2023 has proven to be a remarkable year for builders exploring the potential of new DeFi primitives. During this period, one of the most intriguing developments has been the rise of Liquid Staking Derivates (LSD) protocols and, as anticipated, the subsequent rise of protocols built upon LSD projects, known as LSDfi.
These LSDfi projects can be categorized into several distinct parts. However, in this article, my primary focus will be on LSD-backed stablecoins.
Throughout the article, I will provide a concise definition of LSD and LSDfi. Then, I will delve into the analysis of LSD-backed stablecoins by individually analyzing the projects. Then, I will explain my general overview of the LSD-backed stablecoin landscape by emphasizing both their advantages and limitations. Lastly, I will offer future insights into LSD-backed stablecoins’ evolving landscape by discussing the opportunities and setbacks that these projects can face.
What is LSD? What is LSDfi?
Liquid Staking Derivatives (LSDs) are financial tools that represent ownership of a staked token in a DeFi protocol. These instruments enable users to stake their tokens while retaining the freedom to use these LSDs in various applications. Some of the LSD protocols are Lido Finance and Rocket Pool. LSDs are providing so many benefits to the ecosystem as they unlock the previously locked capital while also providing security to the network.
LSDfi describes projects that utilize LSD protocols by building financial primitives upon these protocols such as Pendle Finance and Unsheth. By offering additional yield-generating opportunities, LSDfi protocols allow LSD holders to put their assets to work and maximize yield.
However, as a sub-category, there are also LSD-backed stablecoins such as Raft, Gravita, Ethena, Prisma, and Lybra which we will review now.
Review of LSD-Backed Stablecoins
LSD-backed stablecoins are CDP model stablecoins that require over-collateralization by liquid staking tokens with liquidation risk. They allow holders to earn yields intrinsically while preserving the key attributes of crypto-backed stablecoins.
As can be seen, LSD-backed stablecoins are not so different from established crypto-backed stablecoins like $LUSD, $FRAX, or $DAI. The main value proposition that LSD-backed stablecoins offer is the $ETH staking yield while enabling users to continue to have exposure to DeFi applications. However, there are also several innovative features that new projects offer.
To have a better understanding of this category, we need to have a look at the protocols individually.
Prisma is an LSD-backed stablecoin that is Liquity fork but with significant improvements. Prisma enables users to mint $mkUSD that is collateralized by multiple LSTs such as $wstETH, $cbETH, $rETH, $sfrxETH, and $WBETH. $mkUSD will be incentivized on Curve and Convex Finance to create a capital-efficient flywheel where users can receive trading fees, $CRV, $CVX, and $PRISMA on top of $ETH staking rewards.
My thoughts on $mkUSD are as follows:
Competitive value proposition: Every LSD-backed stablecoin offers the $ETH yield to the users, however, on top of it, as the $mkUSD pools are deployed on Curve, users who deposit $mkUSD can earn trading fees, $CRV, $CVX, and $PRISMA rewards which will possibly make $mkUSD more competitive against competitors.
Not a medium of exchange: $mkUSD is a yield-bearing stablecoin and the protocol does not prioritize to be used as a medium of exchange. Most users hold $mkUSD for the APR that holding $mkUSD provides.
Yield-bearing assets: As $mkUSD 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
Innovative tokenomics approach: vePrisma holders will be able to incentivize certain pools, thus, LST providers may be interested in incentivizing $mkUSD with their own LSTs. This can create a positive flywheel effect for the demand for $mkUSD. According to the document, voters can direct emissions towards minting with a certain collateral, to keep an active borrow with a certain collateral, and to any LP tokens staker. Considering that deep liquidity is key to maintaining the peg, this will be an important point that differentiates Prisma from competitors.
Multiple LST Collateral: There are several LSTs that can be used as collateral such as $wstETH, $cbETH, $rETH, $sfrxETH, and $WBETH with different market caps. Thanks to the unique tokenomics approach, these protocols can incentivize users to mint $mkUSD, thus, increasing the exposure to Prisma.
Lack of capital efficiency: The over-collateralization model means that $mkUSD is limited in terms of capital efficiency as users need to put more money than they get. Moreover, there is always a risk of liquidation considering that the collateral rate should always be above 120%.
Strong backers: Compared to the competitors, even though Prisma Finance is late to the game, the protocol is supported by several strong backers such as Curve Finance, FRAX, and Convex. This backing will surely help Prisma to become more competitive as can be seen from how it utilizes $CRV and $CVX rewards via its tokenomics model.
