Stablecoins remain a central topic of discussion within the ecosystem due to their significant alignment with market demand. As a result, both developers and enthusiasts have been actively exploring avenues to create a stablecoin that can exert a lasting influence on the ecosystem. However, the progress in this endeavor has been relatively modest thus far.

I believe that the inherent limitations of crypto-backed stablecoins are not discussed enough. As we will discuss in the article, the current projects have failed to attract users as the crypto-backed stablecoins are limited against fiat-backed stablecoins in several areas such as capital efficiency, liquidation risks, limited use cases, and liquidity.

Throughout the article, I’ll look at some stats on the current landscape of stablecoins and share some thoughts on that. Then, I will discuss stablecoin functionality as a concept that helps us to understand the reasons for the state of the stablecoin market. Lastly, I will focus on crypto-backed stablecoins individually, and address their problems.

Current Stablecoin Market Stats

Looking at the numbers from DeFiLlama:

• The total stablecoin market cap is around $125 billion with almost 87% of it held by $USDT and $USDC.

• Around 92% of the whole market is held by fiat-backed stablecoins with almost $116 billion.

• Only around $7 billion is held by crypto-backed stablecoins in which $DAI holds around $5 billion.

• The total market cap of algorithmic stablecoins is around 2 billion while $FRAX and $USDD capture 75% of the market share.

What does this data tell about the market conditions?

This data provides several insights about the market conditions:

1. $USDT and $USDC are projects that have achieved product-market fit and are in sync with market and user demands.

2. Despite the increasing number of projects in the crypto-backed stablecoin category, the dominant market share of $USDT and $USDC proves that there is no demand for alternatives right now.

3. Even though the increase in the DAI Savings Rate has helped DAI to gain market share for a while, $DAI has failed to maintain its market cap in terms of USD value for the last year while its dominance among crypto-backed stablecoin is unchallengeable.

4. With $DAI being the primary widely adopted crypto-backed stablecoin, its move towards RWA including US treasuries highlights the absence of a scalable stablecoin that is resistant to censorship and immune from counter-party risks.

5. Other crypto-backed stablecoins, excluding $DAI, have limited adoption, suggesting that their success and potential might be overestimated.

6. The viability of algorithmic stablecoins is uncertain, given that $FRAX is also attempting to distance itself from algorithmic mechanisms.

7. Notable changes in the stablecoin landscape are unlikely unless a major event undermines the credibility of $USDT and $USDC, or a groundbreaking project emerges.

Why do users prefer $USDT and $USDC?

Crypto started as a movement that was defined by the belief in freedom, decentralization, and skepticism toward centralized actors. However, the current landscape of the stablecoin market says otherwise. It is clear that with adoption in the ecosystem increases and more people coming to the space, the purity of the ecosystem also decreases, as most of the newcomers are not here for decentralization or censorship resistance.

The most centralized and may be the least transparent projects are the market leaders. The main reason for this situation can be explained with a new concept that I framed, called stablecoin functionality:

Stablecoin functionality is a new concept to understand some of the main topics in the stablecoin landscape:

1. The market dynamics between users and stablecoin projects

2. The reasons why some stablecoins are adopted while others not

3. The vision that stablecoin project developers should have

I claim that stablecoins should be treated as the digital versions of off-chain assets to which they are pegged. Thus, in our case, USD-backed stablecoins need to represent the functions of USD. These functions can be integrated into stablecoins as:

1. Medium of Exchange: A stablecoin should be seen by the users as a tool to exchange cryptocurrencies or make transactions with others, and it needs to be available in major protocols such as CEXs and established DeFi projects like Uniswap, Balancer, Curve, etc. and needs to have basic pairs.

2. Store of Value/Peg Stability: A stablecoin should have a historical performance of maintaining its peg, even a change of 1% can be seen as a failure from the perspective of the user.

3. Capital Efficiency: If a stablecoin requires over-collateralization or poses a liquidation risk, it is not capital efficient which will limit the adoption of users as most of the users understandably expect their holdings not to have these risks or limitations.

4. Fiat On-Ramp/Off-Ramp: If a stablecoin does not provide on-ramp/off-ramp solutions, it is becoming harder to use it as the long road of converting the crypto assets into cash dollars makes the process costly and tiring.

5. Censorship Resistance: A stablecoin should protect its users from the arbitrary actions of centralized actors by being a safe haven of privacy and self-custody while also not relying on centralized entities such as banks.

