Stablecoins: The Current Market Outlook

The primary distinctions that can be made between different stables are:

1. Collateralization - Are the tokens fully backed by assets? Partially backed? No backing at all?

2. Centralization - Does the collateral involve government backed assets like USD, GBP, or T-bills? Or is it made up of decentralized assets like ETH?

Keeping these attributes in mind, we can start to build a framework for comparing different stables. Let’s see how some of the major players today stack up against one another.

Looking at the top 10 stablecoins by volume we can see that centralized stables, which are essentially just on-chain dollars, are the most widely used. These don’t offer censorship resistance or insulation from trad-fi banking crises. Case in point, when Silicon Valley Bank went under in March, USDC holders were left wondering about the fate of reserves held there. Many scrambled to exchange their USDC for more robust options, including LUSD, and that wasn’t the first time we’ve seen the decentralization premium come into play.

The end game for stablecoins is an option that cracks the trilemma of decentralization, capital efficiency, and peg retention, which USDC and USDT clearly fall short of. For the stablecoin sector to advance, we must look beyond these two options - so what does the playing field currently look like?

Out of this top 10 only 3 can be considered somewhat decentralized; DAI, FRAX, and LUSD.

Frax is a fractional reserve stablecoin that uses an AMO (algorthimic market operations) system to alter its collateral ratio and converge price to the peg. At the most basic level, the AMO raises the ratio when peg is under $1 and lowers it when above $1. What this means for FRAX holders is that redemptions are met according to the current level of collateralization. If the ratio is 90% then 1 redeemed FRAX would get paid out with .90 USDC from the protocol’s reserves + $.10 worth of FXS( Frax shares) minted by the AMO. With the dynamic nature of the collateral ratio it’s difficult to figure out the actual amount of collateral backing FRAX at any given time.

A recently passed proposal indicates that the community is in favor of moving to a fully collateralized model. The motivation here is primarily due to the increased regulatory scrutiny surrounding algo-stables after Terra’s UST debacle. Overall, algo-stables are still a highly experimental sector of the market, and while Frax has been able to grow successfully using its AMO model, it looks to be shifting.

DAI with its CDP model has proved to be the most successful stablecoin outside of the on-chain dollars like USDC and USDT. The main caveat here that most people may not realize initially is that DAI borrows are often collateralized with those same centralized stablecoins, exposing it to the same centralization risks. Since expanding to a multi-collateral model, these centralized stablecoins have become a major component of DAI backing, at times over 50%!

With the reserve uncertainties we’ve identified for both Frax and DAI, let’s look at how the rest of the decentralized stablecoin market stacks up. Let's continue on and see which stables are both decentralized and collateralized only by crypto assets.

LUSD is by far the most prominent in the realm of stables that are fully collateralized solely by crypto assets. It has reached this point by establishing rock solid fundamentals: immutable smart contracts, economically sound peg mechanisms, and capital efficiency that provides room for growth without jeopardizing the collateral ratio. Despite the fact that Liquity’s smart contracts are always going to stay on Ethereum, LUSD has now been bridged to L2 as well, with over $11m in liquidity combined on both Optimism and Arbitrum.

Since the start of this year, circulating supply has increased by over 100M LUSD, and over 10M has made its way to L2. Rollups have been accumulating significant TVL in 2023, with Arbitrum’s more than doubling from $980M to $2.3B and Optimism’s rising from $500M to $900M. Mainnet users aren’t the only ones who value decentralized stablecoin options, presenting ample opportunity for LUSD to capture more market share on L2s.

Along with circulating supply, Trove count has been climbing a lot this year coming close to all time highs. 1200+ active Troves is something not seen since the 2021 bull market, and considering ETH price is still nowhere near where it was back then, it would appear these users are coming for the stablecoin rather than the ETH leverage.

Forks

They say imitation is the highest form of flattery, and the Liquity model is being replicated by a handful of new stablecoins. Most are doing the same CDP style, but with staked ETH as collateral instead. It makes perfect sense with the amount of attention ETH and its LSDs have been getting in the first half of 2023, and with withdrawals now enabled, staked ETH is much more liquid and attractive to hold.

Is staked ETH better than ETH as collateral? It’s tough to say definitively, but there’s certainly some tradeoffs to consider. The major bonus to using an LSD like stETH as the backing for a stable is for the interest bearing property. The main downsides look to be a combination of slashing risk and LSD de peg risk. For these reasons, a higher minimum collateral ratio is typically used relative to LUSD. Beyond these risks the contracts for most of these stables are upgradeable and controlled by a multisig, unlike the immutable contracts behind Liquity. This means parameters like collateralization rates are subject to change. Staked ETH backed stables are definitely interesting, rating well in terms of decentralization and yield generation, but are less capital efficient than vanilla ETH to accommodate the added risks.

Dollar Risks and the Decentralization Premium

Something we touched on at the beginning of this piece that’s worth coming back to - TradFi banking crises. Silvergate, SVB, First Republic, three of the largest bank failures in U.S. history all occurred within the past few months.

The real question underlying these events is, where would you feel most comfortable keeping your funds during times of crisis? Not all dollars are created equal, and as the recent bank failures have reminded us, bank deposits can be wiped out in a flash. Sure, there’s FDIC insurance up to $250k and the government has shown its willingness to bail out failing banks, but with the fractional reserve system that the dollar operates on, people will still seek safety in times of uncertainty. This means bank runs, and we got a first hand look at how that can affect stablecoins relying upon fiat reserves with USDC and SVB.

Decentralized stablecoins have a pertinent use case for those concerned with the protection of their assets during periods of uncertainty, providing true non-custodial ownership. So, which stablecoin would you choose over a 5+ year period from a resilience standpoint? If it runs on immutable smart contracts and is always redeemable for a fixed amount of a decentralized asset, then you’re in the right place.

That’s why LUSD frequently experiences a price premium in times of crisis: people want to hold it when other more centralized stables are looking risky. Putting decentralization first in the hierarchy of the stablecoin trilemma is what sets LUSD apart from so many other stables, and has allowed Liquity to grow its TVL by over $380M during the bear market.

Every bank failure reiterates the value of truly decentralized stablecoins, and LUSD is consistently viewed by the market as the stable to hold when things get dicey. Adding bridges and liquidity venues on L2s has opened up LUSD to a wider group of market participants, while still retaining the immutability that makes the protocol so resilient. We’ve all seen the drawbacks of centralized stables, and while algo-stables have the potential to offer similar decentralization, they are yet to reach a point where they can be used reliably. LUSD is built to stand the test of time and adverse market conditions, evidenced by its consistent growth out of the depths of the bear market. Now that staked ETH has become a dominant asset in crypto we’re seeing new protocols fork Liquity with LSDs as collateral, which further speaks to the strength of its design.

This report was produced in collaboration with Liquity Protocol. Learn more about Liquity by following them on Twitter.