Raft is a protocol that mints $R stablecoin that is backed by LSTs in an over-collateralized way with a liquidation risk. Users can earn sustainable yield via depositing into Savings Rate.
My thoughts on $R are as follows:
Lack of innovation: Raft is a fork of Liquity with small changes, so there is not much innovation on the product, thus, it may be easily overtaken after Liquity v2, which will utilize LSTs, is launched.
Not a medium of exchange: $R is a yield-bearing stablecoin and the protocol does not prioritize to be used as a medium of exchange. Most users hold $R for the APR that holding $R provides
Peg Stability: $R is currently worth around $0.98, and the team is trying to find solutions to restore the peg. The team proposed to implement an interest fee instead of a one-time fee to mint $R. By doing this, they aim to restore the peg by incentivizing buying pressure from the open market. The reason for the depeg can be attributed to the one-time fees to mint $R, lack of liquidity, and lack of use cases to create organic demand.
Limited value proposition against competitors: At this point, users do not need to pay an interest fee to borrow $R so they can leverage their $ETH positions. This is the main value proposition of $R. However, if the team decides to change this model there won’t be any value proposition for Raft.
Yield-bearing assets: As $R can generate revenue for its holders, there will surely be a demand just to 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.
Lack of capital efficiency: As $R is a CDP model stablecoin that requires over-collateralization with liquidation risk, it is not a capital-efficient model for retail users. This will limit the ability to grow as there is limited possibility to scale.
Gravita is a fork of Liquity that accepts different LSD products as collateral. It enables users to borrow without an interest fee and it does not take a cut of the yield generated by the deposited LST. The redemption mechanism was not launched at the beginning of the launch but has been gradually released throughout the process. This may be the reason of $GRAI is around $0.98 from the beginning which surely creates a trust issue from the user's perspective.
My thoughts on $GRAI are as follows:
Lack of innovation: As stated, Gravita is a fork of Liquity, and there is not so much innovation on the product, thus, it may be easily overtaken after Liquity v2, which will utilize LSTs, is launched.
Limited value proposition against competitors: Users do not need to pay an interest fee to borrow $GRAU so they can leverage their $ETH positions. Also, allowing $bLUSD to be used as collateral without any risk of liquidation and not taking any fee from the staking yield is a value proposition that Gravita offers.
Not a medium of exchange: $GRAI is a yield-bearing stablecoin and the protocol does not prioritize to be used as a medium of exchange. Most users hold $GRAI for the APR that holding $GRAI provides
Peg Stability: Since the launch of $GRAI, the price has fluctuated around $0.98. This can be due to the fact that redemptions of $GRAI are not allowed during the launch, and then it is released gradually, which may create excess supply, thus, decreasing the price without any arbitrage opportunity. Moreover, low liquidity and lack of use cases to create organic demand may limit the demand growth for $GRAI which also worsens the situation.
Yield-bearing assets: As $GRAI can generate revenue for its holders, there will surely be a demand just to 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.
Multiple LST Collateral: There are several LSTs that can be used as collateral such as $WETH, $rETH, $wstETH, and $bLUSD. This can be an advantage as it provides several opportunities for users.
Lack of capital efficiency: The over-collateralization model means that $GRAI is limited in terms of capital efficiency as users need to put more money than they get. Moreover, there is always a risk of liquidation which will limit the growth..
$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%. The protocol has also a governance token called $LBR with limited utility. With the introduction of Lybra v2, several new features were released which are expected to improve the drawbacks of the protocol.
My thoughts on $eUSD are as follows:
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. Moreover, there is always a risk of liquidation considering that the collateral rate should always be above 150%.
Limited value proposition against competitors: To have the potential to grow, newly emerging LSD-backed stablecoins need to possess unique value propositions. However, even though $eUSD has an early-mover advantage, it does not offer a competitive collateral requirement or any significant improvement against its competitors.
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. Most users hold $eUSD for the high APR that holding $eUSD provides.
Peg Stability: $eUSD holders are eligible for staked $ETH rewards. Thus, instead of minting $eUSD, most users prefer to buy it on the market, which creates demand pressure. 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. This can create a problem for the holders in the long term.
Yield-bearing assets: As $eUSD can generate revenue for its holders, there will surely be a demand just to 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.
Multiple LST Collateral: With the introduction of Lybra v2, new LST collaterals such as $rETH and $WBETH can be used. This will increase the possibilities for $eUSD minting, but we should not overestimate its impacts.