As it can be understood, $USDT and $USDC have most of these functions including medium of exchange, store of value, capital efficiency, and fiat on-ramp/off-ramp solutions, but both stablecoins are centralized and thus not censorship resistant. Even though $USDT and $USDC are not able to achieve full success within the framework of stablecoin functionality, they are the most successful ones in this framework, thus, they are product-market fits. Adding to these, the early-mover advantage of these projects coupled with brand awareness makes them highly adopted by users.

Thus, it is clear that to threaten to dominance of $USDT and $USDC, a stablecoin project needs to meet these 5 major requirements and then have brand awareness among the community.

However, we need to consider whether it is even possible or not to challenge $USDT and $USDC among the current models/technological developments within the crypto-backed stablecoins. Let’s dive into some of the existing stablecoin projects that may be considered challengers to $USDT and $USDC.

Review of crypto-backed stablecoins

In this section, I will focus on a couple of stablecoins that I think are worth analyzing as they comprehend all aspects of the crypto-backed stablecoins that are necessary to have a look at.

Before diving into each stablecoin, I would like to highlight that I believe that the limitation of the Collateralized Debt Position (CDP) model is a major problem that every crypto-backed stablecoin faces. CDP requires users to lock crypto assets in an over-collateralized loan with liquidation risk, thus, it is inherently limited in scale.

The lending-borrowing relationship between users and protocols is problematic as it does not suit stablecoin functionality in several ways:

1. Medium of exchange: As users are creating a lending position via minting, other than leveraged yield farming and leveraged trading, they won’t use this stablecoin for transactions. Therefore, crypto-backed stablecoins are not treated as a medium of exchange.

2. Capital efficiency: As CDP requires over-collateralization with liquidation risks, it is not capital efficient from a user perspective as there are more capital-efficient ways instead of minting a crypto-backed stablecoin.

As a result, we can say that crypto-backed stablecoins are not product-market fits, however, we need to analyze these stablecoins individually so that we can have a better understanding of the limitations and drawbacks while also highlighting the opportunities.

$DAI

$DAI is an over-collateralized CDP stablecoin that is issued by MakerDAO. It is one of the biggest crypto-backed stablecoins that attracts billions of dollars and saw good adoption in the DeFi ecosystem. However, with the launch of new crypto-backed stablecoins and the recent depeg of $DAI related to the depeg of $USDC, the stablecoin lost some of its market share to the competitors. However, with the introduction of the Enhanced DAI Savings Rate, the protocol achieved some traction again, even though the discussions on sustainability continue.

While it is one of the most profitable businesses in the ecosystem as the protocol utilizes its holdings in treasury bills, its future is also questionable as the protocol receives several criticisms such as ‘’$DAI is poor man’s $USDC’’ or dependency on centralized actors.

It is clear that the Maker DAO team decided to part ways with the ethos of decentralization and focus on monetization of the protocol, which in essence is not a bad thing in terms of business, however, it surely created some problems, for example, why should I use $DAI, why I can use $USDC?

As far as I am concerned, there are several challenges that $DAI will face:

1. Lack of innovation: $DAI is minted by a CDP position that is over-collateralized, thus, it does not possess any significant technological superiority against its competitors. The launch of the Enhanced DAI Savings Rate is also a good indicator that the project is having difficulties attracting users.

2. Dependency on centralized actors: $DAI is not a mostly decentralized stablecoin as it is reserved by mostly $USDC and RWA assets and revenue is generated via treasury bills which means that the custody of the assets is handled by a centralized actor.

3. No significant value proposition: The main value proposition of crypto-backed stablecoins is being decentralized and censorship-resistant. As a trade-off, these protocols implement CDP models and require over-collateralization with liquidation risk. However, while $DAI maintains these drawbacks, it does not offer any value proposition in terms of decentralization. Thus, it combines the worst parts of fiat-backed and crypto-backed stablecoins.

On the other hand, there are also opportunities that $DAI possesses:

1. High adoption: $DAI is one of the most well-known and adopted stablecoins in the ecosystem. This can be proven that there are around 500K $DAI holders*. Moreover, $DAI exists in most of the well-established DeFi protocols with strong liquidity. Considering that bootstrapping liquidity is the toughest part that every stablecoin project faces, $DAI is positioned in a very good place.

2. Medium of exchange: $DAI is perceived by many as a medium of exchange which can be proven by the fact that it is used by many to make transactions and buy/sell crypto assets while it has several pairs in different protocols with deep liquidity.

