Stablecoin is a very profitable business, which already found its product market fit in the ecosystem. Millions of people around the emerging markets use stablecoins to access USD, which was not possible before.
However, it should be noted that even though stablecoins are a byproduct of the crypto ecosystem, at the current state, they inherently clash with the main ethos of crypto, decentralization. As known, the biggest stablecoins in terms of market cap are fiat-backed stablecoins such as $USDC and $USDT or RWA-backed ones such as $DAI and $FRAX.
Several projects aim to challenge this dynamic such as $LUSD, $crvUSD, or $mkUSD, however, as I discussed in a previous article called ‘’Crypto-backed stablecoins are broken’’, current crypto-backed stablecoin models are inherently limited and can’t scale. This problem has been pointed out several times, and some protocols like $DAI and $FRAX pivoted from their decentralized versions to become RWA-backed so that they become scalable and profitable while giving up on decentralization.
Even though there has been no significant change in the market that challenges my view until now, some developments encouraged me to write a follow-up as I think that the current crypto-backed stablecoin ecosystem is in an identity crisis.
What is the identity crisis of crypto-backed stablecoins?
For the last year, the RWA narrative has been becoming stronger in the stablecoin enthusiast circles as we saw how the leading crypto-backed stablecoins like $DAI and $FRAX adopted centralization over decentralization. This trend has coupled with the bleeding of the market cap of the crypto-backed stablecoins as the RWA yields are more attractive than the crypto-native yields.
As a result, the crisis is growing which forces crypto-backed stablecoins to find a new path, or let’s call it identity to both be scalable and decentralized.
Most of the crypto-backed stablecoins are forking Liquity or adding new elements - $crvUSD and $mkUSD
Liquity is developing a new model - Liquity v2
New yield sources are explored - $eUSD
Financial engineering - $fETH
These are bad times for decentralized crypto-backed stablecoins. However, we should note that bad times create strong people.
Failure of the CDP model: The ‘Growth’ of Prisma Finance and $LUSD redemptions
Prisma Finance is a newly emerging Liquity fork that utilizes LSTs as collateral assets. The only major difference of the protocol is that minting $mkUSD will be incentivized on Curve and Convex Finance so that users can receive trading fees, $CRV, $CVX, and $PRISMA on top of their $ETH staking rewards.
Since it was supported by the major players in the stablecoin ecosystem like Curve and Convex, its launch was viral, however, the results were not satisfactory.
After the launch of the governance token, $PRISMA, the protocol has reached a $170m $mkUSD supply and is currently hovering around $160m, however, most of this supply comes from Justin Sun, who is farming the governance token and dumping it to the holders, so, we are just seeing an example of liquidity farming where a whale gets all the benefits until he/she leaves.
As a CDP model stablecoin, $mkUSD shares all the inherent limitations of the CDP model, and as a result, I believe that the further demand for the protocol will be lower. Until now, I believe that the ‘growth’ of Prisma Finance has proven my thesis regarding CDP models.
On the other hand, one of the most OG stablecoin projects in the ecosystem, Liquity, has been losing its market share lately, decreasing from $300m to around $200m, due to the increasing redemption of $LUSD which also affects Trove owners.
Liquity has a built-in $LUSD redemptions mechanism that allows anyone to swap 1 $LUSD for $1 of $ETH using the protocol, which is a process that uses (lowest c-ratio) users' Troves. However, things are getting worse as even if you have a %285 collateralization, you’re not immune to the Trove redemption risk.
The launch of DAI Saving Rates is becoming a major blow to Liquity as people are creating a CDP position on Liquity with a low one-time fee that is around 0.5-1%, and then selling it for $DAI to have a 5% yield for $sDAI. This situation has been increasing the $LUSD redemptions and it is clear that the side effects of these redemptions are becoming unbearable for the users.
Given the fact that Liquity is currently building Liquity v2, which will be a separate stablecoin, we can assume that the team also thinks that the CDP model’s scalability issues will be a major limitation to the growth of the protocol.
Improvements to the CDP Model: Success of crvUSD
Curve team always leads the innovation in the ecosystem, and this trend continues with their stablecoin, $crvUSD.
$crvUSD is a CDP stablecoin project that requires over-collateralization with low 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.
Since the launch of $crvUSD, there has been a steady growth in the supply powered by the $CRV rewards, and it is possible that soon $crvUSD will be the biggest CDP model stablecoin. As LLAMMA is way more efficient than the current liquidation methods, traders who are looking to leverage collateralized debt positions prefer $crvUSD over competitors.
It is possible that during the bull market, the demand for CDPs will increase as traders will want to increase their exposure to $ETH, on the other hand, as the demand for CDP will decrease during the bear market, the market cap of $crvUSD will decrease as well. So, we can assume that $crvUSD is very dependent on the market cycles, which should not be seen from a stablecoin, just consider $USDT.
