB failures, which is logical for large holders to diversify investments.

! [In the era of rising interest rates, how does Circle solve the dilemma of declining USDC supply?] ](https://img-cdn.gateio.im/webp-social/moments-7f230462a9-6434b938e7-dd1a6f-69ad2a.webp)

Top holders

We further check the top holders of USDC. The top 1% and 10% of addresses now account for a larger share of total USDC supply than they did at the beginning of 2023. This concentration peaked around the SVB crisis, probably due to USDC being sent to 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.

! [In the era of rising interest rates, how does Circle solve the dilemma of declining USDC supply?] ](https://img-cdn.gateio.im/webp-social/moments-7f230462a9-777dc8079c-dd1a6f-69ad2a.webp)

The supply landscape for USDC in 2023 is complex, but is primarily driven by two overarching trends: the migration of SVB backwards to offshore stablecoins and rising interest rates incentivizing capital to chase higher yields. While uncertainty may be clouded on the supply side, rising interest rates are boosting Circle's business operations.

Circle treasury

One advantage of stablecoin design is supply transparency, which is auditable in real-time (at least as far as data on the blockchain is concerned). However, if we also consider Circle's financial statements and monthly validation reports, we can start building Circle's USDC treasury model and how it works, especially its profitability.

If we look at BlackRock's Circle Reserve Fund, we see that it lists a portfolio breakdown by investment asset maturity date, all assets with maturity dates within 2 months, and 65% of assets with maturity dates between 1-7 days. This estimate is based on a constant proportional combination allocation of overnight reverse repo and 4-period notes, 70% and 30%, respectively.

The size estimate of the portfolio happens to be the current USDC supply, which may not fully represent Circle's treasury operations, especially redemption operations, but should be proportionate and consistent. However, this should constitute a naïve estimate of the expected daily returns of these investments, as it ignores transaction costs, rollover costs, and management fees that occur in managing this portfolio.

Based on FRED's data, we can estimate the earnings these securities will generate, estimate the earnings on overnight reverse repo investments using the effective federal funds rate, and estimate the gains on the rest of these assets using the 4-period Treasury bond rate, 70% and 30%, respectively.

! [In the era of rising interest rates, how does Circle solve the dilemma of declining USDC supply?] ](https://img-cdn.gateio.im/webp-social/moments-7f230462a9-d7bfb1e294-dd1a6f-69ad2a.webp)

As you can see in the chart above, the daily rate of return is highly correlated with interest rates. Although USDC supply peaked in early 2022, the estimated daily revenue actually peaked in early 2023 – after supply decreased by almost $7 billion. Even today, supply is $18 billion below levels earlier this year, and interest income is still well above 2021 levels, when USDC supply was on par with current levels. This speaks well of the fiat-collateralized stablecoin's business model, suggesting that interest rate sensitivity is increasingly becoming a determining factor in driving their profitability.

! [In the era of rising interest rates, how does Circle solve the dilemma of declining USDC supply?] ](https://img-cdn.gateio.im/webp-social/moments-7f230462a9-6ee08c9c1a-dd1a6f-69ad2a.webp)

Using the quarterly data in the chart above, we can compare these figures to the reserve interest income disclosed by Circle in its earnings report. We can see that they reported interest income of $274 million for the third quarter of 2022, similar to our estimate of $240 million – however, this simple model doesn't seem to work when we take into account all the data and redemptions for the current year. The absence of publicly available financial statements after 2022 hampered our model validation. Still, it's worth noting that Circle reported that revenue in the first half of this year alone (taking into account all of Circle's businesses) was even higher than last year's entire year, at $779 million versus $772 million, respectively.

Even as the news of PayPal stablecoins is fueled by growing interest in stablecoins, the structural factors driving their adoption are changing, most importantly rising interest rates. The increasing opportunity cost of holding cash could drive a shift of stablecoin users to yielding investments such as money market funds, which offer substantial returns of more than 5%, compared to less than 2% annualized returns over the past few years. In addition, earnings stablecoins such as sDAI and sFRAX are starting to gain adoption, and Coinbase is also offering USDC 5% gains.

Summary

The wild swings in USDC supply in 2023, including the aftermath of the SVB crisis and increased regulatory scrutiny, created a challenging environment for the business. Despite a significant drop in its supply, Circle has managed to take advantage of the exact same interest rate dynamics to boost its business operations. Changing macroeconomic conditions and the evolving stablecoin landscape, alternatives represented by yield stablecoins highlight the need for adaptability and innovation. Circle's strategic partnership with Coinbase, which offers competitive returns to USDC, justifies the need for proactive measures in this fast-moving environment. As Circle considers going public, its ability to navigate through these turbulences will prove its business acumen and vision for the future of digital money.