3. Store of Value: With the introduction of treasury bill revenue distributed to the DAI stakers via the Enhanced DAI Savings Rate, $DAI can be a safe and reliable source of yield and store of value, thus, increasing the adoption.

$FRAX

$FRAX started as an algorithmic stablecoin that is both backed by an algorithmic mechanism and a crypto reserve that is undercollateralized. However, the fall of $UST caused a loss of trust regarding algorithmic stablecoins made the FRAX team change this model. Thus, they decided to use $USDC as the reserve to reach 100% ratio collateralization. However, this model got criticism as $FRAX became a ‘’poor man’s $USDC’’.

However, this model will also change with the soon-release of FRAX v3. Even though not all the detail is public, it is rumored that the dependency on $USDC will be dropped and the FRAX ecosystem and its stablecoin $FRAX will be backed by US Treasury Bills.

As far as I am concerned, there are several challenges that $FRAX will face:

1. Dependency on centralized actors: One of the most frequent criticisms is that $FRAX depends on $USDC if $FRAX is reserved by $USDC, what is the reason to hold it? Even though they are changing the model, the dependency on centralized actors will still continue as they will work with other centralized actors for the FED Master Account.

2. The confusing and changing vision of the leadership team: It is debatable whether the criticism is valid or not but the FRAX leadership team looks like they’re focusing on too many developments in a short period of time and changing the roadmap very frequently which raises the question of what is the vision FRAX.

3. **Lack of $FRAX holders/users:** Considering that [$FRAX has around 8k holders](https://etherscan.io/token/0x853d955acef822db058eb8505911ed77f175b99e) according to Etherscan stats with a market cap of around $800 million**, the value proposition that $FRAX posses is not being a medium of exchange, thus, this limits $FRAX’s potential to challenge $USDT and $USDC. Frax is not widely used as a pair in the ecosystem. Apart from the products that are built on top of the Frax, it is only used on Curve. The reason for this is the incentives that Curve pays to $FRAX pools as a result of the position of Frax on Curve Wars. The sustainability of the Curve will be an important parameter for $FRAX as well.

On the other hand, there are also opportunities that $FRAX possesses:

1. Capital efficiency: At this point, users can deposit 1 $USDC and get 1 $FRAX which is capital efficient. It can be supposed that with migrating the new model, this capital efficiency will continue, thus, it is a competitive advantage that $FRAX possesses.

2. Established FRAX ecosystem to boost the use cases of $FRAX: Most of the stablecoins face the use cases problem, meaning that there is no place to utilize the underlying stablecoin. However, $FRAX can be used effectively via the general FRAX ecosystem including Fraxswap, Fraxlend, Fraxferry, and maybe in the future in the Fraxchain.

$LUSD

$LUSD is one of the most-forked stablecoin projects in the ecosystem as it offers a unique solution that provides censorship-resistant stablecoin. It is backed by $ETH, and users can borrow against their $ETH holdings with a minimum collateral ratio of only 110%.

Some of the features that make $LUSD competitive:

1. Immutable Smart Contracts

2. Governance Free

3. No interest charged

4. Collateral quality

Moreover, as we can see from the latest announcements from Liquity Protocol, with the launch of Liquity v2, they will develop a new model that will utilize delta-neutral methods to maintain the value of the collateral. This will be a new stablecoin that is separate from the existing project.

As far as I am concerned, there are several challenges that $LUSD will face:

1. Limited Scalability: Even though $LUSD is one of the most inspiring projects in the ecosystem, it is also one of the least scalable ones as it requires over-collateralization, possesses liquidation risks and only $ETH is accepted as collateral.

2. Lack of $LUSD holders/users: As a result of the lack of scalability of $LUSD, there are only 8k holders of the stablecoin with a market cap of around $300 million according to Etherscan***.

3. Lack of use cases: As $LUSD is not scalable enough, it is not possible to find enough liquidity across the major protocols, thus, preventing the adoption of $LUSD.

4. Capital Efficiency: Liquidity requires over-collateralization with liquidation risks, thus, it is not a good choice in terms of capital efficiency that limits the ability of $LUSD to be treated as a medium of exchange.

On the other hand, there are also opportunities that $LUSD possesses:

1. Censorship resistance: The most unique aspect of $LUSD is that it is the best project in terms of decentralization and censorship resistance. I do not think that there is competition in this field.

2. Strong brand: $LUSD’s long-term success in terms of decentralization and peg stability and the team’s success in achieving trust among the community makes the $LUSD brand a strong one, that can be utilized by the team.