Bad tokenomics: $LBR is the governance token of the protocol, however, as almost all the yield from LSDs goes to $eUSD, not $LBR, the token almost has no utility. The bad tokenomics also perpetuates the positive premium of $eUSD, so it is always over the peg since users are incentivized to hold $eUSD as it is an interest-bearing stablecoin with significant $LBR emissions, the demand for holding $eUSD greatly exceeds the demand for minting $eUSD.
Ethena Labs is a new project that has not been released yet. The project differs from the competitors by offering a delta-neutral-backed model instead of a CDP model. With this model, the project will use LSDs as collateral and create a spot-long, 1x short position on the exchange, thus, preventing the volatility of the collateral. $USDe will be more efficient as it will offer a 1:1 collateralization ratio, and also other than the LSD yield, it will also offer funding fee yield which is the result of the delta-neutral model. However, users are not exposed to $ETH price volatility.
My thoughts on $USDe are as follows:
Innovation: Among all of the existing projects, Ethena is the only project that offers an innovative solution. I believe that the delta-neutral model can be successful in solving some of the main problems of LSD-backed stablecoins such as capital efficiency, lack of scalability, peg stability, and more.
Capital efficiency: Thanks to the delta neutral model, the protocol does not require over-collateralization to maintain the peg, thus, it can offer a 1:1 collateralization ratio. As a result of this, $USDe is the best among the competitors in terms of capital efficiency.
Peg stability: $USDe will use delta-neutral positions to maintain the peg stability. Considering that ‘’spot-long, 1x short position on the exchange’’ will always protect the value of the collateral in theory, we can feel safe about the peg mechanism. However, it is always important to see the results in practice.
Medium of exchange: As $USDe offers a 1:1 collateralization ratio, it can solve the scalability problem of existing crypto-backed stablecoin. As a result of it, $USDe can be used as a medium of exchange across platforms with deep liquidity.
Strong value proposition against competitors: $USDe has two main distinct advantages against its competitors that can differentiate the product in the market. First of all, it can offer a 1:1 collateralization ratio which will be more attractive to the user. Moreover, adding to the LST yield, $USDe will also offer the funding rate yield, which will be more competitive against the existing projects.
User adoption: As every innovative project faces the same problem, $USDe will also face some suspicion from the community as the delta-neutral method is not widely known and experienced, so it will take some time for Ethena to educate the users and experiment with the method.
No exposure to ETH volatility: As the deposited collateral is used to create a hedged position, the user won’t have any exposure to the price volatility of $ETH. Risk-averse users can see it as a benefit, however, $ETH maxis may see it as a drawback.
Thoughts on the general Landscape of LSD-Backed Stablecoins
Until now, I shared my thoughts on individual LSD-backed stablecoins so that we can have a better understanding of the dynamics of these stablecoins while analyzing their opportunities and limitations. I believe that this analysis can be helpful in understanding the competitive landscape of LSD-backed stablecoins and prove the trade-offs of every individual stablecoins.
Now, I will share my general overview of the LSD-backed stablecoin landscape so that we can predict how this category may evolve. To do so, I will implement a SWOT analysis:
Note: It should be highlighted that a general SWOT analysis for every LSD-backed stablecoin can’t provide a great overview as every one of them has different values/features. This especially applies to Ethena Labs, as their delta-neutral mechanism is completely different from CDP models. For example in the weakness section, capital efficiency, medium of exchange and limited use cases do not apply to $eUSD, Ethena’s stablecoin.
Store of Value: LSD-backed stablecoins are great tools as a store of value as most of them have achieved price stability while offering the $ETH yield to the users. As a result, they can increase their market share in the near future as a low-risk yield opportunity and as a store of value. With people realizing that LSD-backed stablecoins empower users by sharing the inherent yield with them over fiat-backed stablecoins, the adoption rate will grow.
Yield opportunity: While having 5-8% APR on their stablecoins may not be attractive for retail traders, it is a great opportunity for the whales and leveraged traders considering that the high-yield opportunities in the DeFi ecosystem have been limited as the bear market continues.
Unlocking the liquidity: LSDs are a great way to unlock the staked $ETH liquidity, and on top of this, LSDfi, and in particular, LSD-backed stablecoins improve this situation further by creating new use-cases for LSDs which will surely further grow the opportunities for the ecosystem.
Increased $ETH Exposure: LSD-backed stablecoins are great tools to expand the Ethereum ecosystem as they improve the ways users can expose $ETH and also create new use-cases for it, so more organic demand.
Growth depends on LSDfi adoption: LSDfi is a new category that needs to be explored further. As the first movers in this category, LSD-backed stablecoins will be highly dependent on the overall growth of the market which is partly independent of their impact.
