Explore the current outlook of the stablecoin market

Author of the article: rxndy444 Compiler: Block unicorn

The narrative of cryptocurrencies has fluctuated, but stablecoins have been firmly established in the market as a core component of on-chain financial infrastructure. There are currently more than 150 stablecoins on the market, and new stablecoins are released seemingly every week. How should the user choose among all the different options?

When evaluating the strengths and weaknesses of different stablecoins, it is helpful to categorize them based on common design elements. So, what are the basic ways in which stablecoins can change?

The main differences between the different stablecoins include:

1. Collateralization: Are these tokens fully backed by assets? partial support? Or no support at all?

2. Centralization: Does the collateral involve government-backed assets such as dollars, pounds, or treasury bonds? Or is it composed of decentralized assets such as Ethereum?

Keeping these properties in mind, we can start to build a framework for comparing different stablecoins. Let's take a look at how some of today's major players stack up against each other.

Deep Dive into Decentralized Stablecoins

Looking at the top 10 stablecoins by trading volume, we can see that centralized stablecoins, basically on-chain dollars, are the most commonly used. These stablecoins do not offer censorship resistance or protection from traditional financial banking crises. For example, when Silicon Valley Bank collapsed in March, holders of USDC had to worry about the fate of the reserves kept there. Many have rushed to swap their USDC for more robust options, including LUSD, and this isn’t the first time we’ve seen the decentralization premium play out.

The ultimate goal of stablecoins is to find an option that can achieve decentralization, maintain capital efficiency, and maintain price stability, which is obviously impossible for USDC and USDT. To move the stablecoin space forward, we must look beyond these two options - so what does the current playing field look like?

Of the top 10 stablecoins, only 3 can be considered somewhat decentralized; DAI, FRAX, and LUSD.

Frax: The Road to Algorithmic Stablecoins Frax is a fractional reserve stablecoin that uses the AMO (Algorithmic Market Operations) system to change its collateralization ratio and keep the price close to the anchor price. At the most basic level, AMO increases the ratio when the price is below $1 and decreases it when the price is above $1. What this means for FRAX holders is that redemption satisfaction depends on current collateralization levels. If the ratio is 90%, then redeeming 1 FRAX will get $0.90 from the protocol reserve + AMO’s newly generated FXS (Frax shares) worth $0.10. Due to the dynamic nature of the collateral ratio, it is difficult to determine the actual amount of collateral behind FRAX at any given time.

A recently passed proposal shows community support for moving to a fully collateralized model. The main motivation here is largely due to heightened regulatory scrutiny of algorithmic stablecoins following Terra’s UST woes. Algorithmic stablecoins are still a highly experimental segment of the market in general, and while Frax has been able to successfully grow using its AMO model, it appears to be shifting.

DAI: Partial Decentralization

With its CDP model, DAI has become the most successful stablecoin besides on-chain USD such as USDC and USDT. The main problem here is that, what most people probably don’t realize initially, borrowing in DAI is often collateralized with the same centralized stablecoin, exposing it to the same centralized risk. Since expanding to a multi-collateral model, these centralized stablecoins have become a major component of DAI backing, sometimes over 50%!

Given our uncertainty about Frax and DAI reserves, let's look at the rest of the decentralized stablecoin market. Continue to watch which stablecoins are decentralized and only backed by crypto assets.

LUSD

LUSD is by far the most prominent in the field of stablecoins fully collateralized by cryptoassets. LUSD has achieved this status by building on solid foundations: immutable smart contracts, an economically sound peg mechanism, and capital efficiency that provides room for growth without jeopardizing collateralization ratios. While Liquity’s smart contracts will forever remain on Ethereum, LUSD has also now been bridged to L2, with Optimism and Arbitrum having a combined liquidity of over $11 million.

Since the beginning of the year, the circulating supply has increased by over 100M LUSD and over 10M has been transferred to L2. Rollups amassed significant TVL in 2023, Arbitrum's grew from $980 million to $2.3 billion, and Optimism's grew from $500 million to $900 million. Mainnet users aren’t the only ones valuing decentralized stablecoin options, which presents ample opportunity for LUSD to capture more market share on L2.

Along with the circulating supply, the number of Troves has also risen sharply this year, approaching all-time highs. We haven't seen 1200+ active Troves since the 2021 bull run. Considering that the price of Ethereum is far from returning to the level at that time, these users seem to be more inclined to stablecoins than Ethereum leverage.

Stablecoin Market Trends

Forking

It is often said that imitation is the highest level of praise, and the Liquity model is being replicated by some new stablecoins. Most are doing the same CDP style, but with collateralized ETH. Given the attention ETH and its LSDs have received in the first half of 2023, and withdrawals now enabled, staking ETH is significantly more liquid and attractive.

Is staking ETH better than ETH? It's hard to say for sure, but there are definitely trade-offs to consider. The main benefit of using an LSD like stETH as the backing of a stablecoin is the interest yield feature. The main downside appears to be a combination of slashing risk and LSD unanchoring risk. For these reasons, higher minimum collateralization ratios are generally used relative to LUSD. These risks aside, the contracts of most of these stablecoins are upgradable and controlled by multi-signatures, unlike the immutable contracts behind Liquity.

This means that parameters such as collateralization ratios may change. Collateralized ETH-backed stablecoins are certainly interesting and perform well in terms of decentralization and yield generation, but are less capital efficient than regular ETH due to the added risk.

Dollar risk and decentralization premium

One of the issues worth recalling that we mentioned at the beginning of this article is - traditional financial banking crisis. Silvergate, SVB, First Republic, the three largest bank failures in US history have all occurred in the past few months.

The real question behind these events is where do you feel safest to store your funds in times of crisis? Not all dollars are created equal, and as recent bank failures remind us, bank deposits can disappear in a flash. Sure, there is FDIC insurance up to $250,000, and the government has shown a willingness to bail out failing banks, but people still seek safety in uncertain times thanks to the dollar-run fractional reserve system. This means a bank run, and we have seen for the first time how this affects stablecoins that rely on fiat reserves, such as USDC and SVB.

In times of uncertainty, for those concerned with protecting assets during crises, decentralized stablecoins have a relevant use case, offering true non-custodial ownership. So, from a resilience standpoint, which stablecoin would you choose as an option for 5+ years? If it runs on immutable smart contracts and is always redeemable for a fixed amount of decentralized assets, then you are in the right place.

This is why LUSD often sees a price premium in times of crisis: people want to hold it when other, more centralized stablecoins look riskier. Putting decentralization at the top of the stablecoin trilemma is what sets LUSD apart from many other stablecoins and has enabled Liquity to add over $380 million in TVL during bear markets.

Summarize

Every bank failure reaffirms the value of a truly decentralized stablecoin, and LUSD has long been viewed by the market as the stablecoin to hold when the going gets tough. Adding bridges and liquidity venues on L2 makes LUSD accessible to a wider audience of market participants, while still retaining the immutability that makes the protocol so powerful. We’ve all seen the downsides of centralized stablecoins, and while algorithmic stablecoins have the potential to offer similar decentralization, they haven’t reached the point where they can be reliably used. LUSD is designed to withstand the test of time and adverse conditions, as evidenced by its continued growth in bear market troughs. Now that collateralizing ETH has become a dominant asset in cryptocurrencies, we are seeing new protocol forks, Liquity, and using LSD as collateral, further illustrating the superiority of its design.