3. Liquity v2: Liquity team is aware of the existing problems regarding the scalability of the protocol, and they aim to scale without breaking. Developing a delta-neutral model that uses a principal protection method to prevent the losses caused by the volatility can solve the scalability issue to some extent.

$eUSD

$eUSD is a stablecoin that is reserved by staked $ETHs as collateral. Owning $eUSD leads to a consistent earnings stream with an APY of around 8%. It is a CDP stablecoin that requires over-collateralization with liquidation risks.

As far as I am concerned, there are several challenges that $eUSD will face:

1. Lack of capital efficiency: The over-collateralization model means that $eUSD is limited in terms of capital efficiency as users need to put more money than they get with a liquidation risk.

2. Limited use cases: $eUSD does not have many use cases as the stablecoin does not have enough demand to create liquidity for several pools which limits the ability to scale.

3. Limited growth potential: To have the potential to grow, newly emerging stablecoins need to possess unique value propositions, however, even though leveraging LSD products can be seen as a good way to scale, it is limited as the market is very competitive.

4. Not a medium of exchange: $eUSD is a yield-bearing stablecoin and the protocol does not prioritize to be used as a medium of exchange. Even though this is also an important value proposition, it limits growth potential.

5. Peg Stability: eUSD holders are eligible for staked $ETH rewards. As a result of this, there is more demand for eUSD than its supply which breaks its peg above $1.00. Unless the system changes, eUSD will not find its peg.

On the other hand, there are also opportunities that $eUSD possesses:

1. Yield-bearing assets: As $eUSD can generate revenue for its holders, there will surely be a demand to just use it as a store of value. If users trust the peg stability, it can be a good way to have exposure to $ETH yield.

2. Exposure to LSD products: LSDfi is a growing market that surely has achieved product-market fit, Utilizing LSDs to mint a stablecoin is a lucrative business both for the protocol and the user.

$crvUSD

$crvUSD is a CDP stablecoin project that requires over-collateralization with liquidation risks. What makes $crvUSD unique is its liquidation mechanism called LLAMMA. With this method, LLAMA employs distinct price ranges to gradually sell off segments of the collateral, instead of immediately selling everything at a designated liquidation value. Consequently, as the collateral's price decreases, portions of it are auctioned off in exchange for $crvUSD.

Until now, the stablecoin has achieved a gradual increase in market cap without any major depeg. However, while it has around $100 million in liquidity, it only has around 600 holders**** which is concerning in terms of how scalable the product is.

As far as I am concerned, there are several challenges that $crvUSD will face:

1. Lack of capital efficiency: As $crvUSD is over-collateralized CDP position with liquidation risk, it can scale up to a certain as it does not differentiate itself from competitors in terms of capital efficiency.

2. Limited use cases: Due to the low liquidity and lack of scalability of $crvUSD, there are limited use cases of $crvUSD in which you can use the stablecoin. There are several staking pools of $crvUSD, however, considering the trade-offs, it is not very attractive.

3. Lack of holders: As stated, there are around 600 $crvUSD holders which is due to the lack of demand for CDP stablecoins. Thus, even though, it offers a unique liquidation mechanism that is superior to other CDP stablecoins, $crvUSD will have a problem attracting new holders.

On the other hand, there are also opportunities that $crvUSD posses:

1. Unique liquidation mechanism: $crvUSD’s soft liquidation mechanism is a great innovation that will surely be copied by the competitors as it prevents hard liquidation until a certain point which can increase the scalability of CDP stablecoins.

2. Curve backing: Curve is a well-established stable swap that has been in the ecosystem for years with deep liquidity that $crvUSD can utilize in the future and effectively increase its scalability.

Conclusion

It was a long read, and there is one simple thing that you should remember after closing the tab.

"The future of crypto-backed stablecoins will be determined by a simple question:

'Will users be able to buy stablecoins instead of lending?'

The current models do not provide a great solution in the crypto-backed stablecoin landscape that achieves stablecoin functionality. Thus, $USDT and $USDC can continue to dominate the space.

However, they also have some limitations, especially in terms of decentralization, censorship resistance, and self-custody.

I am sure that there can be new models that tackle these problems and achieve stablecoin functionality, however, I am also pretty sure that current models are broken and won’t succeed.

Notes

*This data is taken from Etherscan, and it may not include the stakers.

**This data is taken from Etherscan, and it may not include the stakers.

***This data is taken from Etherscan, and it may not include the stakers.

****This data is taken from Etherscan, and it may not include the stakers.