Can On-Chain Stablecoins Break Through A Fiat-Dominated Market

A review of the more innovative on-chain stablecoin space


by Chris Powers

Last month, we looked at the largest (fiat-backed) players in the stablecoin market and the hazy regulatory scrutiny they’re trying to navigate. It’s becoming increasingly clear that these issuers are at the relative mercy of US regulators. Indeed, just shortly after our post, the third-largest stablecoin (BUSD) received a possible death sentence from the SEC and NYDFS because of unbacked BUSD on the BNB Chain. This month, we explore a different class of stablecoins; ones that are much smaller and somewhat less stable. Yet crucially, because they’re trying to operate on-chain and outside of the TradFi infrastructure and regulatory constraints that fiat-backed stablecoins face, they have the most potential to unlock new credit innovations and efficiencies. 

It’s no surprise that money creation was one of the first financial experiments on blockchains. Tokens on a blockchain that represent a US dollar are in theory useful for payments, but the market for this never really took off. Instead, the first real use case for such tokens was the same thing that underpins most crypto headlines: speculation.

Traders looking to increase their crypto exposure through leverage powered the first synthetic dollar-pegged stablecoin (Dai), with over-collateralized on-chain loans backing it through a complex system of smart contracts and oracles. Since then, there have been many attempts to create more efficient designs, with less and less collateral backing.

This was taken to its logical extreme with algorithmic stablecoins like Terra, or (who remembers?) Empty Set Dollar and the associated series of zero-collateral death spirals in January 2021. These failures turned many sour on innovative stablecoin designs, but the ability to print money is so enticing that new ventures are always going to emerge. And with many of the latest innovations coming from DeFi veterans, there should be stronger conviction regarding their future success. Yet will any of them be able to challenge the large fiat-backed stablecoins? To attempt an answer to this hypothetical question, let’s take a look at the most prominent players on this side of the market.     

MakerDAO: Flying too close to the sun

The OG decentralized stablecoin spent from 2020 through most of 2022 centralizing its reliance on USDC, some now dubbing it “wrapped USDC”. It spent that time soul searching with its founder Rune Christenson penning its Endgame Plan, which aims to move MakerDAO away from its reliance on the US dollar and into an truly independent and stable store of value.

The Endgame Plan was poorly received. The underlying conundrum MakerDAO finds itself in is one that every creator of a new, innovative stablecoin will eventually run into: how to scale and grow supply relying exclusively on on-chain assets and enforcement mechanisms. MakerDAO grew and grew in 2021 and 2022, but that growth came at a cost: it’s now nearly 60% backed by fiat stablecoins.

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This highlights an inconvenient truth: there is more demand for stablecoins on-chain than there is on-chain collateral to back it. For now, at least. But since Rune talks about Maker on a century-long timeline, it would be wise to slow Dai’s ascent to match with the current asset base of blockchains. 

Looking ahead, while MakerDAO is pushing forward with strategic initiatives like raising the Dai Savings Rate (DSR) to 1% and forking Aave v3’s front-end (Spark Protocol) to strengthen its position, it seems to have become a victim of its own success. It’s simultaneously in both decentralization and growth mode: the latest example being allowing Dai to be minted with MKR collateral. It is going all-in on regulatory arbitrage, but also betting big on real world assets (RWAs) that are very easy to regulate.

Aave’s GHO: It’s all about the network

MakerDAO has long been focused on getting Dai into the upper echelons of liquid stablecoins, but it increasingly looks like it will have to defend turf against fellow DeFi OGs Aave and Curve, which have imminent plans to launch stablecoins of their own.

The rumors surrounding secondary lending platforms like Aave and their plans to launch stablecoins have been around for some time. These lending protocols already have the key piece of infrastructure needed to launch a stablecoin: the ability to quickly liquidate an underwater position. Lending protocols want their own stablecoins for the same reason that centralized exchanges have their own preferred stablecoin: to create lock-ins to their ecosystem.

