From Stability to Profit: The Rise of Yield-Bearing Stablecoins

Last week we covered stablecoins in relation to Mica regulation in this blog. This week is all about a practical view of the topic. Imagine having a digital currency that not only maintains a stable value but also generates income over time. This concept is appealing, and it represents the essence of yield-bearing stablecoins, a development that is generating more and more interests in the digital asset community. These stablecoins combine the stability of traditional stablecoins with profit-generating capabilities often sought by investors. This article explores this exciting development, breaking down the complexities into easily digestible insights.

Understanding the Roots of Stablecoins: Stability Without Yield

Initially, stablecoins such as MakerDAO’s DAI, Circle's USDC or Tether's USDT were created to provide a stable digital counterpart to traditional currencies like the US dollar. They achieved this stability through collateralization, backed by reserve assets ranging from fiat currencies to commodities or even other cryptocurrencies. However, these stable assets had one limitation: they didn’t generate returns intrinsically like traditional interest-bearing accounts.

Stability with Benefits: How Stablecoins Can Earn You Money

Yield-bearing stablecoins maintain the stability we appreciate in traditional stablecoins but come with an added perk – they can generate yield, or in simpler terms, earn you money over time.

Demystifying the Yield: The Mechanics of Earning with Stablecoins

The magic behind yield-bearing stablecoins isn't really magic at all; it's smart financial mechanics. These  mechanics could either be integrated into the design of the stablecoin or the stablecoin can be made available for a protocol that generates revenue. The most common mechanisms are:

‍Decentralized Lending: One common approach to generating yield is the use of decentralised lending protocols, whereby users can deposit their stablecoins into decentralised lending pools. Subsequently, the deposited assets are loaned out to borrowers, generating interest that is distributed back to the depositors as yields. This model is similar to traditional lending and borrowing, but it operates in a decentralized manner. One prominent example of this category is the sDAI Token. sDAI is a yield-bearing stablecoin, representing DAI in the DAI Savings Rate (DSR) module, which distributes revenue from the Maker protocol to DAI holders.

‍Participating in DeFi Mechanisms: In addition to lending, these stablecoins can also earn yields through other decentralised finance (DeFi) practices. They may be utilised to provide liquidity to automated market maker (AMM) pools or engage in yield farming activities, which involve employing various strategies, such as staking, providing liquidity, or participating in governance processes, with the objective of maximising returns.

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‍Utilizing Off-Chain Yield: Imagine a scenario in which a government bond could be digitised and used as a stable digital currency. This is the basic premise of stablecoins. To gain a deeper understanding of this concept, it is helpful to examine two examples from this category: Blackrock’s  BUIDL and Ondo's USDY.  The objective of both of them is to maintain a stable value of $1 per token while providing passive income to investors. To achieve this, traditional financial assets, such as bonds, are converted into digital tokens. It's like saying, "This digital token equals X amount of a Treasury bond." These tokenized assets now act as the foundation for the stablecoin. They ensure that for every digital dollar (like USDY) out there, there's a real asset backing its value. As the underlying assets are often interest-bearing (such as bonds), there is an intrinsic yield mechanism in place. This implies that holding such stablecoins could also generate passive income over time, based on the performance of the underlying treasuries.

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Algorithmic Strategies: The final category, which employs algorithmic or semi-algorithmic structures to maintain stability while generating yield, is not directly comparable to the candidates described above. The most prominent example of this category is Ethena’s ENA token, which describes itself as a “synthetic dollar”. To summarize, the mechanism operates as follows:  Users deposit assets like stETH, USDC, or USDT and receive a token called USDe. Here’s where it gets interesting: rather than just sitting on your deposit, Ethena engages in a strategy known as delta hedging. This means they manage the risk of price movements in the assets by taking opposite positions in the market. For instance, if they stake assets in one direction, they'll also open a corresponding derivatives position in the other. This balancing act shall not only ensure the stability of the assets against market volatility but also taps into the "funding rate" or "carry" from these market activities – a reward paid by those who are bullish about the market to those who hedge against it. This mechanism enables the yield generated from these market interactions. At this juncture, it's worth noting a little food for thought: the nature of this product raises the question of whether it's truly a stablecoin. The complex structure and methods employed are reminiscent of financial products such as hedge funds.

Benefits and Uses of Yield-Bearing Stablecoins for the Smart Investor

Yield-bearing stablecoins aren't just a neat technological trick; they offer tangible benefits:

• Passive Income: They allow you to earn income on your holdings, potentially at higher rates than traditional savings accounts.
• Capital Efficiency: They enable you to maximize the utility of your digital assets, putting your money to work rather than sitting idle.
• Liquidity and Efficiency: By incentivizing participation in liquidity pools, they enhance the overall functionality and fluidity of the DeFi ecosystem.

The practical applications and use cases of yield-bearing stablecoins are numerous and diverse. For individual investors, these assets offer the potential for passive income generation on their holdings, with the possibility of higher returns than those achievable through traditional savings accounts or fixed-income investments.

Furthermore, it allows traders to earn an additional return on their collateral while it is locked up in trading positions. This sets yield-bearing stablecoins apart from traditional stablecoins, which do not inherently generate returns when used as collateral.

Similarly, yield-bearing stablecoins can be used as collateral for borrowing or as a means of earning rewards through staking or liquidity mining programs.

Institutional investors and fund managers can also leverage yield-bearing stablecoins to generate yields on their capital reserves or as part of their investment strategies.

In the DeFi space, yield-bearing stablecoins are used in a variety of protocols and applications. Lending platforms leverage these assets to facilitate borrowing and lending activities, while decentralized exchanges rely on them to provide liquidity for trading pairs.

The Investor's Dilemma: High Rewards vs. Potential Pitfalls in Stablecoins

With opportunity comes risk, and being aware of these risks is crucial. These include:

• Centralization Risks: Many yield-bearing stablecoins operate by tapping into centralized financial platforms to generate returns. While this can be effective, it also introduces counterparty risk. This is the danger that the entity you're relying on might run into problems or even fail to meet its obligations, which could have a direct negative impact on the returns you expect from your investment.
• Smart Contract Vulnerabilities: Another layer of complexity in the world of yield-bearing stablecoins is the use of smart contracts. While they’re a cornerstone of many cryptocurrency-based applications, they can contain vulnerabilities. Just a single exploit or coding error can lead to substantial financial losses, as has been seen in various incidents within the decentralized finance (DeFi) sector.
• Regulatory Uncertainties: The regulatory landscape for yield-bearing stablecoins can be somewhat tricky to navigate. These financial tools combine elements from both the traditional finance sector and the DeFi space, leading to potential legal and compliance hurdles. Regulatory agencies are increasingly scrutinizing these products for how they protect investors, adhere to anti-money laundering (AML) norms, and fit into existing tax laws. The outcome of this scrutiny could have a significant impact on their adoption and development.

It is crucial for anyone considering adding yield-bearing stablecoins to their portfolio to understand and manage the associated risks.

Looking Ahead

The journey from stability to profit through yield-bearing stablecoins is just beginning. As technological and regulatory landscapes evolve, so will the opportunities and challenges associated with these digital assets. Their promise of combining the best of both worlds – stability and profitability – makes them a fascinating development in the world of finance. It is important to stay up to date, manage the risks sensibly and, where possible, participate in the rewards that innovation brings to our financial future.

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