Special Feature | Is Stablecoin a Good Business? Insights into Its Business Model from Circle's Financial Report

Stablecoin issuers have a large cash reserve and do not need to pay interest to customers, making it sound like a profitable business. Currently, the total market value of the top three stablecoins in the market has reached $130 billion, accounting for about 15% of the total cryptocurrency market value, with trading volume representing around 90% of the overall crypto market. Stablecoin issuers, who have always been low-key due to not having to disclose financial reports, often draw attention to the reserves behind them. This time, through Circle's submission to the SEC in November of Form S-4, which is a form related to company mergers or exchange offers submitted to the U.S. Securities and Exchange Commission, we can finally get a glimpse of their financial situation and operational model from the extensive 813-page report.

The Rise of Circle

Stablecoins are a type of cryptocurrency designed to maintain a stable value through the backing of assets or algorithms. Currently, the top three stablecoins in the market, USDT, USDC, and BUSD, have a total market capitalization of $130 billion, accounting for about 15% of the total cryptocurrency market value, serving as a bridge between traditional finance and cryptocurrencies.

USDC, the second-largest stablecoin by market capitalization, is backed by a 100% reserve of US dollars and is managed by the Center Consortium, an alliance formed by Circle and cryptocurrency exchange Coinbase in 2018. The circulating market value of USDC is approximately $42.7 billion.

Circle has always emphasized its compliance, publishing its USDC reserve status weekly on its website. It also commissions the accounting firm Grant Thornton to provide monthly reserve attestations based on the certification standards set by the American Institute of Certified Public Accountants (AICPA), making it the most transparent stablecoin issuer among all stablecoins. However, is stablecoin really a profitable business? In a shocking revelation from Circle's 813-page S-4 filing submitted to the SEC, the cumulative losses in the first half of this year amounted to a staggering $850 million, with a $500 million loss even during last year's bull market. Is stablecoin truly a lucrative business? Let's delve into Circle's financial statements to understand its operational model.

Circle's Revenue Model

Circle's two main sources of revenue:

• Reserve Interest Income: The significant source of Circle's revenue is its USDC reserve, which accounted for 79% of total revenue in the first half of this year. However, as the issuance of USDC is done in partnership with Coinbase, the interest income source also needs to be split with Coinbase. Circle invests 80% of its reserves in short-term US Treasury bonds and, starting in November, collaborates with asset management group BlackRock to manage funds in an exclusive currency fund managed by professional managers.
• Transaction and Treasury Service Fees: In addition to the monthly fees paid by customers using Circle's services, Circle also charges transaction fees for each trade or transfer, making it the second-largest source of revenue, accounting for 18% of total revenue in the first half of this year.

Operating Cost Analysis

Operating costs include interest income to be distributed to Coinbase and costs related to transactions. The gross profit margin, which is the percentage of revenue after deducting operating costs, ranged from 50% to 77% for Circle from 2020 to the first half of 2022. These costs are mostly fixed and cannot be easily reduced, so the focus shifts to the bulk of operating expenses causing losses.

Operating Expenses Analysis

• Compensation Expenses: Accounting for 40% of operating expenses, the increase in employee expenses was mainly due to employee stock grants and a significant expansion in 2022.
• General and Administrative Expense: Supporting business operations, these expenses accounted for 17% of operating expenses, with the increase in 2022 primarily from legal consulting fees.
• Marketing and Advertising Expense: Accounting for 13% of operating expenses.
• Digital Assets Loss and Impairment, Net: Refers to the fair value changes of cryptocurrencies or related collateral held by Circle, representing 26% of operating expenses. However, Circle clarified in the report that these collaterals would eventually be returned to the borrowers. The potential impairment costs, gains and losses from returning Bitcoin collateral, and fair value changes of derivative instruments may affect the current operating performance. From this perspective, this profit and loss are merely on paper and not actual losses.

We measure the cost-to-income ratio to be 258% for Circle in the first half of this year, indicating a situation of revenue shortfall. With 100% being the breakeven point, it's evident that cost-cutting measures are crucial for Circle's profitability.

Recognition of $710 Million Convertible Bond Conversion Loss

In June of this year, Circle recognized over $700 million in other expenses, attributed to the market price difference resulting from the automatic conversion of convertible bonds into common stock and E-series preferred stock, amounting to $710 million, appearing as a one-time recognition.

How Does Circle Yield Operate?

Circle Yield, launched by Circle in the second quarter of 2021, allows customers to lend their USDC to Circle in exchange for a fixed yield. Circle then generates income by investing in the CeFi lending market, where the yield fluctuates based on market conditions. In this scenario, Circle bears market risks, making it not a risk-free venture. With Genesis ceasing its lending product redemption, Circle disclosed an amount related to Genesis as $2.6 million, fully refunded to customers by Circle, and no longer accepting new transactions. However, the balance of Total Volume Lend as of the end of June reached $200 million. Does Circle have related products placed elsewhere?

Outlook for Circle

Looking at Circle's disclosed financial reports since 2020, the breakeven was barely achieved in 2020 with a modest profit of $20 million due to the recognition of $20 million in extra gains from selling Poloniex. Subsequent losses have been severe, highlighting the importance of increasing revenue sources and reducing costs for Circle to potentially turn losses into profits.

According to the financial statements, Circle's reserve interest income for the first half of this year was $100,395,000. Calculated based on the USDC circulation volume of $55,569,661,000 at the end of June, the annualized return rate is only 0.36%, with a portion redistributed to Coinbase. However, with the Federal Reserve raising interest rates significantly this year, the current one-month US Treasury bond yield has exceeded 3.8%. Circle recently disclosed an average duration of 27.8 days for its Treasury bonds, indicating potential substantial interest income in the future.

While reserve interest income constitutes a significant portion of Circle's revenue, interest rates are subject to macroeconomic conditions beyond Circle's control. If viewed from a banking perspective, Circle, despite attracting substantial deposits, can only rely on investing in the safest US Treasury bonds for returns, which may not be sustainable. If unable to lock in interest rate spreads through lending models, Circle should focus on increasing transaction fee income. Circle also mentioned partnerships with Visa, international remittance company MoneyGram International, and Signature Bank in its report. Expanding Circle's stablecoin market share and enhancing connections between existing payment channels and digital asset payments and settlements could potentially increase customer numbers and transaction volumes.

Reducing operating expenses, such as personnel and administrative costs, is a direction Circle should strive for. Even after excluding the $710 million convertible bond loss, Circle still incurred a $140 million loss in the first half of this year. Simply relying on open-source solutions may not be sufficient to bridge this significant gap, emphasizing the importance of more efficient operations for Circle's potential profitability.

Circle recently announced the temporary abandonment of its IPO plans, citing unfavorable market conditions, but the lack of profitability seems to be the real key factor. With the recent turmoil in the cryptocurrency market, more regulatory challenges may arise, questioning whether stablecoins are truly a lucrative business, a truth that only time can reveal.