Aave’s GHO stablecoin is quickly approaching launch, deploying on test net two weeks ago. It doesn’t offer anything new in terms of design; its success will hinge on the ability to capitalize on Aave’s network effects. Aave has already out-competed Compound in this sense, by deploying to more networks and listing more assets. Attracting more on-chain borrowing demand is a tall task, but Aave has been leading the way in DeFi on this front for several years. Much like a bank with wide distribution, Aave will try and leverage its existing lending footprint to upsell to GHO. How it deals with peg enforcement and manages its reliance on fiat-backed stablecoins is another issue altogether.

crvUSD and Gyroscope: Innovating core design

In developing its stablecoin-launch plans, Curve’s stable swap pools have been critical in unlocking liquidity by pairing them with other stablecoins. Like Aave, Curve will soon launch a stablecoin (crvUSD) to enhance its ecosystem. But unlike Aave, crvUSD will be based on a new, innovative design where liquidations are replaced with a special purpose AMM. One way to make collateral more efficient is by earning fees off of it through liquidity provisioning, and indeed crvUSD will be backed by collateral that is also market making on ETH and USD. 

crvUSD’s whitepaper is heavy on the math and on the hand-waving, but it does showcase a new stablecoin design that could prove a breakthrough in efficiency and in attracting new on-chain borrowing demand. The question of whether this design works out for Curve should be answered imminently; crvUSD cleared an important governance milestone last week, and could be live in the next few weeks.

Gyroscope is another new stablecoin soon to launch on Ethereum with an innovative design. It aims to limit reliance on single oracle feeds for prices by meta-aggregating and indexing them. It also introduces an updated version of Maker’s Peg Stability Module that would attempt to prevent the Gyroscope stablecoin (GYD) from getting co-opted by a centralized stablecoin in its search for peg stability (what happened to Maker). Gyroscope is live on Polygon and preparing for a mainnet launch. 

Frax: A one-stop shop for DeFi

Perhaps no DeFi project has had a better past year than Frax. After successfully bootstrapping itself in 2021 through some ponzi-nomics, it built on key partnerships to integrate Frax around DeFi. 

Frax is developing more than just a stablecoin, but rather an ecosystem of different financial products and services. Most recently, it launched one of the most successful ETH liquid staking derivatives ever (LSD). Frax has the same issue as MakerDAO in terms of dependence on the centralized USDC for backing, but its smaller size means it will be easier to wean itself off. We’re optimistic about Frax because the success of any stablecoin will ultimately come down to having a huge swath of users looking to take on debt in that stablecoin, and Frax has demonstrated its ability to grow market share in more than one product vertical.

Frax started as a partially-backed algorithmic stablecoin, but is now moving to be fully-backed, with a signal vote passing this week. This will inspire more confidence in Frax but also means it will be harder to scale as it runs into a similar set of problems as Maker and Dai.

LUSD & RAI: Resisting the centralized-collateral temptation 

Many DeFi die-hards and ETH maximalists long for single-collateral Dai, which was previously backed entirely by ETH – the purest asset known to humanity. Liquity’s LUSD and Reflexer’s Rai are the only ETH-only stablecoins still standing. We covered Rai’s attempt to become a non-USD stablecoin in the summer of 2021. Ultimately, it failed to generate enough demand for its stablecoin and its “un-governance” design prevented any changes to the core protocol. Ameem Solemani, one of Rai’s co-founders has done a mea culpa, explaining that ETH is not great collateral in a world of liquid staking derivatives (LSD), which have the same fungibility but come with built-in yield. Staked ETH may soon become the most popular collateral on Ethereum. 

That may be a problem for Liquity’s LUSD, which is backed entirely by ETH and boasts a low collateralization ratio (110%) as well as a no-interest-rate structure and an avenue for LUSD holders to earn yield through liquidations. It has stayed stubbornly above $1.00 for the last six months, but is finally inching its way down, in part due to chicken bonds. While some now tout the ETH-only collateral, will Liquity stay competitive if borrowers prefer ETH with a yield a la LSDs?

It’s important to remember the difference in size. Liquity’s is currently $600m, Rai maxed out at $100m. Frax is at $1bn and Dai at $5bn. All of these combined still only represent 15% of the size of USDC, and even less of a proportion of USDT. While printing your own money on-chain will forever be enticing and profitable for an ecosystem building lending products, fiat-backed stablecoins remain the only way to meet the insatiable demand for dollars on the blockchain.

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