Capital efficiency: As LSD-backed stablecoins also implement the CDP model, they require over-collateralization with liquidation risk. Thus, capital efficiency becomes a central challenge that users face.
Medium of exchange: LSD-backed stablecoins are inherently used for yield opportunities and as all of them are dependent on the CDP model, there is no possibility for LSD-backed stablecoins to be treated as a medium of exchange which will limit the scalability of these products.
Limited use-cases: Even though being a sustainable yield-bearing asset is a great value proposition, the liquidity fragmentation and lack of liquidity limit the use cases of LSD-backed stablecoins. Other than holding it, there are limited ways of utilizing these stablecoins.
ETH Staking Adoption: ETH staking is one of the areas in which we’ll see further growth with the continuing trust in the safeness of the Ethereum ecosystem and $ETH staking yield. With the $ETH staking rate possibly growing in the future, it can be predicted that LSD-backed stablecoins will benefit from it.
Store of value against inflation: There will always be a strong demand for yield-bearing assets due to inflation. As we can see from the attempts to build inflation-resistant stablecoins/flatcoins, there is a massive demand for them. Even though, in essence, LSD-backed stablecoins do not exist to beat inflation or act as a store of value against inflation, they proved that they can work as a great tool against inflation.
Lack of innovation: I believe that LSD-backed are mostly Liquity forks with little difference. As a result, they don’t add so much value proposition against Liquity except by allowing Liquid Staking Tokens (LST) to be used as collateral. I don’t see the reason why most of the investors would still use these protocols when Liquity allows LSTs to be allowed, which possibly will be realized with the launch of Liquity v2.
Yields may go lower: As there is always the possibility of $ETH staking yield going lower, the yield that LSD-backed stablecoins will be lower as well. This may disincentivize users to prefer these stablecoins. Considering that more $ETH will be staked in the future, this is an inevitable result that LSD-backed stablecoins will face.
Low demand and liquidity: Until now, most of the LSD-backed stablecoins are not able to maintain the peg around $1. Even though there are specific reasons for this situation, the common problem is that there is no strong demand and liquidity for these stablecoins.
Liquidity fragmentation due to the competition: At this point, there are several teams that are trying to build an LSD-backed stablecoin, and there is no clear-cut winner in this race. This means that liquidity fragments among the competitors which limit the ability to grow, thus preventing the product more effective or generating revenue. All of these may have a long-term impact on the success of the LSD-backed stablecoins.
The end of the bear market: Most of the investors choose LSD-backed stablecoins as a yield-bearing asset as there is no better solution/alternative during the bear market. However, when the bull market starts, the capital can flow into more profitable ventures as 5%-8% APR during the bull run may not be attractive. However, it should be noted that the end of the bear market will surely help these protocols grow as the general market cap will further grow.
Future Implications: Making LSD-backed stablecoins more efficient
It is clear that there is a growing interest in the LSD-backed stablecoins coinciding with the rise of LSDfi products. I believe that this trend will continue to grow. However, I think that most of the current models of LSD-backed stablecoins are not going to be a product-market fit or they won’t have a competitive edge over their competitors.
Some LSD-backed stablecoins such as $R, $GRAI, and $eUSD do not have definitive value propositions against existing projects like $crvUSD and $LUSD. It is possible that these protocols will be able to diminish the share of the aforementioned projects.
Prisma Finance is an interesting case as they’re developing unique tokenomics to improve the yield for the stablecoin holders and may create value for the governance token holders. Even though the stablecoin’s current CDP model is not unique and it does not add a new value proposition against the existing ones, the protocol may have a chance due to its tokenomics as it creates an organic demand for the user which deepens the liquidity so that maintaining the peg becomes easier.
Ethena Labs is a unique model that challenges the existing models. The protocol is more capital efficient and can create more revenue via funding fees due to the delta-neutral position that the protocol opens to maintain the collateral. This is crucial as this model creates an organic yield over to the existing LST yield and makes the protocol more competitive. However, it should be noted that in the CDP model, when the price of collateral goes up, the borrower gains profit. Still, in the case of Ethena, the user gives up the possible profit from the upside volatility of $ETH as the peg is maintained by the delta-neutral position. In general, I think that Ethena can solve some of the main problems of LSD-backed stablecoins such as capital efficiency, lack of scalability, peg stability, and more.
In general, the future of the LSD-backed stablecoins will depend on:
New models to improve capital efficiency
New sources of yield
ETH Staking adoption
We’ll see what the future brings.