I believe that as every CDP model faces, the scalability and capital efficiency issues of CDP models will hinder $crvUSD’s success in terms of stablecoin functionality. As a result, I don’t think that $crvUSD can challenge the current state of the stablecoin market but dominate the CDP category against LUSD and mkUSD.
New Models Emerging: f(x) Protocol
Considering that CDP models are broken and the growth of this category is limited, there are surely people who are trying to develop new models to develop a scalable and decentralized stablecoin.
As I recently discovered, the f(x) Protocol developed by Alaaddin DAO is tailoring a unique solution that can provide a scalable and decentralized stablecoin that is immune to the TradFi and macroeconomic conditions and depends on the $ETH economy.
f(x) Protocol decomposes ETH into two products to build a decentralized stablecoin that aims to offer capital efficiency without liquidation risk while eliminating the risk associated with exposure to RWAs.
The protocol splits ETH into two products:
fETH: a decentralized floating stablecoin
xETH: a zero-cost leveraged long ETH position that absorbs the volatility of ETH price movements to stabilize fETH
These tokens are generated by dividing ETH collateral into two parts: a lower-volatility element termed $ETH with a beta (β) value less than 1, and a higher-volatility counterpart known as leveraged $xETH with a beta (β) value greater than 1. By enforcing the constraint βf = 0.1, $fETH token captures a portion of the cryptocurrency market's growth while curbing volatility sufficiently to maintain stablecoin-like attributes.
However, there are discussions among the community about creating a separate stablecoin that is pegged to USD as it can be an efficient way to attract capital.
Even though the current market cap of the protocol is around $8m and $fETH’s market cap is around $4m, I am sure that this model has the potential to replace CDP models for several reasons:
Capital efficiency: Unlike the traditional CDP model where over collateral is locked, the model releases the liquidity of the excess collateral into the market as a byproduct $xETH. In the case of CDPs, as over-collateralization is required, 1.5 $ETH can generate a corresponding amount of stablecoins equivalent to 1 ETH. In the f(x) model, 1.3 $ETH can create $fETH valued at 1 ETH and xETH valued at 0.3 $ETH. This approach has significantly improved capital efficiency.
Scalability: Compared to CDP models, the protocol depends on the demand for the stablecoin, not on the demand for CDP.
ETH-powered: As an Ethereum native stablecoin, while the protocol is empowered by the general Ethereum ecosystem, it is also empowering the Ethereum and its LST ecosystem.
Unlocking ETH LST liquidity: The protocol allows $ETH LSTs such as $stETH to be effectively utilized for further financial activity which was not possible before.
No exposure to the macroeconomy: $fETH is a decentralized stablecoin that has no exposure to TradFi and is an Ethereum native stablecoin that is anchored by the $ETH economy.
Yield-bearing: $fETH is a yield-bearing stablecoin that can generate native LST yield for the depositors in the Rebalance Pool.
Peg stability: Even if the protocol fails, $fETH will be pegged to $ETH so that users won’t lose their investments
No borrowing cost: Compared to CDP models, users do not borrow stablecoin, so there is no borrowing cost.
No liquidation risk of the collateral: As the users do not open a collateralized debt position for $fETH, there is no liquidation risk for the collateral.
However, there is a major concern for the future of the protocol:
‘’Will there be enough demand for $xETH that allow the scalability of $fETH, especially during the bear market?’’
Until now, we haven’t seen any problem regarding the demand for $xETH against $fETH, however, time will give the best answer considering that the market cap of the protocol is still very small
The Future
Crypto-backed stablecoins are in an identity crisis. They are not able to serve thousands of people, but a small minority because of the inherent problems of CDP models. As a result, the market cap of major crypto-backed stablecoins is stagnant or bleeding gradually.
To survive, some protocols like $DAI and $FRAX completely abandoned the possibility of decentralization and went all in for the RWAs. Their promise of decentralization and censorship resistance is totally marketing buzz.
However, even though these protocols have breathing room for a short time, it is not clear what will happen when the US treasury bill rates go down.
On the other hand, current crypto-backed stablecoins need to develop new models and find new yield sources. Several problems need to be tackled:
scalability
capital efficiency
lack of yield sources
Surely there are more problems but I believe that if crypto-backed stablecoins can’t solve these problems while staying decentralized, we can assume that we won’t see any major decentralized crypto-backed stablecoin in the next bull cycle.
So, we should think about whether is there any chance of being both scalable and decentralized. Until now, we can easily say that the answer is ‘’NO’’. However, as the f(x) Protocol shows, there is a chance that LSTfi and financial engineering can help us to develop new solutions to tackle this problem. Moreover, UXD Protocol proved that new yield sources can be found in the on-chain ecosystem.
Decentralized crypto-backed stablecoins can still survive, however, they need to develop new solutions to this identity crisis.