Why are interest rates on dollar-pegged stablecoins so much higher than interest rates on actual dollars? You’d think that a stablecoin worth a dollar would command the same interest rate as a dollar, namely zero. But a quick search of lending rates on stablecoins reveals rates of anything from 9% to 13%, or even more.
The easy explanation is that high interest rates compensate people for the risk that the stablecoin will fall off its peg. But prime stablecoins like USDC and Pax (USDP) are fully backed by high-quality dollar assets, so the risk that people will lose their money is small. No, there is another reason – and it highlights a fundamental conflict in the purposes for which stablecoins are used.
Frances Coppola, a CoinDesk columnist, is a freelance writer and speaker on banking, finance and economics. Her book “The Case for People’s Quantitative Easing,” explains how modern money creation and quantitative easing work, and advocates “helicopter money” to help economies out of recession.
We know why interest rates on actual dollars are so low. The Federal Reserve has cut interest rates to zero, so banks have no reason to pay interest on deposits. And the Fed has issued trillions of new dollars, so there are far more cash dollars circulating in conventional markets than anyone has a use for. No one wants dollars so they don’t command any interest.
But the reverse is true for stablecoins. Demand for stablecoins constantly exceeds supply. So people with stablecoins to lend can charge premium interest rates, and crypto platforms desperate for stablecoins offer high interest rates to attract new stablecoin lenders. That’s why stablecoin interest rates are so high. It’s simple economics.
You’d think stablecoin issuers would issue enough coins to satisfy demand. There are, after all, no limits on stablecoin issuance. Stablecoins can be created from thin air at the press of a button. They are the crypto world’s equivalent of quantitative easing (QE), only without the asset purchases. And, indeed, stablecoin issuers have been minting new coins at an extraordinary rate. But Jeremy Allaire printing billions of USDC doesn’t bring down interest rates. The market simply swallows everything he prints and comes back for more. Where is all this demand coming from?
The most obvious place is exchanges. Stablecoins make great liquidity for crypto exchanges. They enable people to trade in and out of cryptocurrencies easily and quickly without risking losses on the bridging asset. As crypto trading increases, so, too, does demand for stablecoins. A growing exchange such as FTX needs ever-larger quantities of stablecoin liquidity to maintain trading activity. Without these infusions, it would either have to restrict trading in and out of stablecoins or allow stablecoins to fall off their dollar pegs at times of high demand.
Stablecoins also provide crypto investors with a “safe haven” when cryptocurrency price volatility is high. So when cryptocurrencies go on a wild roller-coaster ride, as they have in recent months, demand for stablecoins rises. This tends to push them off their pegs, which rather destroys their purpose. So when people are cashing out of risky crypto into nice, safe stablecoins and USDC is starting to look expensive, Jeremy Allaire cranks up the printing presses.
But although printing more stablecoins keeps them on their pegs when demand is high, it doesn’t bring down interest rates on stablecoin lending. In this respect, stablecoin issuers are not like central banks. Central banks aim to control interest rates. Stablecoin issuers only control exchange rates. When you print money to hold an exchange rate peg, interest rates rise. Jeremy’s printing therefore contributes to the high interest rates on stablecoins.
But it’s not the only reason. There’s an insatiable demand for stablecoins – and it doesn’t come from exchanges. It comes from decentralized finance.
Dollar-pegged stablecoins are used as prime collateral in DeFi lending and staking pools. As more and more people dip their toes into DeFi and more and more new platforms appear, demand for stablecoins as collateral is rising exponentially. In December, research by The Block revealed that stablecoin issuance had risen by 388% in a year, mainly driven by demand from DeFi. If this trend continues, demand for stablecoins as collateral may outstrip use of stablecoins as safe assets on exchanges.
Collateral is by definition illiquid. When you borrow against an asset, that asset becomes “encumbered.” You can’t sell it and you can’t lend it out without your lender’s permission because the lender wants to be able to seize that asset if you default on your loan. So if you pledge USDC in return for DAI stablecoins, you are locking up your stablecoins in MakerDAO’s vaults. They are no longer in circulation. And the same happens if you pledge stablecoins in return for governance tokens on DeFi platforms.
All over the crypto world, there are vaults full of stablecoins. As demand from DeFi grows, more and more stablecoins are being locked up in vaults almost as soon as they are issued. That giant sucking sound you can hear is DeFi draining liquidity to support its massive derivatives pyramid. No wonder Jeremy has to keep printing. If he didn’t, the system would gradually freeze as liquidity becomes scarcer and scarcer and stablecoins less and less like actual dollars.
It is possible to make collateral liquid – if you don’t mind putting other people’s assets at risk. The conventional financial system, which had a similar liquidity-draining derivatives pyramid in the mid-2000s, invented what it thought was a sure-fire way of preventing collateral illiquidity from collapsing the pyramid. It’s called rehypothecation. Instead of locking up pledged assets in vaults, lenders lent them out, over and over again. The double spiral of cash lending and collateral rehypothecation enabled the derivatives pyramid to grow to a dizzying size. But it wasn’t sustainable. It collapsed disastrously in 2008.
Read more: What Is a Stablecoin?
Now those long rehypothecation chains have been regulated away, conventional markets have become reliant on infusions of liquidity from central banks. The Fed has even invented a liquidity pump: It lends dollars to banks in return for pledged securities (the “standing repo facility,” or SRF), and lends securities to non-banks in return for dollars (“overnight reverse repos”, or ON RRP). The idea is to keep control of interest rates. No way is the Fed going to let them fall through the floor or rise to the heights that stablecoin interest rates are reaching.
The crypto world rejects both central bank interference in markets and the regulation that makes it necessary. Unsurprisingly, therefore, crypto lenders are finding ways of making collateral liquid. And whether knowingly or unknowingly, they are reaching for the same tools. Rehypothecation is back. Lending platforms like Celsius use rehypothecation to generate high returns for its depositors: Celsius has been accused of “endlessly rehypothecating” pledged assets, though it denies that it does this.
But at present, rehypothecation in DeFi is small beer. Constant infusions of new stablecoins are the only significant relief for the terrible illiquidity that comes from feeding crypto’s main medium of exchange to the ever-thirsty derivatives monster. And that is why Jeremy Allaire can’t stop printing.